The Boom in Private Markets Has Transformed Finance. Here’s How
1. What are private markets?
It’s a term given to the ecosystem of investors — private-equity firms, venture capitalists, institutional investors, hedge funds, direct lenders and fund managers — and the companies seeking to sell shares or borrow large sums. They’re newly important but not new: It’s the way J.P. Morgan, the quintessential private banker, worked in shaping the US steel industry. In the decades after World War II, such dealmakers were overshadowed by the buildup of robust public venues, such as the New York Stock Exchange and the Nasdaq, which helped make equities widely held among Americans, while traditional banks were the main source for loans.
A new phase began with the leveraged-buyout boom of the 1980s, as innovations in the bond market made it possible for so-called takeover firms to purchase far larger publicly traded companies. As the field grew into what’s now known as private equity (PE), some of the most prominent firms, including Blackstone Inc. and KKR & Co., branched out into buying real estate, financing infrastructure and lending to companies. Some even take stakes in hedge funds and sports teams. A plethora of money seeking high-yielding investments fueled the growth of “unicorns;’ closely held startups valued at more than $1 billion, almost a decade ago. What’s become known as private credit took off when investment firms with piles of money stepped into a void left when banks retreated from middle-market or other kinds of risky lending.
•3. How big are private markets?
Assets in global private markets totaled $10 trillion in September 2021, nearly five times as much as in 2007, according to Preqin, a financial data provider. Public markets are still far bigger but have grown more slowly, roughly doubling in the same period. In the US, companies that have stayed private have raised more money than those whose securities trade in public markets every year since 2009, according to a Morgan Stanley 2020 report. In debt markets, private credit represents a fraction of the financing provided by banks or publicly traded bonds but doubled globally over the last five years to $1.2 trillion.
4. What’s driving this?
For investors, private markets have offered the prospect of high yields during a period of historically low interest rates. Pension funds, endowments and large asset managers have become comfortable with a range of investments that includes direct lending as well as Silicon Valley tech ventures. For startups, staying private as they grow allows them to avoid regular disclosure requirements, investor calls and the threat of unwelcome activist shareholders breathing down their necks. For borrowers, working with private lenders can mean faster approval on better terms.
5. How is it playing out in equities?
New developments are changing the cast of characters and their goals:
• Hedge funds and mutual-fund managers have joined the gold rush. While PE firms still dominate the ranks of shareholders in closely held companies, other managers are reaching beyond public-market stock-and-bond picking to bet bigger on companies that have not yet had an IPO. Investments from hedge funds such as Tiger Global Management, Viking Global Investors LP, Coatue Management LLC and D1 Capital Partners LP have surged in recent years. Stockpicking funds run by Fidelity Investments and T. Rowe Price Group have also jumped into this corner of finance. Many deals in buzzy startups will be written down in coming months, a reflection of how the field isn’t immune to economic down swings.
• The “merely rich” are being invited in as well. Firms such as Blackstone are looking beyond the family offices of the very wealthy, pensions and big institutions and are aiming to get the cash of dentists, lawyers and the average millionaire. That is, to reach people who meet the US Security and Exchange Commission’s defini· tion of a “qualified” or “accredited” investor allowed to buy unregistered securities. They’re assembling sales teams to bring private-equity funds to this group, and to get the investments sold through wealth advisers at banks.
• Sticky money is gaining appeal. Private-equity firms historically raised pools of money that needed to wind down in about 10 years. This meant they faced strict deadlines to sell out of holdings and return cash to investors. Today, private-equity firms are setting up massive pools with no deadline to exit bets. The rise of such perpetual capital funds is transforming an industry once known for flipping companies to one more focused on delivering steady income. Shareholders of publicly listed private-equity firms such as Carlyle Group Inc. and Apollo Global Management Inc. prize perpetual capital because they lock up investor money — and produce fees — for the long haul.
6. How is private credit evolving?
Lenders are chasing bigger deals with new structures while setting old cautions aside:
• Historically, private-equity firms worked with banks to arrange financing for takeovers. The banks would underwrite junk bonds or leveraged loans and then sell the debt to a broad range of investors. Laws and regulations that followed the 2008 financial crisis prevented banks from helping private-equity firms take on levels of debt regarded as too steep. Institutional investors have jumped on the opportunities that created. Private credit initially focused on midsized or so-called middle-market companies, but the explosion of cash has meant many firms are now chasing larger deals that traditionally went to banks. SoftBank Group Corp., the venture capital giant, turned to Apollo for a $5.1 billion loan earlier this year. Another difference from bank lending: Private-credit firms typically hold loans to maturity.
• Central to the private credit story is the so-called unitranche. Syndicated bank loans can be enormously complex, with the debt carved into an array of tranches with different levels of risk and reward meant to attract a wide array of third-party lenders. The unitranche combines two separate loan facilities — one senior and one junior — into a single structure with a single blended rate that reflects the pricing of the two tranches, making for a simpler experience for the borrower. The benefit to the lender is that in the event of a bankruptcy, it’s the unitranche provider — usually either a sole direct lender or a so-called club of them — that is first in line for payments.
• In their haste to put ever-increasing amounts of money to work, many firms are forsaking key protections, known as covenants, such as those that give lenders the right to intervene in a company’s operations when cash flows used to make interest payments deteriorate. Private credit deals also face what’s known as liquidity risk: They’re not typically traded among investors, meaning that in a downturn firms could be stuck with loans that have turned sour. And a number of private-credit arms were launched by private-equity firms that often lend to their PE rivals. If a wave of bankruptcies emerge, it’s unclear whether such rivalries would stand in the way of an orderly resolution.
7. What does this mean for investors?
The growth of the private markets has largely shut out individuals other than the wealthy, though there’s a debate over whether that’s good or bad. Small investors are missing out on a chance to get in on the ground floor the way they could when a fledging Amazon.com Inc. or Google sold shares to the public. On the other hand, they’ve been less exposed to money pits like WeWork, which raised billions of dollars before a failed IPO. Managers of mutual funds face regulations around the maximum share of investments they can tie up in hard-to-trade holdings. US regulators under President Donald Trump made it clear that private equity could have a place in retirement accounts known as 401(k)s, though the Biden administration has pulled back on the idea. Corporate overseers of such plans worry about being dragged into lawsuits over whether that would violate rules requiring so-called fiduciaries to act solely in the best interest of their clients, since PE funds typically charge significantly more than traditional stock and bond funds, taking 2% of fees on assets managed and some 20% of investment returns.
8. What do regulators say?
Since its creation after the panic of 1929, the SEC’s primary tool for policing markets has been its rules for the disclosure of financial information. The rise of private markets means regulators and governments have less visibility into chunks of the economy. Private-equity firms are also regulated more lightly and face looser disclosure rules than money managers that cater to retail investors, leaving regulators with more blind spots concerning the risks buyout firms might pose. In response, the SEC has proposed rules requiring firms operating in private markets — whether in equity or credit — to provide more data and disclose fees clearly to investors. Other proposals would make it costly for them to take higher levels of risk.
• A Bloomberg News article on Blackstone raising a fund to seek investments by the “merely rich.”
• An article on the SEC’s push for new regulations for hedge funds and PE firms.
• Guidance issued by the US Department of Labor in 2020 on private-equity investments and retirement accounts and its clarification in 2021.
• A 2020 overview of the private credit market by the Alternative Credit Council.
• An article on default levels in private credit markets.
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