Private capital

What Is Private Capital?

Private capital refers to capital that is not traded on a public exchange. This broad category within investment finance encompasses funds invested in private companies, assets, or projects, distinct from those available through public stock or bond markets. It generally includes equity and debt financing provided by investors directly to private enterprises, rather than through initial public offerings (IPOs) or other public securities offerings. Private capital is often deployed through specialized funds managed by financial institutions that pool money from institutional investors and high-net-worth individuals, aiming for long-term growth and higher rate of return than traditional publicly traded assets.

History and Origin

The concept of privately funding businesses has existed for centuries, but the formalization of private capital as an industry gained momentum in the mid-20th century. A significant milestone occurred in 1946 with the establishment of American Research and Development Corporation (ARDC) by Georges Doriot, regarded as the "father of venture capitalism." ARDC was one of the first firms to pool money from institutions and wealthy individuals to invest in private companies, particularly those with innovative technologies.¹¹,¹⁰ This laid foundational groundwork, and the passage of the Small Business Investment Act of 1958 further supported the growth of private financing by enabling the U.S. Small Business Administration (SBA) to license Small Business Investment Companies (SBICs).⁹, These early structures primarily resembled what is now known as venture capital, focusing on startups and emerging companies. The modern form of private capital, particularly encompassing leveraged buyouts, began to solidify in the 1960s with transactions like the acquisition of Orkin Exterminating Co. in 1964, marking an early instance of a modern leveraged buyout.⁸

Key Takeaways

• Private capital is a broad category of funding for private companies, assets, or projects, distinct from public markets.
• It is primarily sourced from institutional investors and high-net-worth individuals.
• Investments in private capital typically involve longer holding periods and less liquidity compared to publicly traded securities.
• The sector includes various strategies such as private equity, private debt, and alternative investments.
• Investors often seek private capital for portfolio diversification and the potential for higher returns.

Interpreting Private Capital

Interpreting private capital investments requires understanding the underlying strategies and the nature of the assets involved. Unlike public securities with readily available pricing and disclosure, private capital investments demand extensive due diligence due to their limited transparency and bespoke nature. The value of a private capital investment is not determined by daily market fluctuations but rather by the long-term performance and eventual exit strategy of the underlying portfolio companies or assets. Investors typically evaluate private capital based on metrics such as internal rate of return (IRR), multiple of invested capital (MOIC), and the overall contribution to their portfolio's strategic objectives.

Hypothetical Example

Imagine a technology startup, "InnovateTech," is seeking to expand its operations. Instead of pursuing an Initial Public Offering (IPO) on public markets, InnovateTech decides to raise private capital. A private capital fund, "Growth Horizons LP," specializes in early-stage technology investments. Growth Horizons pools $50 million from several institutional investors and wealthy families.

Growth Horizons' investment committee performs extensive due diligence on InnovateTech, including reviewing its business plan, financial projections, management team, and market potential. After satisfactory review, Growth Horizons agrees to invest $10 million in InnovateTech in exchange for a significant minority equity stake. This private capital infusion allows InnovateTech to hire more engineers, expand its sales team, and develop new products without the immediate pressures and regulatory burdens of being a publicly traded company. Growth Horizons expects to hold this investment for 5-7 years, working with InnovateTech's management to grow the company, before seeking a profitable exit through an acquisition by a larger tech firm or eventually an IPO.

Practical Applications

Private capital plays a critical role across various financial sectors by providing flexible and long-term financing that traditional capital markets may not offer. It is particularly prevalent in:

• Corporate Finance: Private capital funds, especially private equity firms, acquire or invest in companies, providing the necessary funding for growth, restructuring, or management buyouts. This allows companies to pursue strategic changes away from public scrutiny.
• Startup and Growth Funding: Venture capital is a key form of private capital dedicated to funding nascent and high-growth startups, enabling them to scale operations and innovate.
• Real Estate: Private real estate funds invest directly in properties, developments, or real estate-backed debt, allowing for large-scale projects and portfolio diversification beyond publicly traded REITs.
• Infrastructure: Significant private capital is deployed into infrastructure projects, such as toll roads, renewable energy facilities, and utilities, which require substantial, long-term investments.
• Credit Markets: Private debt, a component of private capital, involves direct lending to companies, often as an alternative to bank loans or public bond issuances.

The global private equity market, a significant segment of private capital, was valued at approximately $5.3 trillion in 2023 and is projected to reach $6 trillion by the end of 2024, demonstrating its increasing importance in the global economy.⁷ Private capital facilitates economic development by enabling fundraising for companies and projects that might not meet public market listing requirements or that prefer private ownership.

Limitations and Criticisms

While offering significant opportunities, private capital investments also come with notable limitations and criticisms. A primary drawback is the illiquidity of these investments; capital is typically locked up for extended periods, often five to ten years or more, making it difficult for investors to access their funds quickly.⁶ This long investment horizon can be a disadvantage for investors needing shorter investment cycles.

Another criticism centers on transparency. Unlike public companies subject to stringent regulatory reporting, private companies typically have limited disclosure requirements.⁵ This can make it challenging for investors to assess a company's performance, evaluate risks, and perform thorough due diligence. Additionally, private capital investments often involve higher fees, including management fees and performance fees (carried interest), which can significantly reduce overall returns for investors.⁴

Furthermore, private capital, particularly through leveraged buyouts, can introduce higher financial risk to target companies due to increased debt loads. The success of such investments often depends heavily on the ability of the private capital firm to execute strategic changes, which may not always be successful.³ While promising the potential for high returns, there is also the risk of substantial losses if portfolio companies fail to perform as expected.

Private Capital vs. Private Equity

The terms "private capital" and "private equity" are often used interchangeably, but private capital is a broader term encompassing private equity.

In essence, all private equity is private capital, but not all private capital is private equity. For instance, a private debt fund lending to a company is deploying private capital, but it is not a private equity investment because it focuses on debt rather than equity ownership. Both asset classes are often accessed by accredited investors and institutional investors seeking to participate in non-public markets.

FAQs

What types of investors engage in private capital?

Private capital is typically raised from institutional investors such as pension funds, endowments, sovereign wealth funds, and insurance companies. High-net-worth individuals and family offices also frequently participate. Due to the high investment minimums and illiquid nature of these investments, they are generally not accessible to retail investors.

How do private capital firms make money?

Private capital firms, like private equity or venture capital funds, make money primarily through two channels: management fees (an annual percentage of assets under management) and carried interest (a share of the profits generated from successful investments). Their goal is to buy companies or assets, improve their value through operational enhancements or strategic changes, and then sell them for a significant profit. This entire process is overseen as part of their asset management strategy.

Is private capital regulated?

While private capital investments are not subject to the same public disclosure requirements as publicly traded securities, they are still regulated. In the United States, for example, private offerings often rely on exemptions from registration with the U.S. Securities and Exchange Commission (SEC), such as those provided under Regulation D.² However, issuers must still comply with anti-fraud provisions and file certain notices, such as Form D, with the SEC.¹, State securities laws also apply.

What is the typical investment horizon for private capital?

Private capital investments typically have a long investment horizon, often ranging from five to ten years, or even longer. This is because private capital firms need sufficient time to implement their value-creation strategies within portfolio companies and to wait for optimal market conditions for an exit strategy, such as an IPO or sale to another company.