Dive deeper into private market investment types, the opportunities they offer, and how they stand to change with the introduction of digital asset securities.
When you hear the word “investment”, most people think of shares that you might trade on a public stock exchange. Yet the past few years have seen a rapid rise in the amount invested in private markets.
PwC estimates that assets under management in private markets will expand to a total of $13.7-$15 trillion by 2025, or 10% of total global assets under management.
This post expands on our explainer on public markets vs. private markets to dive deeper into private market investment types, the opportunities they offer, and how they stand to change with the introduction of digital asset securities.
Capital markets can be either public markets or private markets. Public markets are where investments are publicly traded, such as shares on a public stock exchange like the NYSE.
Private markets are where investments are traded and exchanged non-publicly. Private market investments tend to feature more alternative asset classes such as private equity, private debt, and real estate.
Like public markets, private markets can be a useful tool for companies to raise capital and secure the necessary funding or mentoring they need to grow.
Since private markets are, well, private, they are less widely known than public markets and less accessible for investors. Most operate largely informally; it’s not uncommon for the majority of business to take place at the conference table.
Common types of private market investments include private equity, private debt, and real estate.
Private equity is when investors make equity investments that are not traded publicly. Private equity is a common way for companies to raise vital capital or grow their business.
Private equity investments can be classified as venture capital, growth equity, and buyout.
Both venture capital and growth equity are forms of investment where investors finance companies in exchange for minority equity. In venture capital, investors finance early-stage companies and startups with high-growth potential; in growth equity, investors finance late-stage companies gearing up for expansion.
Unlike venture capital and growth equity, buyout features investors purchasing majority or controlling equity in a company. A buyout is typically used to take mature, public companies private in order to make internal improvements and turn the business around.
In contrast to public equity investments which are traded frequently and priced daily, private equity investments are typically held for years and priced quarterly or during a financing round.
Private debt is when investors lend money directly to borrowers outside of the public market.
While most private debt is financed by large private entities (think banks, hedge funds, and private equity firms), personal loans from friends and family count as private debt too.
Private debt can be a useful financing alternative for individuals and companies when traditional forms of debt such as a bank loan are inaccessible.
Since private debt is not backed by the faith and credit of the government, it can be a riskier investment than publicly traded government bonds–although it can also offer higher returns.
Real estate investments are tangible assets consisting of land and buildings. Real estate investing is a popular form of investing as it can provide regular income, inflation protection, and capital appreciation.
For example, real estate investments may be income-producing properties, with investors buying a real estate asset (e.g. a residential property) to lease it. Or, investors may target capital appreciation and buy a real estate asset to upgrade it and later sell it at a profit.
Not all real estate investments are private; it’s also possible to invest in publicly-traded real estate investment funds (REITs). However, real estate in private markets is less correlated with public equity and can be a useful investment to diversify one’s portfolio and hedge against market volatility.
Later on we’ll discuss how tokenization has the potential to transform private markets. This is especially pertinent for real estate assets.
Outside of REITs, real estate has traditionally only been affordable to ultra-wealthy individuals, institutional investors, and large companies. Moreover, transactions have been plagued by difficulty: they require a ton of paperwork, manual processes, high costs, and time.
Real estate tokenization brings a much more streamlined and effective way to trade in real estate investments and can also bring transparency to the traditionally opaque industry. Through fractionalization, tokenization can also bring liquidity by reducing the minimum capital investment requirement, increasing the speed of transactions, and widening investor pools.
To learn more about the specifics behind tokenization for real estate, check out these blog posts:
Private market investments can be beneficial inclusions to long-term portfolios because they tend to bring high returns that can help investors overcome low-growth, low-return environments. The trade-off is that the private market is an illiquid market, so private investments carry with them increased risk.
Historically, private equity, private debt, and private real estate investments have outperformed their public market equivalents. This is believed to be because of the illiquidity risk premium.
The most common concern with private investments is that a private market is an illiquid market– private market investments tend to be hard for investors to sell or exchange for cash.
Take equity as an example. Public equity can be easily traded by investors at any time on a public stock exchange where it’s listed. In contrast, private equity tends to be held by investors for years.
Because public equity is easily tradeable or liquid, its price is volatile and usually corresponds to shareholder activity. If a large number of shareholders sell their shares, the value of an investor’s share is likely to fall.
In private equity, there are fewer investors and investments are viewed as longer-term. Investors can usually afford to wait for the optimal time to sell their shares or wait for a liquidity event.
This is the core of the illiquidity risk premium: the idea that private markets return better than public markets even though investors bear more risk investing in an asset that cannot be easily traded.
It must be noted that this doesn’t mean public markets always outperform or return more meaningfully than private markets. Factors like active management, access to deal flow, and access to information play a critical role in an investor’s ability to make a profitable investment.
Private markets have been experiencing exponential growth over the past few decades.
This is especially true for private debt after the 2008 global financial crisis; the value of private debt funds has almost tripled globally since 2010.
After the recession in 2008, banks became required to fulfill minimum capital requirements and leverage ratios. The capital adequacy ratio – the ratio of a bank’s capital in relation to risk-weighted assets and liabilities – is helpful to prevent banks from taking excess leverage leading to insolvency, but introduces restrictions to bank lending. Private debt is an attractive alternative for individuals or companies unable to find financing from banks.
For investors, private debt pays a premium over bank interest, especially when lending over the medium- or long-term. While it carries a high amount of risk – especially if the borrower has poor credit – private lending can provide higher returns because the lender is able to impose steeper interest rates. This is the illiquidity risk premium at work again.
The potential for superior rewards from private assets attracts investors who are looking to diversify and balance their portfolio with investments that carry less day-to-day market volatility.
The tendency of private markets to outperform public markets makes them attractive investments in uncertain times as they show resilience through short-term market downturns. In fact, private market buyout and private credit never had negative returns over any five-year period from 1995-2020.
One of the most popular private asset classes is private equity. Even in a tough economic environment, institutional investors favor private equity; a survey by State Street found that 63% plan to make it their largest allocation in the next two to three years. It makes sense that issuers and investors are drawn to private equity for acquisition, business transformation, and exit.
Issuers can leverage the illiquidity of private markets to their benefit as it means private equity investments will be held for longer than public equity, and as a result, company owners will have a longer time involvement. This lack of frequent change of ownership can be helpful to plan for longer-time horizons. Private company boards also tend to be more engaged and involved in the company operations, which can lead to higher value creation– and ultimately, the potential for higher returns.
For investors, private equity is attractive because it provides exposure to the total universe of investable assets throughout all stages of a company’s lifecycle. Investors who only invest in public markets miss out many opportunities for portfolio diversification and excess-return.
For example, private equity gives investors a chance to participate in sectors of the economy that are hard to reach in public markets. Listed infrastructure tends to concentrate in utilities, power generation, oil, and gas. Unlisted infrastructure brings many more opportunities and exposure to new types of industries, including renewables, social infrastructure, and data infrastructure.
Finally, inventors are turning to private equity because companies are choosing not to list publicly and instead wait until they become more established to exit. This is particularly true for very disruptive technologies and Silicon Valley unicorns. Just look at Uber, Airbnb, and Spotify: all waited ten years or more before launching an IPO.
In 1999, the median age of companies at IPO was 5 years; in 2021, it was 11. This prevents public market investors from benefiting off of 6 years of growth in some of the most exciting companies.
In order to reap the benefits of investing in disruptive companies earlier, investors need to invest privately.
The investing landscape is set to change further with emerging technologies such as blockchain, which leverages decentralized ledger to bring proof-of-ownership and transparency to the issuance and trade of private market securities.
Here are the most significant examples of how blockchain will disrupt the private markets sector:
Blockchain enables the tokenization of assets – including private equity, private debt, and real estate – via security tokens, providing issuers with a new way to raise capital through exposure to a wider pool of investors. Tokenization also allows for fractionalization, which can create liquidity by splitting assets into fractional shares. Meanwhile, the secure and transparent network provides proof-of-ownership and transparency that can simplify asset management and investor relations.
Blockchain provides an immutable, transparent record of ownership and transaction history that can build trust between issuers and investors and make it easier for participants to comply with complex regulation.
With blockchain, many of the processes involved in private market investing – such as investor verification, KYC/AML, compliance checks, and settlement – can be automated, reducing reliance on intermediaries as well as associated costs and time. With near-instant settlement, private market transactions can be on par with the speed of public markets, making private investing more efficient and accessible.
The global nature of blockchain brings global access to private digital asset securities, providing issuers with a wider pool of investors and capital while enabling investors to diversify their portfolios with exposure to new opportunities in private markets.
If private markets can be elusive for investors, secondary markets for private investments – where investors go to trade existing private investments – are even more so. Blockchain can facilitate the creation of secondary markets and allow investors to buy and sell private securities more easily, which in turn will drive liquidity and make them more attractive to new investors.
Overall, tokenization can provide new opportunities for both issuers and investors by bringing a fully-digital process to private markets that can improve liquidity, transparency, and access of both primary and secondary markets.
As tokenization evolves and blockchains such as Polymesh become more widely adopted, the private market sector stands to radically change.