ALT 3 Investments in Private Capital: Equity and Debt

Private capital is the umbrella term for funding supplied to companies from outside the public markets. It does not come from selling shares, bonds, or other securities on an exchange, and it does not come from a traditional institutional lender such as a government or a bank. When that outside funding takes the form of an ownership stake, it is called private equity. When it takes the form of a loan or another debt claim, it is called private debt. Private capital therefore spans the whole capital structure: private equity plus private debt.

Alternative assets like these behave differently from the traditional pairing of public debt and public equity. They carry their own return, risk, and information profiles, and they have historically shown low correlation with listed stocks and bonds. Selecting, managing, and eventually selling them calls for specialized expertise, and because they are generally less liquid than exchange-traded assets, judging their valuation and return characteristics is itself a specialized skill.

Where private capital enters the corporate life cycle

Non-public equity is usually classified by the point in a company’s life at which the investor commits capital. Venture capital funds tend to arrive early, when a business is young, cash flow is negative, and business risk is very high. Private equity buyout funds tend to arrive later, once a company is mature or in decline and its cash flows are more predictable. The two windows overlap during the growth stage, where either form of capital can fit.

An investor can gain exposure directly or indirectly. A direct commitment is made through a single private fund into one specific asset, sometimes alongside a lead sponsor as a co-investment. An indirect commitment is made through a fund-of-funds vehicle that holds stakes in many underlying private funds, which spreads the money across more managers and deals.

The main private equity strategies are the leveraged buyout, venture capital, and growth capital. In a leveraged buyout (LBO), a private equity firm sets up a buyout fund to acquire a public or an established private company, funding a large share of the purchase price with debt. The target’s own assets usually serve as collateral, and its cash flows are expected to be enough to service that debt, which then sits inside the target’s capital structure after the deal closes. Because the acquired company becomes or stays privately owned afterward, an LBO of a listed firm is often described as a going-private transaction, since its shares are largely no longer traded.

An LBO can take a particular form. In a management buyout (MBO), the existing management team joins in the acquisition; in a management buy-in (MBI), the incoming team replaces the current managers and runs the company. Buyout managers try to add value by sharpening operations, lifting revenue, and raising profits and cash flow. Ranked by their usual contribution, the sources of cash flow growth are organic revenue gains, then cost cuts and restructuring, then acquisitions, and finally everything else. Returns lean heavily on leverage, so when debt financing is scarce or expensive, LBOs become less attractive and less frequent, and managers may shift focus as financing conditions change.

Private equity compared with public equity

Both public and private equity give the holder direct ownership and a say in the company: shareholders vote at the annual meeting to elect the board, shape strategy, and decide major questions, and every owner holds a proportional claim on residual cash flow through dividends. What sets private equity apart is degree of control. Large concentrated stakes let private equity owners steer decisions far more directly than a dispersed public shareholder can, which is exactly why running a direct private position demands knowledge specific to the firm’s industry and sector. Capital gains, whether from price appreciation or from free cash flow the holding throws off, are typically the biggest driver of returns. Across public and private markets alike, equity has historically paid more than debt in exchange for more risk, with unlimited upside and downside capped at the amount invested.

Venture capital and its financing stages

Venture capital means financing private companies with strong growth prospects, usually start-ups or young firms, though capital can be injected anywhere from the concept phase to the edge of an IPO. The return an investor demands rises the earlier the stage, because an earlier stage carries more risk. Like every private equity manager, venture capitalists stay hands-on, working closely with the companies they back. They usually take an equity interest but may also lend, often through convertible debt.

Reading up the ladder: pre-seed capital, also called angel investing, funds the idea itself, helping to build a business plan and gauge the market, and it is small and usually raised from individuals. Seed capital supports product development, marketing, and market research, and is the first point at which venture funds normally invest. Early-stage financing carries a company toward operation but before commercial production or sales. Later-stage, or expansion, financing arrives after sales have begun but before an IPO, funding growth, a plant upgrade, product improvements, or a marketing push; at this point owners often sell control to the VC investor, and the fund may add debt or convertible instruments mainly for the protection they give in a bankruptcy rather than for income.

Mezzanine-stage financing is the bridge that readies a company to go public, infused between private and public status. Note the wording trap: mezzanine-stage financing is defined by its timing, whereas mezzanine financing describes a type of instrument, namely equity-debt hybrids like a convertible bond or convertible preferred stock. A mezzanine-stage round can use mezzanine financing, but the main funding at that point is usually equity-like, to capture upside from the coming listing, or else short-term borrowing.

A common instrument for raising venture money is the convertible preferred share. The holder may convert the preferred into a set number of common shares after a stated date, and sometimes at a stated price, which aligns the interests of the founders and the investor because the conversion value tracks the start-up’s valuation. Crucially, in a liquidation, convertible preferred holders rank ahead of common holders and recover their full investment before common shareholders receive anything, a protection ordinary equity does not offer. Because these young businesses lack years of operating and financial history, valuing them and their prospects is highly subjective.

Growth capital and PIPEs

Once venture capital has taken a company forward, private equity can step in. Later-stage private equity firms generate returns by directly influencing management and changing strategy, often at underperforming firms, cutting weak business lines and building a more durable strategy so the company can be sold at a higher valuation. A mature company in transition may instead seek only a minority stake to expand, restructure, or acquire. A firm that takes such a less-than-controlling position is doing growth equity, also called growth capital, and the investee’s own management often initiates it in order to cash in part of its holding before an IPO while keeping control. This happens mostly with private companies, but listed firms can raise private equity too through PIPEs (private investments in public equities).

A PIPE is a private offering to a select group of investors that carries fewer disclosures and lower costs, letting the issuer raise money faster and more cheaply than through more regulated routes. In a standard PIPE, newly issued common stock, shares sold by existing holders, or a mix of the two in an already-listed company are offered to certain investors, usually institutional buyers such as investment firms and mutual funds, who sign an agreement to purchase at a fixed price. PIPEs are common in workout or rescue situations where market price and valuation diverge sharply, and a special case raises capital through convertible debt or convertible preferred. Because PIPEs dilute existing shareholders and the new investors demand a discount to the market price, they can pit old and new shareholders against each other.

Private equity firms buy or fix a business and then sell it at a higher valuation, holding for about five years on average, though the range runs from under six months to more than 10 years. A fund typically has an investment period of roughly five years followed by a harvesting period when exits occur and the valuation environment matters most. Capital is committed over several years rather than paid in one lump, which gives managers flexibility over the timing of entry and exit. Before choosing how to exit, managers weigh the industry’s dynamics, the economic cycle, interest rates, and the company’s own performance. The two principal exit routes are the trade sale and the public listing.

Trade sale

In a trade sale, all or part of the private company is sold, by direct negotiation or auction, to a strategic buyer that wants to widen its scale and scope. The main attraction is that a strategic buyer will pay a premium for anticipated synergies with its existing business. A trade sale is also comparatively fast and simple, cheaper than an IPO, and confidential because only a few parties are involved, and the buyer can assess fit without outside scrutiny. The drawbacks are that management may resist a sale to a competitor out of fear for their jobs, employees may prefer a public listing that monetizes their shares at a possibly higher price, and the pool of trade buyers may be small, which can invite regulatory scrutiny and depress the price.

Public listing

There are three public-listing routes: the initial public offering (IPO), the direct listing, and the special purpose acquisition company (SPAC). The IPO is the most common route and uses intermediaries to underwrite the offering; the portfolio company sells shares, including some or all of those the private equity firm holds, to public investors. An IPO may fetch the highest price, raises the company’s visibility, lets the sponsor keep a stake and share in later gains, and usually keeps management in place, which secures their support. Against that stand high fees to banks and lawyers, a long timeline, heavy disclosure, exposure to stock-market volatility, and a possible lockup period that freezes the sponsor’s stake. Not every company suits an IPO: small firms, those in out-of-favor industries, and those with unclear strategy, unstable finances, or short track records make poor candidates. A direct listing floats the equity on the market without underwriters, cutting cost and complexity, and is used less often.

A SPAC is a blank-check company that exists only to acquire an unspecified private company within a set period, returning capital to investors if it fails to do so. Companies fit for an IPO are also fit for a SPAC, but the valuation method differs: a single counterparty sets the SPAC terms, which reduces valuation uncertainty. SPACs offer an extended window for disclosure to build investor interest, flexible deal structures, and access to high-profile sponsors and their networks, and they can give more forward guidance than an IPO allows, with a valuation fixed in advance that lowers price volatility. Their shortcomings include a higher cost of capital from dilutive instruments such as warrants, a spread between the SPAC’s equity value and the value of the equity it buys, deal-execution risk, unsettled regulatory treatment, and possible stockholder overhang, meaning the selling pressure that weighs on the share price when large blocks are unloaded after the deal is announced.

Other exit strategies

Three further routes round out the set. A recapitalization introduces or increases leverage at the portfolio company and pays the private equity firm a dividend from the new capital structure; it is not a true exit, since the firm usually keeps control, but it lets the investor pull cash out and lift its internal rate of return (IRR). A secondary sale hands the company to a different private equity firm or a group of financial buyers, and such exits have grown as global private equity has raised ever more capital. A write-off or liquidation occurs when a deal has gone badly: the firm marks the investment down or winds up the portfolio company and moves on. These routes can be combined or used for a partial exit, for instance selling one product line to a competitor by trade sale and the rest to another firm by secondary sale.

Risk and return from private equity

Private equity investors expect ownership returns, the cash flows from dividends and from exit proceeds, shaped by the industry’s market conditions. The higher returns that private equity can offer over traditional investments stem from three things: access to private companies, direct influence over portfolio company management and operations, and the use of leverage. Those same features make it riskier than listed common stock, so investors should demand a higher return for bearing the added illiquidity and leverage risk. Published private equity indexes are an unreliable performance gauge: like hedge fund data, they rely on self-reporting and suffer survivorship, backfill, and similar biases that tend to overstate returns, and before the 2008 to 2009 financial crisis firms often did not mark investments to market absent a liquidity event. Failing to mark, together with the lag caused by illiquidity, understates measured volatility and correlations, so the data need adjusting, and many investors now expect quarterly or annual marks by an independent party.

Private debt is the range of debt supplied by investors directly to private entities. The market has grown quickly over the past decade, driven by private lending funds that stepped into the gap between borrowing demand and the reduced lending supply from traditional lenders after regulation tightened following the 2008 crisis. The primary methods fall into four main types, direct lending, venture debt, mezzanine loans, and distressed debt, and this variety brings both diversification and exposure to areas such as real estate and infrastructure.

As with private equity, an investor can go direct or indirect. Direct private debt means lending straight to a specific operating company. The indirect path means buying an interest in a fund that pools money from many participants and lends to a set of operating companies. Either way, the investor receives interest and the return of principal after a fixed term, and the debt is usually secured with covenants in place to protect the lender.

Venture debt

Venture debt backs start-ups and early-stage companies that may generate little or negative cash flow. Founders often seek it, as a line of credit or a term loan, to raise money without further diluting their ownership, which lets existing shareholders keep control longer. Like mezzanine debt, it may carry extra features that compensate the lender for the higher default risk and for the lack of hard assets to pledge as collateral, for example a right to buy equity in the borrower under certain conditions.

Direct lending and leveraged loans

In direct lending, investors provide capital straight to borrowers and receive interest, principal, and sometimes other payments, usually on a fixed schedule as with a bank loan. The debt is typically senior and secured with protective covenants, comes from just a handful of investors, and differs from a public bond that can be sold to many holders and traded openly. Direct lending is run mainly by dedicated private debt firms, or the debt arms of private equity firms, that raise capital from investors chasing higher-yielding debt and then lend, at higher rates, to mid-market companies or other private equity funds needing acquisition financing, borrowers that traditional banks may be unwilling or unable to serve. Managers run thorough due diligence first. Many firms also extend a leveraged loan, meaning one funded with borrowed money, so the private debt firm borrows, lends the proceeds on, and enhances the return on its loan portfolio.

Mezzanine debt

In private debt, mezzanine debt is credit that ranks below senior secured debt but above equity in the borrower’s capital structure. It is a layer of additional capital sitting above equity but below senior secured debt, and it commonly funds buyouts, recapitalizations, and acquisitions. Its junior ranking and usually unsecured status make it riskier than senior secured debt, so investors demand higher interest rates and frequently want equity participation, adding features such as warrants or conversion rights that let them convert the debt into equity or buy the borrower’s equity under certain conditions.

Distressed debt

Distressed debt investing means buying the debt of mature companies in financial trouble, whether in bankruptcy, in default, or likely to default. Some investors target firms with a temporary cash-flow squeeze but a sound business plan, buying the debt in the expectation that both the company and its debt will recover in value. Turnaround investors go further, taking an active role in managing and reviving the company. Because the price of distressed debt reflects the recovery rate investors expect, they need specialized skill in judging default likelihood and recovery rates, and recovery estimates can misjudge the true risk over long horizons; bankruptcy itself can be lengthy, complex, and capital intensive, so investors must also know how to restructure companies and their debt. Some distressed funds specialize in debtor-in-possession (DIP) financing, which supplies operating funds to firms already in bankruptcy.

Unitranche and specialty loans

Unitranche debt is a hybrid, blended structure that merges secured and unsecured tranches into a single loan carrying one blended interest rate. Because it mixes the two, its rate generally falls between the rates demanded on secured and on unsecured debt, and it usually ranks between senior and subordinated debt in priority. Private debt firms may also make specialty loans to niche borrowers in specific situations. In litigation finance, for example, a specialist funder lends to a client, often a plaintiff, covering the legal costs of a case in return for a slice of any award.

Risk and return of private debt

Private debt can offer fixed-income investors higher yields than traditional bonds, partly by taking opportunistic positions on market inefficiencies. Investors can capture an illiquidity premium, the extra return required for giving up liquidity, and gain diversification from holding these assets. The interest rate is usually quoted as a spread over a reference rate, for instance SOFR (the Secured Overnight Financing Rate) plus 375 bps, so the coupon moves with that rate as the interest-rate environment changes. Adding value takes specialized knowledge: returns depend on the company’s life cycle phase, with earlier financing carrying higher risk and return; the debt structure matters, as with collateralized loan obligations (CLOs) priced off the market reference rate (MRR); and the investor must understand the underlying assets, especially for secured lending such as real estate. Higher return comes with higher risk. Senior private debt gives a steadier yield at moderate risk, while mezzanine private debt carries more growth potential, equity upside, and risk. Overall, private debt is riskier than traditional bonds, exposed to illiquidity and elevated default risk, and its returns are hard to model given poor data quality and artificially smooth reported figures.

Because private debt and private equity performance depends heavily on the company’s specific life cycle phase, comparing them straight against public debt and equity can mislead. Investing in a start-up is riskier than investing in an established firm; a business stuck in a declining or disintermediated industry rarely delivers a positive return over a long horizon; and the ongoing performance risk of a public position can be hedged away far more easily than that of a private one.

Vintage year and the life of a fund

The vintage year, usually the year a fund makes its first investment, matters for comparing private equity and venture capital funds against peers of the same year. A fund typically runs 10 to 12 years, split into an investment period, usually the first five years, when capital is drawn from the limited partners and put to work, and a harvesting period over the remaining years, when the fund exits and returns capital to those partners. Vintage matters because the environment at launch shapes results: a fund that starts in a low-valuation, low-risk-appetite recovery phase can ride the upswing, while a fund that deploys most of its capital at high valuations just before a crash or a long contraction is far less fortunate. This is why investors are urged to diversify across vintage years. Funds seeded in the expanding phase of the cycle tend to earn excess returns when they back early-stage companies; funds seeded in the contracting phase tend to earn excess returns when they back distressed companies.

Source: Cambridge Associates, data as of 31 December 2020.

Risk and return across the capital structure

Private capital investments differ in risk and return along the capital structure hierarchy. Private equity, the riskiest, offers the highest expected return, and private debt returns step down along a continuum to the safest, most secured form, infrastructure debt. Selecting between equity and debt, and between junior and senior debt, moves an investor along the same risk-return trade-off familiar from traditional investing.

Correlation with public markets

Adding private capital to a portfolio of listed stocks and bonds provides a moderate diversification benefit. Correlations with public market indexes range from 0.63 to 0.83, and if an investor can identify skillful managers, there is scope for excess returns in exchange for the extra leverage, market, and liquidity risk taken on.

Source: Preqin, annualized quarterly returns of the Private Capital Quarterly Index.

Venture capital shows the lowest correlations across the major indexes, which implies it offers the highest diversification benefit among the private capital categories. One caution runs the other way: direct lending can concentrate a large commitment in a single borrower, raising concentration risk and reducing diversification, so the portfolio effect depends on the category.