With investors increasingly struggling to generate substantial returns in the public markets and a growing constituency with private fundraising needs, all the ingredients are in place for continued private capital market growth.
The private capital markets are booming. Previously the preserve of a relatively niche set of players, these markets are increasingly attracting mainstream asset managers, pension funds, sovereign wealth funds, family offices and even high-net-worth individuals. Last year, there were more than 11,000 investment firms active in the private markets, a 5% increase compared with 2019 and 8% growth per year since 2015, according to McKinsey.
With the private capital sector now representing $7.3tn-worth of assets under management, it is debatable to what extent the label ‘alternative investments’ still applies. Certainly there are few signs of growth slowing down.
Looking for growth
At a basic level, this is a story about better investment returns. With interest rates remaining at record lows and stock markets, particularly in the US, trading at all-time highs, achieving returns in the public markets is perceived to be increasingly tough.
We’re seeing a lot of appetite [for private markets]. We don’t see that changing in the next couple of years
Borja Azpilicueta, global head of private capital group at HSBC, observes that in the private markets “you have access to very specific strategies, which can create value in a way that is decoupled from what is happening in the public markets”.
“In the current market,” he adds, “public instruments can only offer so much.”
While the public markets experienced considerable market volatility in 2020, another attractive feature of the private markets is that they are more shielded from such effects. Market participants speak of the pandemic as a stress test in which the private markets proved their resilience, and this has only further increased their appeal.
Value creation
One specific area that has won much attention has been the growth capital space, i.e. capital for mid- to late-stage private companies to finance their expansion. “A lot of investors have woken up to the value creation in the mid- to late-stage private markets, which has, in many sectors, exceeded the returns people have been able to achieve in the public markets,” says Stephen Bloom, head of Americas private capital markets at Bank of America.
There is a clear sense that the innovation economy, compared with established public firms, is where value is being generated. As Jason Hutchings, Europe, the Middle East and Africa head of private financing markets at UBS, observes, investors active in these markets see the opportunities for growth as being “around companies that are doing something disruptive and differentiated to the norm”.
Georg Wunderlin, Schroders Capital
This is a trend that has intensified in a post-Covid-19 context, along with the growing sustainability agenda, and there is a sense that many sectors need to adapt in order to remain relevant and viable in the long term.
“People might think of the private markets largely in terms of the pure-play technology industry, but it is a really broad swathe of sectors that are able to attract this type of capital,” says Mr Bloom. “There has been a tremendous amount raised by companies that are taking a disruptive approach to more traditional industries. So, things like proptech in the real estate industry, fintech and businesses engaged in energy transition and clean energy.”
In another part of the market, Mr Azpilicueta highlights the investment opportunity posed by major infrastructure programmes. “On the infrastructure investment side, there is a large allocation of capital required for some of the big post-Covid initiatives,” he says. “For instance, digital infrastructure or social infrastructure, such as retirement homes and hospitals. Private funds are going to play a significant role in funding these developments.”
Maturing sector
This is a market that is becoming easier to navigate. In the past, market participants spoke of a freewheeling scene, without established norms. Now, as the market has matured, with a greater number of investors active as well as firms seeking capital, a higher level of structure has developed.
Georg Wunderlin, global head of Schroders Capital at multinational asset manager Schroders (which recently launched the Schroders Capital brand to bring together its previously separate private capital assets capabilities), says the industry “has become more standardised and industrialised, and has therefore become investable on a much larger scale for institutional and individual investors”.
The increase in investment interest in private capital markets has also led to firms that are seeking funds being in the enviable position of having much greater choice beyond traditional venture capital and private equity players.
“The broader investor base has enabled companies to optimise what they’re looking for from an investor partner in these processes,” says Mr Bloom. “We spend a lot of time helping companies to think about what an optimal partner looks like for their business, whether that relates to an investor’s industry experience, the other companies they may have in their portfolio, or even whether there are some operational synergies. They could also be looking for a partner that is happy with a more passive and longer-dated investment. These are all options.”
At the same time, the greater number of firms looking for funds means they too are facing stiffer competition. “As more companies look to raise capital, it becomes more important to be able to differentiate yourself, to have a strong story and be able to talk to the right investors,” says Mr Hutchings. “And in a sense the process does become more like doing an initial public offering (IPO), especially considering the sums being raised are increasing and there will be greater competition for dollars. So I expect there will be a shift towards engaging with investment banks and other advisors for capital raising in the private markets.”
For Sonya Iovieno, head of venture and growth banking at Silicon Valley Bank’s (SVB’s) UK branch, there is now additional complexity for firms to navigate. “There is much more education in the market and the investment community about what ‘good’ looks like. So, as a founder, you need to be really laser-focused on your metrics and what the competition is doing at a very early stage, probably much earlier than five or 10 years ago.”
However, she also believes this is balanced by a greater level of experience within the sector, in which it is much more common to see serial entrepreneurs, as well as highly experienced finance teams.
For Ms Iovieno, one of the most exciting aspects about this space is the speed and scale of change in the funding environment, where she says, “it’s becoming common for institutions to set up growth funds and get involved much earlier in companies’ lifecycles” than they would have in the past. Increasingly, she observes, “we’re seeing more established start-ups buy early stage start-ups, and that’s something that private equity and other bigger players need to look at, because there is increased competition.”
Need to go public?
The vitality of the private capital markets also continues to fuel questions about the role, if any, of going public for many firms. In the past, one major attraction of an IPO was that it would provide access to a large pool of investors. This incentive is now far less potent given that capital is readily available in the private markets, without the disclosure requirements and other demands associated with being a public company. Some bankers privately concede they are now more reticent than in the past about recommending clients to IPO.
Mr Bloom, however, is philosophical about the changing market dynamics. “I don’t see private markets as competition to the public markets,” he says, “I think the real difference now is that companies can be more thoughtful about when the right time to go public is, and how to maximise the value of doing it.”
Secondary market liquidity
Elsewhere in the market, the twin dynamics of many companies opting to remain private for longer and investor clamour for investment opportunities has created demand to increase liquidity in the secondary private markets.
In July, Nasdaq announced it would be spinning out its Nasdaq Private Market platform, with financial backing from SVB, Citi, Goldman Sachs and Morgan Stanley, to create a new platform for trading private company shares.
Facilitating organised liquidity has been a significant trend in recent years
It presented the venture as “a more transparent and efficient offering for private companies, their employees and investors looking for access to private assets”, particularly in relation to making it easier for staff of private companies to trade their shares before a company is public. The private markets at present remain a very brokered space, in which it is difficult for individuals to operate.
Brian Schaeffer is managing director at InvestX, a firm that facilitates access to the private equity markets, which in February this year launched its own online trading platform, GEM, which enables broker-dealers to trade in what it labels as “pre-IPO giants” (firms with a $1bn plus valuation). “There is a clear and undeniable trend that companies are staying private for longer,” he says. “[Today] we have companies like Impossible Foods that are not yet public with valuations in excess of $10bn. The markets need to adjust to this new paradigm, and technological solutions like InvestX GEM enable that to happen.”
While trading in the public equity markets is now highly electronified, the current situation in the private markets is at the other extreme. However, Mr Schaeffer expects big changes. “Trading in the private markets remains very antiquated, incredibly tough and with almost zero electronification,” he says. “We’re very bullish, given the factors pushing growth in these markets, about the private markets becoming much more electronified.”
Broader market access
The creation of such platforms is seen by some as part of a wider process of increasing the efficiency and accessibility of these markets, which remain off limits to most individual investors either due to financial sophistication and net worth regulations in different jurisdictions or the practicalities of accessing these markets, even for those who do qualify. Adam Fleisher, a partner at Cleary Gottlieb, focuses on the capital markets. “It has been challenging to create fully liquid private exchanges in the past because companies typically want to retain some control of who is in the cap table,” he says. “However, facilitating organised liquidity has been a significant trend in recent years.”
In relation to the US markets, Mr Schaeffer believes there is “a groundswell” within the industry for there to be broader investor access and suggests that “the US Securities and Exchange Commission is also paying quite a bit of attention to this, in terms of potentially redefining what an accredited investor is”.
Adam Fleisher, Cleary Gottlieb
Indeed, in December 2020, new rules came into force broadening the definition of an accredited investor (AI) to include investors that can demonstrate their financial knowledge based on certain qualifications (more in line with the rules in other jurisdictions such as the UK and the EU). Although it is debatable to what extent that rule change has broadened access. Mr Fleisher says: “It’s unlikely to change things dramatically. Many people likely would have qualified under the old definition, but it of course will increase the number of AIs at the margin.”
It remains to be seen whether further rule changes are coming; some speculate it may not happen quickly due to partisan differences among the commissioners on this issue.
In the short term, at least, there is consensus that broadening investor access will largely continue to be facilitated via larger institutions. As Mr Wunderlin points out, there can be considerable practical hurdles for individuals. “It can be difficult to deal with the capital costs and also to deal with practical matters, such as if you are on holiday and you are sent a capital call, you would have to wire the money. It’s these kinds of issues that can make it difficult for individuals.” However, he points out that the asset management industry has been innovating to create products and structures suited to individual investors, such as semi-liquid funds, and a number of fintechs have entered this space, which connect investors and their advisors with private capital markets investment opportunities.
Pension fund allocations
But perhaps the biggest opportunity area is likely to be pension funds increasing allocations to private markets assets, an area with which historically they have not engaged. In the US last year, the Department of Labor issued guidance clarifying that private equity investments could be included in 401(k) plans (defined-contribution retirement accounts offered by many US employers), potentially encouraging greater allocations.
A number of large Canadian pension funds are already active in the private markets, and some pension funds in other jurisdictions have started to follow suit. For example, AustralianSuper, a pension fund that reportedly covers one in 10 of the Australian workforce, has indicated it intends to begin investment in private debt and infrastructure. In the UK, Nest, one of the country’s largest workplace pension funds, has indicated it intends to increase allocations in private market assets.
Although, so far, allocation levels generally remain modest, they are expected to rise. “There is still a lot of growth to happen,” Mr Azpilicueta says. “We have seen increasingly large allocations from some of the bigger capital allocators, such as pension funds and sovereign wealth funds. It is still a relatively small share of their overall portfolio. But we expect to see allocations continue to increase over the coming years.”
This view is echoed by Mr Wunderlin, who also expects pension fund allocations to increase and, more broadly, expects to see the value of the private markets almost double over the next seven to 10 years. “We’re seeing a lot of appetite,” he says. “We don’t see that changing in the next couple of years.”
