Investments in Private Capital: Equity & Debt

This Learning Module and the subsequent four Learning Modules explain the investment characteristics of specific alternative asset types, starting with private equity and private debt. The subsequent Learning Modules focus on real assets, natural resources, hedge funds, and digital assets. Each Learning Module introduces core characteristics, distinguishing features, and risk–return characteristics for the specific asset class. Alternative assets differ from the traditional asset classes—debt and equity—due to their unique return, risk, and information profiles and historically show low levels of correlation with debt and equity. Moreover, alternative assets often require highly specialized knowledge to select, manage, and divest these assets. Since these alternative assets are generally considered to be less liquid than traditional asset classes, understanding the valuation and return characteristics is a specialized skill.

• Private equity is a form of private capital funding sourced from outside public markets through non-traditional sources, such as venture capital and leveraged buyout firms. It can be injected at various stages of business development, from initial idea to final transition to public company status. 
• The duration of a private equity investment also varies, with funds conducting their exits typically by the strategies of trade sales to strategic buyers or public listings through IPOs or special acquisition companies (SPACs). Other strategies include recapitalizations, secondary sales, and liquidations, with all the strategies having their unique advantages and drawbacks.
• Compared to traditional investments, private equity can offer better returns combined with higher risks. This contrast is a function of private equity’s distinct choice set, greater management control, and greater leverage. Data ambiguities make it challenging to reliably measure the benefits of private equity investing.
• Private debt primarily refers to the various forms of debt provided by investors directly to private entities. Its four major categories are direct lending, mezzanine loans, venture debt, and distressed debt, and it also includes unitranche debt of blended loans and other specialty loans.
• As in private equity investment, private debt can be arranged on a direct or indirect basis, with funds deployed over the corporate life cycle straight from an investor or intermediated through a fund. Investors receive interest payments and the return of principal after a designated term, with debt typically secured and having protections/ covenants.
• Private debt has potentially higher returns and risks than traditional f ixed income, with its investors needing specialized knowledge to adjust exposures for differences across company funding stages, debt structures, and underlying assets.
• Private debt and equity are distinct in terms of risks and performance from their public counterparts due to illiquidity and concentration risk and to the often-greater uncertainties of both their underlying businesses and the means to hedge away their risks. And a fundamental timing characteristic for private capital is its vintage year, with the valuation and economic environment at the origin of a private equity fund having a potentially substantial effect on realized results over the fund’s set lifespan.
• To offset the potentially adverse performance effects of an ill-timed fund launch at an unfavorable stage of the business cycle, investors can diversify exposure across fund vintage years.
• Investments in private capital vary in terms of risk and return across the corporate capital structure hierarchy, with a diversified mix of private equity and debt investments potentially balancing private capital risks and returns. And when combined with public stocks and bonds, investments in private capital funds can add a moderate diversification benefit with opportunities for excess returns due to private capital’s additional leverage, market, and liquidity risks.