Once reserved for large institutional investors, private markets are becoming increasingly accessible.
They are important because they can provide alternative sources of return to investors, can be used to diversify a portfolio as they are often less correlated to traditional asset classes and tend to be less volatile than publicly traded assets.
While the nature of transactions can be complex, the terminology need not be. Here, we demystify ten essential terms for investors to learn about private markets.
1. Private assets: Investments that are not listed or traded on a stock exchange.
Basically, there is capital investmentwhich is an equity interest in an unlisted/non-public company, and private debtwhich is a loan held by or granted to a private company.
Private equity investors hope that by investing in a private company they can make it more valuable – by improving efficiency for example – and sell their stake at a later stage.
Meanwhile, private debt tends to be issued to companies or assets that need more flexible financing terms than those offered to them by banks.
Other types of private assets include infrastructure and real estate.
2. Venture Capital (VC): A private equity strategy that provides minority funding to fast-growing start-ups in exchange for an equity stake.
Within a portfolio of companies backed by venture capital, it is generally assumed that most of the returns will come from a few successful companies.
3. Growth Equity: Another private equity strategy, in which investors finance a fast-growing, but more mature company with significant additional growth potential, in exchange for a minority stake in the company.
4. Buyout with leverage: Acquisitions of majority/controlling stakes in an established company using debt to finance the transaction (LBO).
5. General Partners vs Limited Partners of a Private Equity Fund: General Partners (GPs) are investment professionals responsible for managing the fund. They usually commit a smaller initial sum to set up the fund, have unlimited liability and usually receive a management fee – a certain proportion of the fund’s invested capital.
Limited partners (LP) are the outside investors who provide the capital for private investments. Their liability is limited to the amount they have invested. GPs often work with GPs with whom they have an established relationship.
6. Closed fund vs. open fund: A closed end fund is the most traditional structure for private market funds. They have a fixed term, which is usually 10 to 15 years or more, to raise, invest, earn and distribute capital.
In contrast, an open-end fund has no set life, so it can continue to operate, raise, invest, earn, and distribute capital until it is actively closed. Investors are not locked in for the life of the fund – they can liquidate their holdings during a “liquidity window”.
7. Liquid, semi-liquid and illiquid: While private markets are generally considered illiquid (meaning you can’t easily buy or sell your investments), funds can provide varying degrees of liquidity.
A liquid open-end fund is a rare beast in private markets. One of the main issues is that managers would have to hold high levels of cash to meet liquidity needs, which could hurt performance.
Semi-liquid open-end funds have monthly or quarterly subscription and redemption cycles. They often use tools such as redemption limits or the ability to suspend subscriptions and redemptions so that the manager can better control the liquidity within the fund.
Semi-liquid closed-end funds have a set duration but offer periodic windows of liquidity for a managed secondary market.
Closed-end funds are illiquid, but holdings in these funds can be sold by investors (limited partners) in the secondary market.
8. Capital calls: Investors in closed-end private asset funds tend to provide capital as needed. A call for funds occurs when a fund manager asks fund investors to provide capital in order to make investments and meet fund obligations such as expenses and fees. A capital call is usually made formally in writing.
9. Bonuses – complexity vs illiquidity: Private assets typically have holding periods of several years or more. Illiquidity is often seen as a disadvantage compared to liquid investments; therefore, the private investor expects to be compensated by a performance premium for his illiquid investment.
The complexity premium is the excess return that can be captured in private assets when scarce skills are deployed to manage a complex investment. The nature of the complexity bonus differs by asset type, but unique skills and complexity must be present for it to emerge.
10. ELTIF/LTAF: Regulatory changes make private markets more accessible for sophisticated or ultra-high net worth retail investments. Examples of new regulations in Europe include the European Long Term Investment Fund (“ELTIF”) and in the UK the future Long Term Asset Fund (“LTAF”). An ELTIF is a closed-end fund that invests in long-term projects and small and medium-sized European companies. An ELTIF aims to invest in the real economy with projects intended to help recovery from the pandemic. The fund could also offer the possibility of co-investment. A co-investment is when an investor takes a minority stake in a company alongside the private equity managers. Typically, a co-investment has lower fees and allows investors to invest in specific companies rather than the traditional 10-year blind pool vehicle.
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