Capital markets are venues where savings and investments are exchanged between the parties who own capital and those who need it. These markets are foundational to economic growth in the present capitalist structure.
Over the past decades, a new kind of market has emerged which has created a distinction in how capital markets operate. This is the private capital market. Private capital refers to the assets that are not publicly traded like stocks and bonds. It ranges from the now-mainstream private equity and real estate to fast-growing areas including infrastructure and private credit. The market spans across investment banks, private equity, and venture capital firms in contrast to broker-dealers and public exchanges.
Private markets currently account for only an estimated 6% of the value of corporate equity and credit issuance, however, there is significant room for further expansion. Research estimates that private capital markets (comprising both private equity and private credit) are growing at twice the rate of their public counterparts.
How Do Private Markets Differ From Public Markets?
Valuation: The market establishes value for public companies, whereas private companies must rely on a point-in-time appraisal or a transaction to determine value. On one hand, it is possible to use the Internet to obtain real-time pricing of private securities. On the other hand, much work needs to be done in order to ascertain the value of private securities.
Limited Liquidity: Public companies have ready access to capital, but private companies must create capital solutions one deal at a time, with little certainty of success. Securities offered in the private markets have longer hold periods (3–7 years) as they are used to fund longer-term projects such as real estate and renewable energy, thus they are harder to sell. Shareholders in public companies are able to diversify because of the high liquidity available in the public capital markets and they do not have to allocate all their eggs to one basket. Private owners have nearly all their wealth tied up in one asset, the stock of their business.
Regulatory Differences: Entities issuing securities or assets in the private markets can leverage various prospectus exemptions to raise capital; however, they are governed by a separate set of rules which restricts who can hold those securities. In most cases, investing in the private capital markets is restricted to high net worth individuals, accredited investors and institutions.
Fragmented Reporting : Unlike publicly listed companies, private issuers are not required to disclose much financial information to the public. This makes it much more difficult for investors to cash out at any given time and can materially increase the perceived risk associated with such assets and securities.
How could technologies such as Blockchain & Artificial Intelligence (AI) play a role in improving private capital markets?
Blockchain and AI solve different problems, but their combined applications can produce strong results in the finance industry. The security mechanisms inherent in distributed ledger technology (blockchain) can be bolstered using the analytical power of AI. From issuance to redemption, the entire investment lifecycle can be streamlined for superior efficiency and compliance.
One of the fundamental benefits of blockchain is its decentralized approach to function as a borderless payment system. To leverage this attribute of decentralization, many blockchain protocols were designed to enable frictionless payments with low transaction costs. However, lingering security concerns challenge the widespread adoption of this technology.
Since blockchain transactions require a set of public and private keys, social engineering hacks remain a threat. With the help of AI and machine learning the investors can biometrically verify their identities avoiding inconsistencies. By recording all financial transactions on a blockchain ledger, all permissioned participants have real-time access to the information to ensure correctness. Moreover, financial reporting can be generated instantaneously because the information has already been recorded. These features are highly valuable in tracking the flow of funds and asset operations avoiding errors and costs associated with manual reconciliation.
The future of private capital given examples with asset tokenization
In the near future, private capital markets can be optimized through the tokenization of assets. Tokenization refers to the process of representing real tradable assets as digital blockchain tokens. As mentioned above, one of the limitations of private capital markets is limited liquidity. With a token economy, greater liquidity can be unlocked as tokens are highly divisible, meaning investors can purchase tokens that represent small percentages of the underlying asset.
In Deloitte’s words, “Rather than requiring very large investments, or tying up your money for extended periods with your investment split across a number of other assets in the fund, tokenization could permit you to invest €50 in the piece of art or specific building in which you are interested, and then easily sell the token at your discretion.”
This freedom to invest will potentially lead to greater personalization and customization in the investment management space -an area that is increasingly relevant as investors now look beyond just returns and pay much closer attention to how their money is affecting the planet and society at large.