Private Capital E-Book

Stefan W. Hepp

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 1035

Veröffentlichungsjahr: 2024

Beschreibung

In Private Capital: The Complete Guide to Private Markets Investing, renowned private markets investor and expert Dr. Stefan W. Hepp delivers an insightful and comprehensive exploration of the history, nature, and influence of private market investing. The author offers a robust examination of the key practical and conceptual issues faced by investors as they move forward into the future. In the book, you'll find fulsome discussions of the rise of private market investment following the conclusion of World War II, as well as why the limited partnership became the dominant investment vehicle for private equity. You'll also discover the importance of the convergence of technology, government, academia, and venture capital that came to define what we now know as Silicon Valley. The book includes: * Explanations of the emergence of buyout firms, as well as why and how buyouts differ from other forms of mergers and acquisitions * Examinations of the explosive growth of private equity and other private asset classes since the turn of the millennium * Discussions of the issues set to dominate the future of private markets, including ESG investing, value creation, unicorns, special purpose acquisition companies (SPACs), and more A must-read book for regulators, investors, asset managers, entrepreneurs, founders, and other businesspeople, Private Capital will earn a place on the bookshelves of anyone with a stake or interest in private equity and other private asset classes.

Leseprobe

Private Capital

The Complete Guide to Private Markets Investing

Stefan W. Hepp

This edition first published 2024

© 2024 John Wiley & Sons Ltd

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Library of Congress Cataloging‐in‐Publication Data is Available:

ISBN 9781394217694 (Cloth)

ISBN 9781394217700 (ePDF)

ISBN 9781394217717 (ePUB)

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In memory of

Dr. theol. Frank Jehle.

Abbreviations

AC alternating current

ACRS accelerated cost recovery system

AGM annual general meeting

AI artificial intelligence

AM arithmetic mean

ARD American Research & Development Corporation

APRR Autoroutes Paris‐Rhine‐Rhône

ARPA Advanced Research Projects Agency

AuM assets under management

BA British Airways

BATS Baidu, Alibaba, and Tencent

BREP Blackstone Real Estate Partners

BRIC Brazil, Russia, India, and China

BTS Bureau of Transportation Statistics

CAD computer‐aided design

CalPERS California Public Employees Retirement System

CAPA Centre for Aviation

CAPAM Capital Asset Pricing Model

CDLI Cliffwater Direct Lending Index

CDO collateralized debt obligation

CFA chartered financial accountant

CLO collateralized loan obligation

CMBS commercial mortgage‐backed security

CPI consumer price inflation

CPPIB Canada Pension Plan Investment Board

CPU central processing unit

CRV Charles River Ventures

CSRC China Securities Regulatory Commission

DARPA Defense Advanced Research Projects Agency

DC direct current

DC defined contribution

DDR&D Directorate of Defense Research & Development

DEC Digital Equipment Corporation

DPI distributions to paid‐in

DST Digital Sky Technologies

E&P exploration and development

EBIT earnings before interest and taxes

EBITDA earnings before interest and taxes, depreciation, and amortization

ECB European Central Bank

EDA electronic design automation

EFH Energy Futures Holdings

EFSF European Financial Stability Facility

EIA (US) Energy Information Agency

EIB European Investment Bank

EIOPA European Insurance and Occupational Pensions Authority

EOP Equity Office Properties

EPS earnings per share

ERISA Employee Retirement Income Security Act

ERTA Economic Recovery Tax Act

ESG environment, social, and governance

ESM European Stability Mechanism

ETF exchange‐traded fund

EU European Union

FAANG Facebook, Amazon, Apple, Netflix, and Google

FCFE free cash flow to equity

FDIC Federal Deposit Insurance Corporation

FED Federal Reserve Board

FIRREA Financial Institutions Reform, Recovery, and Enforcement Act

FoFs fund of funds

FOMC Federal Open Market Committee

FSLIC Federal Savings and Loan Insurance Corporation

FTC Federal Trade Commission

GAAP generally accepted accounting principles

GDP gross domestic product

GE General Electric

GenAI generative AI

GFC Global Financial Crisis (2008)

GP general partner

HCC Homebrew Computer Club

HNI high‐net‐worth individual

IASB International Accounting Standards Board

IC integrated circuit

ICT information and communication technology

IFSWF International Forum of Sovereign Wealth Funds

ILPA Institutional Limited Partner Association

IMF International Monetary Fund

I/O input/output

IPO initial public offering

IRR internal rate of return

IS infrastructure

ISSB International Sustainability Standards Board

ITT International Telephone and Telegraph Company

ITU International Telecommunication Union

KfW Kreditanstalt für Wiederaufbau

KKR Kohlberg Kravis Roberts

KP Kleiner Perkins

KPCB Kleiner Perkins Caufield & Byers

KYC know your client

LBO leveraged buyout

LCOE levelized cost of electricity

LCY London City Airport

LLC limited liability company

LLM large language model

LNG liquified natural gas

LP limited partner

LPA limited partnership agreement

LPE listed private equity

LTV loan‐to‐value

M&A mergers and acquisitions

MAC material‐adverse‐change

MBI management buy‐in

MBO management buyout

MBS mortgage‐backed securities

MENA Middle East and North Africa

MIT Massachusetts Institute of Technology

MOIC multiple on invested capital

MOSFETs metal‐oxide‐semiconductor field‐effect transistors

MSCI Morgan Stanley Capital International

MSREF Morgan Stanley Real Estate Fund

NASA National Aeronautics and Space Administration

NASDAQ National Association of Securities Dealers Automated Quotations

NAV net asset value

NBC National Broadcasting Corporation

NBER National Bureau of Economic Research

NLP natural language processing

NR natural resources

NRDC National Resources Defense Council

NVCA National Venture Capital Association

NYMEX New York Mercantile Exchange

NYSE New York Stock Exchange

OCS Offices of the Chief Scientist

OMERS Ontario Municipal Employees Retirement System

ONR Office of Naval Research

OS operating system

OSRD Office of Scientific Research and Development

OTPP Ontario Teachers’ Pension Plan

PC personal computer

PCG Pacific Corporate Group

PD private debt

PE private equity

P/E price earnings ratio

PIK payment in kind

PME Public Market Equivalent

PPF private pension funds

PRI Principles of Responsible Investing

PRISA Prudential Property Investment Separate Account

QIA Qatar Investment Authority

QIC Queensland Investment Corporation

R&D research and development

RCA Radio Corporation of America

REIT real estate investment trust

RePowerEU European program to reduce CO

2

emissions

RMB renminbi

ROI return on investment

S&L savings and loans

SaaS software as a service

SAFE State Administration of Foreign Exchange

SAMR State Administration for Market Regulation

SASB Sustainability Accounting Standards Board

SBDA Small Business Investment Act

SBIC small business investment company

SDS Scientific Data Systems

SEC Securities and Exchange Commission

SFA (Japanese) Financial Services Agency

SFDR (EU) Sustainable Finance Disclosure Regulation

SIFI systemically important financial institution

SMA separate managed account

SMI Semiconductor Manufacturing International

SOEs state‐owned enterprises

SOFR secured overnight financing rate

SOX Sarbanes‐Oxley Act

SPAC special purpose acquisition company

SPC State Planning Commission

SPV special purpose vehicle

STAR segment of the Shanghai Stock Exchange for tech stocks

SWFs sovereign wealth funds

TCJA Tax Cuts and Jobs Act

TPG Texas Pacific Group

TRA United States Tax Reform Act

TVPI total value to paid‐in

TXU Energy Future Holdings Corporation

UN PRI/UNRIP UN Principles of Responsible Investment

USPTO United States Patent and Trademark Office

VC venture capital/venture capitalist

VPN virtual private network

WACC weighted average cost of capital

WaMu Washington Mutual Insurance Company

WTI West Texas Intermediate

WTO World Trade Organization

WWI World War I

WWII World War II

Introduction

You can't really understand what is going on now unless you understand what came before.

—Steve Jobs1

Throughout history, private capital has been crucial for funding ventures, infrastructure, and risky endeavors. While stock markets gained in significance, they did not replace direct private investments. Private Capital takes readers on a journey exploring the drivers of capital accumulation, the interplay between private and public investing in entrepreneurial endeavours that enabled the rise of Western economies and shaped modern capitalism. Drawing from the author's three decades of investment experience in private markets, the book investigates how investors' approaches to this asset class have evolved. It also delves into how the institutionalization of financial capital, involving the separation of ownership and management of financial resources, has shaped the private markets industry.

Moreover, the book integrates new findings from a wide range of scholarly studies on the evolution of capital markets and entrepreneurial finance. These findings provide a foundation for the narrative that charts the advancement of modern private market investment from a niche sector to a large financial industry dominated by mega‐firms with assets worth hundreds of billions of dollars. Private market investing increased 25‐fold over the new millennium, surpassing $10 trillion in assets under management (AuM) in 2021 (Figure 0.1).2 This book aims to tell the story of this distinct form of investing. Its intended audience includes investment professionals, investors, and students who are exploring this asset class, presented in a format that offers ease of understanding and includes technical explanations where they add value.

Figure 0.1 Private markets' alternative assets under management and forecast, 2010–2022.

Source: Preqin data platform, Sept. 2021.

Note: 2021 is annualized, 2022 are Preqin's forecast figures.

Private equity is the most widely recognized type of private market investment and its influence is far‐reaching. The media often covers transactions carried out by buyout firms or venture capitalists. Private equity investments involve providing capital to startups or mature enterprises that require funding for growth or improvement, with the ultimate goal of exiting and generating profits after a few years. According to an American Investment Council (2021) study,3 private equity‐owned firms employed 11.7 million Americans in 2020 and generated approximately 6.5% of total GDP. The “big tech” successes in Silicon Valley have a significant impact on our daily lives. Companies such as Facebook, Apple, Alphabet, Amazon, and others have transformed the way we interact with technology. Private equity's investments extend beyond technology to include sectors such as healthcare, media, aerospace, satellites, and telecommunications, among others. While private equity's growth has increased its public profile, it has also created controversy and found detractors.

Private markets encompass more than just buyouts and venture capital. For example, an infrastructure fund may own a local toll road or airport, while a natural resource manager's investment may be your energy supplier. Your landlord may be a private real estate fund, and your life insurance premium could be funding private debt. Private markets have expanded over time to include investment strategies, such as growth equity, real estate, credit, infrastructure, natural resources, and, more recently, impact and environmental, social, and governance (ESG) investments. Despite the broad range of investment strategies that comprise private market investing, most of the literature on the subject is focused on private equity. This book intends to fill the void by offering an objective perspective as the first compendium that provides an in‐depth overview of the full spectrum of private markets investing. Following a chronological timeline to chart the history of private capital investing (Figure 0.2), the growth and complexity of the private markets' asset class are explored.

Figure 0.2 A timeline of the evolution of the private markets industry.

This book will focus on the industry as a whole and the reasons behind its emergence in its current form. It consciously avoids focusing on the colorful personalities and personal histories of founders and deal‐makers, which often attract media attention. The private market industry's evolution has not occurred in isolation; it has been influenced by economic, legal, and regulatory shifts, alongside the increasing institutionalization of capital markets since World War II. The requirement of substantial minimum subscriptions, often exceeding $10 million, underscores that this is not an asset class tailored for small‐scale investors but primarily aimed at large institutional investors.

To invest in the asset class, one needs to understand the economic and legal developments that provided opportunities for deal‐making and value creation during different cycles. An in‐depth analysis of the development of different types of private markets investments provides valuable insights into the conceptual issues faced by investors in this asset class.

The broader economic perspective of this book serves to explain why a kind of investment centered on the temporary ownership of companies and other assets, the prominent use of leverage, and the alignment of managerial incentives continue to prosper while being criticized by many detractors as obsolete or broken. Taking a historical perspective underscores the dynamics propelling innovation and organizational transformation. The analysis is focused on the structural and institutional changes that introduced new financing and investment models.

Policy decisions that enable these investments to flourish can bestow a competitive advantage upon nations. A comparison of the approach to funding of railroads in Europe and the US provides lessons of the comparative advantages of those distinct models of infrastructure financing, while the story of Silicon Valley illustrates what enables the formation of technology clusters and the characteristics of the technology that generate investment opportunities through repeated waves of innovation. Indeed, there are lessons that only history can provide. During the dotcom boom, differences in investment patterns go a long way to explain the relative lack of success of the European venture capital industry compared to their US peers. A closer look at the factors that enable a successful venture ecosystem also helps to understand the direction venture capital in China is taking and what its “state‐guided” model means for investors.

Knowledge of the asset class is vital for professionals who work in the financial sector, regardless of whether they work for traditional investors in the asset class, such as pension funds, endowments, or sovereign wealth funds, or are banks and asset managers who are increasingly adding private markets to their investment offerings. It is also required by the large number of investment professionals that private markets managers employ globally and the many business school graduates who―for years―made firms specializing in private market investments their most sought‐after employers.

The book also addresses the need to better understand the role of different types of intermediaries in private markets. By providing a comprehensive guide to service providers and their respective roles, as well as describing the different access routes used by investors to gain exposure, the book is a valuable resource for professionals in the field.

Investors need to understand the different risk/return profiles of private market investment strategies. Frequently, asset classes are categorized based on similar risk/return characteristics. This is not the case for private markets. The risk‐reward profile of venture capital is significantly different from infrastructure or private debt. One must inquire about the typical characteristics of the asset class and ask whether a venture capital and buyouts‐based investment model has been successfully applied to those asset types. To answer these questions, it is necessary to examine the industry's track record and deal‐making in greater detail.

The book reviews the empirical evidence of the private market industry's track record by using a wealth of data that is typically not publicly accessible. Indeed, one of the challenges in writing this book was ensuring that the data used throughout was reasonably consistent. There is no single accredited data source equivalent to stock market indices or official fund performance data. Instead, what passes as industry data is collected by a multitude of providers using diverse data sources. In recent years, the availability of better private market data has significantly contributed to our understanding of this asset class's characteristics. This book highlights academic research and quantitative studies that have been instrumental. Notably, deal‐level data has not only improved our understanding of successful strategies in private market investing but has also provided fresh insights into the concept of diversification and portfolio construction.

Readers will gain an understanding of the challenges that must be addressed to make private markets investing accessible to individual investors. But the lessons learned from studying the facts relating to private markets investing are equally important for financial practitioners who seek to emulate large institutional investors in their efforts to make private markets investing available to individual investors.

These insights are combined with a practitioner's view and the experience gained over many years of investing in the asset class that provides context and highlights relevant lessons for those investing in the asset class or dealing with private market firms.

THE STRUCTURE OF THE BOOK

Part I, The Beginning, describes the early forms of funding available for commercial endeavors and the formation of the modern corporation. What follows is a description of the motivation behind attempts to raise venture capital from institutional investors after WWII and the reasons why limited partnerships became the dominant investment vehicle for private equity. Then we take a closer look at the role of the silicon microchip in ushering in the digital revolution that transformed our lives and the interplay between technology, government, academic institutions, and venture capital to create the technology cluster that became known as Silicon Valley. Understanding these drivers helps investors to gauge the opportunity set that technology offers before and after it is commoditized and when venture capital has most of its impact.

Part II, Booms and Busts, describes the emergence of buyout firms and why buyouts differ from other merger and acquisition (M&A) strategies. We explore the conglomerate boom that led to hostile takeovers and the beginning of private market globalization in the 1980s. The hostile takeovers of the 1980s, the telecom and dotcom boom and bust of the 1990s, and their impact on investors and the private markets industry are all discussed. Subsequently, the book delves into the industry's evolution and its performance history throughout the initial decade of the new millennium, ultimately culminating in the Great Financial Crisis (GFC).

Part III, Becoming Indispensable, traces the growth of private markets since the Great Financial Crisis (GFC) and its emergence as a core institutional asset class across a wide range of strategies. The rise of infrastructure or private debt strategies, the emergence of mega‐firms doing mega‐deals, and the industry's response to the GFC are vital topics. The new millennium's second decade witnessed unprecedented growth and profound structural change. Late‐stage venture deals and the unicorn phenomenon―startups worth $1 billion or more―increasing institutional direct investments, non‐traditional investors, special purpose acquisition companies (SPACs), semi‐liquid and permanent capital structures are all manifestations of that transformation.

Additionally, the book explores contemporary shifts that have redefined the landscape of the private markets. As it progresses, it examines the terminology, distinct legal and economic aspects, and the analytical concepts that define the asset class and are essential knowledge for anybody who works or invests in that space. By examining the characteristics of diverse entities, such as major pension funds and sovereign wealth funds, the book demonstrates how the private market industry has been shaped by major providers of capital—large institutions, which now play dual roles as both clients and competitors. Understanding this symbiotic relationship is crucial for anticipating the future evolution of the private markets industry.

NOTES

1

Intel (2012).

2

Preqin estimate as of September 2022.

3

American Investment Council (2021).

PART IThe Beginning

Chapter 1Funding Private Enterprise

Obtaining financing for dangerous endeavors has always been tricky. Then and now, it required refusing to accept no for an answer. Vasco Da Gama's successful voyage to India in 1497–1498 began a new era of maritime trade and exploration, but it was met at first with rejection from Portuguese King John II in 1495 due to concerns about the expedition's feasibility and cost. It was not until 1497, after King Manuel I ascended to the throne, that da Gama finally received the necessary funding and resources for his voyage.

Christopher Columbus, an Italian, lobbied European rulers for nearly a decade to find funding for his mission to seek a western sea passage to Asia. In Portugal, England, and France, the answer was “No.” Finally, King Ferdinand and Queen Isabella of Spain consented to support him, allowing him to set sail in 1492.

Ferdinand Magellan was rebuffed in his native Portugal before finding support for his proposed expedition to find a western route to the Moluccas (Spice Islands) from King Charles I of Spain, and his fleet departed Spain in 1516 (Figure 1.1).

Figure 1.1 Portuguese explorer Ferdinand Magellan's fleet of five ships―the San Antonio, the Trinidad, the Concepción, the Nao Victoria, and the Santiago―after their departure from Spain on September 20, 1519.

Source: Science History Images/Alamy Stock Photo.

In addition to their shared goal of discovering a sea route to Asia, the Portuguese and the Spanish were driven by a strong desire to obtain gold. However, their paths to success diverged significantly. The Spanish achieved their objectives primarily by looting native gold artifacts in the New World and later through gold and silver mining. Unlike the Spanish experience in the Americas, where the conquest of empires like the Aztecs and Incas led to the extraction of vast amounts of precious metals, Africa’s west coast did not possess similar wealth regarding precious metals. This made it less enticing for outright conquest. Portugal also lacked the manpower and resources for large‐scale conquests on the scale seen in the Americas. The Portuguese pursued a trade‐based approach, engaging with African merchants to acquire these valuable commodities. Ship captains assumed a crucial role as business agents, transcending their traditional role as mere transportation providers. They exercised agency in determining the most advantageous locations and prices for exchanging goods for gold. Furthermore, ship captains allocated a portion of their cargo to cover expenses related to supplies and ship repairs, ensuring the smooth progression of their trade ventures.

1.1 FUNDING MARITIME VENTURES

The voyages of Vasco Da Gama, Christopher Columbus, and Ferdinand Magellan marked the beginning of an important transformation, noted by some scholars as the beginning of the Great Divergence―the growing gap in economic performance between Europe and other parts of the world after Columbus's discovery of the New World.1 The significance of their journeys, however, did not become apparent until much later, which is a perfect example of Denis Gabor's dictum that “the future cannot be predicted, it can only be discovered.”2

Sea journeys are risky, as ships can get lost at sea or raided by pirates, and cargo can perish or get diverted by the crew. In addition, maritime trade is capital‐intensive as the ship and the cargo must be paid for in advance. Long‐distance trading was an arbitrage based on the price disparity between two distant marketplaces. Demand and supply were ignorant of each other and brought into touch by intermediaries who knew little about the worth of a shipment to a buyer. An understanding of how those voyages were financed is thus of critical importance for understanding the evolution of risky enterprises' financing.

The earliest overseas mercantile ventures emanating from Spain and Portugal drew on Mediterranean precedents established by Italian city‐states. There, merchants sent their ships out onto the Adriatic, the Black Sea, and the eastern Mediterranean with the hope of accessing established markets in the Levant and further east. The earliest instrument used for funding maritime trade, the “sea loan,” secured capital for seafaring commercial voyages through advances of goods or credit to purchase the cargo from producers and local merchants, who would be reimbursed with interest at the close of the expedition.3 This form of financing required, however, that there was sufficient certainty about the terms of exchange for the goods carried and an acceptance of the risk of loss by the creditors, which makes the arrangement unsuitable for the exploration of new markets.

By the twelfth century, this practice was eclipsed by the Commenda, a medieval form of partnership that opened early transoceanic trading opportunities to a diverse group of traders, colonists, and mariners, creating a decentralized mercantile trade that diffused profits among many stakeholders.4 The Commenda distinguished between “stationary” partners who remained in port and “traveling” (managing) partners who organized the voyage. Both parties would contribute to the cargo by supplying goods or sometimes finance. Because the traveling partner did not assume liability for the home port‐based partner's capital in case of accident or other forms of loss, the arrangement was premised on the stationary party's contributing equity to a particular voyage organized by a traveling partner.5 After the voyage's completion, the profits were split, with 25% of the profit attributable to the stationary party's goods going to the traveling party, i.e., shipowner, captain, and crew. Such partnerships could include multiple investors who owned different types of cargo or even fractions thereof. The fractional ownership further enabled individuals to invest small amounts in a single commercial expedition. Beyond the Italian city‐states of Venice, Genoa, and Pisa, the Commenda contract became central to long‐distance overland and seaborne trades.6 The practice of offering captain and crew a commission as an incentive to act in the best interest of their investors became a feature of maritime trade that survived the ages: Nantucket whalers, for example, could keep up to 20% of the cargo. According to some sources, this is where the term “carried interest” comes from.7

1.2 PRIVATE CAPITAL AND THE SUGAR BOOM

The Portuguese crown used an arrangement similar to the Commenda for its African trade. From the fifteenth century until the end of the sixteenth century, the Portuguese were the only Europeans trading on the Gold Coast (present‐day Ghana) along the Gulf of Guinea. There they obtained gold, ivory, and a commodity which would consistently gain in importance―African slaves―after sugar production started in São Tomé. The slave trade saw rapid growth once Brazil eclipsed São Tomé, becoming the foremost sugar producer in the early seventeenth century. What was termed the “slave plantation complex”8 fed a sugar boom that lasted well into the nineteenth century and was controlled by Portugal for almost 150 years.

The importance of sugar cannot be understated. H. W. French (2021) estimated that Brazil's sugar crop accounted for 40% of Portugal's total revenue in 1620. In 1660, Barbados's sugar production was worth more than the combined exports of all of Spain's New World colonies. The sugar produced in Saint‐Domingue, a French colony in modern‐day Haiti, accounted for 15% of the overall French economic growth during 1716–1787.9 By some estimates, sugar was the most important overseas commodity that accounted for a third of Europe's entire economy during the sixteenth to the eighteenth centuries.10 Maritime trade was the critical element that tied commerce between Europe, Africa, and the sugar‐growing colonies in a transatlantic pattern that became famous as the triangular trade.11

Recent research illustrates the link between maritime trade and capital formation. Mary E. Hicks of the University of Chicago records an episode that sheds some light on the financing arrangements of the seaborne trade during the eighteenth century:

In 1767, the slaving vessel Nossa Senhora left Salvador da Bahia bound for the West African coast and was sized by Dutch pirates. The owner sought restitution from the Dutch government, revealing that the cargo belonged to 35 investors including two Catholic brotherhoods.12

The ship's numerous investors illustrate the existence of economic arrangements that constituted an early form of private equity that provided opportunities for many, and access to investment opportunities was thus different from the highly concentrated land ownership of the nobility that characterized feudal societies.

The sugar boom also increased intra‐European trade as the northern Europeans sold the Portuguese the goods in demand in Africa. The wealth created in the plantation economies, which were largely monocultures, increased the demand for traded goods, which led to an expansion in manufacturing in Northern Europe. In the seventeenth century, the sugar‐growing Caribbean islands would become important export markets for Britain's American colonies, too, providing food, horses, timber, and other natural resources.

The quest to control the sugar trade also increased competition among a broadening array of European powers.13