Private markets: a primer

BIS Quarterly Review  |  December 2021  | 
06 December 2021

This box outlines the structural features of private markets. First, it highlights some key details of the main investment vehicles. Second, it reviews leverage sources. Third, it sketches the alignment of incentives between fund managers and investors. Fourth, it reviews the specialisations of the funds through which alternative asset managers (AAMs) provide corporate financing in private markets.icon

Closed-end funds are the most prevalent investment vehicles in private markets. These funds issue a fixed number of shares that cannot be redeemed before a scheduled wind-down, whose exact timing is decided largely by the fund managers. As such, liquidity transformation is limited in private markets. In many cases, shares rarely trade and are accessible only to large institutional investors. In others, they are listed on exchanges and can be traded by retail investors, which attracts more rigorous regulation. This is the case of US business development companies (BDCs), a vehicle commonly used to channel private loans, which have disclosure requirements similar to those of mutual funds.

There are three sources of leverage in private markets. The first is the often substantial debt of the target companies, taken to fund the asset acquisition and leverage up investment returns. The second is the debt that funds themselves may incur. For instance, BDCs can take debt equal to twice their net assets, compared with half of net assets for US mutual funds. The third comes in the form of "subscription credit lines" (SCLs), loans collateralised by capital that is committed by investors but not yet disbursed. This "dry powder" of the funds is periodically paid in by committed investors at the request of the fund manager, in so-called capital calls. SCLs are used to reduce the frequency of capital calls while retaining investment flexibility.

Alignment of incentives between investors and AAMs is promoted through co-investment. Fund managers are known as "general partners" (GPs). They take all decisions, from capital deployment to winding down the fund. They are also responsible for arranging the financing of the transaction, and undertake all the legal and business due diligence, whose costs and complexity are usually large. Besides receiving fees for portfolio management, GPs also typically co-invest their own capital in the funds they manage. Thus, the investors with no management rights (the "limited partners" or LPs) have some reassurance that the GPs' incentives are aligned with their own. The funds, however, remain legally separated from the GPs' balance sheet.

Recently, some large investors have also started to co-invest in specific projects with AAMs without committing capital to funds. These investors could be pension funds or insurance companies, or sometimes large corporations that set up in-house divisions to manage their own portfolio of private assets. Co-investment allows them to share in the returns of private capital investments without incurring the cost of fund management fees. In exchange, they assume a less diversified investment risk.

Broadly speaking, private markets consist of four business segments: private equity, venture capital, private credit and real assets, as presented below.

Private equity (PE), focused mostly on restructuring mature firms, sprung to life in the United States in the 1970s. The main business of PE firms is leveraged buyouts (LBOs), in which they acquire controlling stakes in firms, including listed companies, with the purpose of improving efficiency and raising enterprise value. LBOs belong to the category of mergers and acquisitions, making substantial use of debt in financing deals. In a typical LBO sponsored by a PE fund, a specially created shell company acquires the target company using mostly syndicated loans from banks and institutional investors but also equity from the PE fund. Subsequent issuance of high-yield corporate bonds by the acquired company repays part of the loans. Given the large amounts of debt involved, and the correspondingly high debt service costs, PE funds favour established companies with resilient cash flows and they become involved in managing the target company to facilitate restructuring. More recently, PE funds have also branched out into growth capital investment, taking minority equity stakes in mature firms and betting on their growth, as well as in turnaround majority investment in severely underperforming firms, and mezzanine lending to distressed firms, where the debt is convertible to common stock.

Modern venture capital (VC) traces its roots to the post-war United States. Previously, wealthy families were the main source of equity capital for start-up companies, in a similar way to today's "angel investors", who take limited stakes and refrain from day-to-day management. In contrast, VC investors are usually more proactive, partly because target companies have high growth potential but also elevated risks and few assets usable as collateral. Hence, close monitoring is key to investment performance. VC fund managers usually provide business expertise to the management of start-up companies, and further add value by providing access to a wide network of business relationships. Given this expertise, and the possibility of providing funding against little or no collateral, VC firms have traditionally focused on sectors with intangible assets, such as technology. As with private equity, venture capital funds aim to realise gains by selling their stakes to other private market investors in so-called secondary buyouts, or by listing target companies in public stock markets through initial public offerings.

Private credit refers to debt financing extended to small firms with a relatively high default risk. This sector grew as banks recalibrated their business models, partly in pursuit of operational efficiencies. Indeed, banks' direct involvement in this area is typically limited, even in credit origination. Most linkages between banks and private credit take the form of SCLs. BDCs provide a common entry point for retail investors. These entities hold mainly loans and other debt.icon

Finally, a significant share of AAMs' funds focus on investment in real assets such as infrastructure, real estate, commodities and natural resources. These private funds are also organised as closed-end vehicles aimed at large institutional investors, unlike real estate investment trusts (REITs) that also tend to be closed-end but target retail investors and trade on public stock markets.

icon The views expressed in this box are those of the authors and do not necessarily reflect those of the BIS. icon Also see Aramonte (2020).

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