How do private markets work?

The term private markets describes a class of assets where investors enter into a legally binding partnership and agree to pool their capital into a fund. An investment strategy is developed by a team of investment professionals that specialize in some pre-defined market segment. For example, some fund managers raise capital they can use to buy groups of office buildings they can make improvements to and then increase leasing rates. Others extend private credit to only biotechnology and medical equipment manufacturers. I am sure you have heard of venture capital firms as well. Other firms “take” a publicly traded company private if they see an opportunity to lower operational costs, increase efficiency, and improve management while maintaining quality and increasing revenues. As you can see, opportunity to buy into private equity can vary greatly. Wealthy people love investing in private equity because it is a vehicle in which they can invest large sums of money over time which is subject to lower taxes than traditional investments.

There are 10s of 1000s of private equity funds being managed by 1000s of private equity firms around the world. A firm can consist of a single fund or multiple funds that have been created in iteration, following a successful predecessor. Managers set a target to raise a sum capital, which is often in the 100s of millions, they believe they can successfully invest and make a profitable return on for their partners.

The Office of Foreign Assets Control (OFAC), the SEC, and Comptroller of Currency, set legal guidelines in place to prevent money laundering and other finance crimes. Investor liquidity must be confirmed, and before any agreement can be signed with potential partners, they must undergo thorough background checks and the sources of the funds can be documented. Investors can partner as different commitment levels: (1) $1M, (2) $500,000, (3) $375,000, etc.

Once the fund target range is reached, the fund is then closed to any additional investment. Documents are finalized, and the date and amount of the first call is set. A “call” is a sum of money that is due towards the partner commitment amount to the fund. Calls occur periodically, and distributions (payments), usually begin after a period of 6-12 months. Some distributions are recallable, meaning they can be requested back at a moment’s notice, and don’t count toward the commitment amount, while others are not recallable.

Unfortunately, like all products that come to market, supply and demand, the ability to negotiate contract terms have shifted greatly in the favor of the management firm. In my professional experience, I have seen wealthy families become sorely disappointed if they miss a closing deadline of a new “buyout” or “secondary” market fund. They can sometimes “pay-in” additional interest upfront with the initial call to bring them on par with the other committed partners, but this happens at the discretion of the fund manager.

The private equity market has grown exponentially since the 1980s and has become increasingly diversified and specialized with our economy. In some cases, lower returns have left investors disappointed as billions in capital has poured into these funds; however, private equity is here to stay. As technology continues to expand, we can expect to see new strategies replace the older funds that wind down.

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