How Do Private Markets Work?

When it comes to the world of alternative investments, we keep hearing updates about startups raising funds from a myriad of private investors and funds. But it is more than that. This is just the tip of the iceberg.

Underneath, there is a whole world with its own innate characteristics. It has its own rules and its own set of interactions. Venturing into this world without understanding the intricacies can be akin to going on a stroll through the savannah. You never know what you could run into!

For starters, we can have different types of funds depending on the assets that they invest in. We can also have different structures for the creation of the fund in the first place.

In this chapter, we will delve into the details of the various fund structures in the private markets and understand how they operate.

First, let’s understand the difference between direct investments and fund-based investments.

As the name suggests, direct investments are when the investors initiate the process and execute it on their own. This means they evaluate different startups in the fundraising stage, do their own due diligence and then complete the investment process.

Take, for instance, Kunal Shah. The CRED founder has made several direct investments in Indian startups like Unacademy, Innov8, and ClearTax, providing them with capital and mentorship. In the same vein, heavyweights such as Ratan Tata, Anand Mahindra, Nandan Nilekani, and Sachin Bansal have also chipped in to directly fund Indian startups.

On the other hand, funds provide a vehicle through which investors can invest in the private markets. In this case, the fund pools capital from different investors and then deploys it as a whole. The portfolio is managed by a professional investment team.

We will mainly focus on the latter in this chapter.

1. Limited Partnership

   This has emerged as a prevalent structure in private markets. There are two types of partners in this case — Limited Partners (LPs) and General Partners (GPs).

   LPs are the ones who add capital to the fund. Examples can include institutions like pension funds and endowment funds and even high-net-worth individuals. But, they don’t have much control over the investment decisions of the fund. These are handled by the GPs.

   This means the GPs are responsible for the management of the fund and the deployment of the fund capital. It is up to them to identify suitable opportunities and verify their potential.

   It is also important to note that LPs have limited liability in this case. They are not liable for the amount that they contribute to the fund capital. If the fund fails on the whole and the capital deployed is lost, the GP will be liable for any debts that the fund owes!

   Profits and losses are generally allocated to the LPs in proportion to their capital contributions. As for the GPs, they receive management fees as well as a share of the profits, known as carried interest.

   FYI carried interest is a share of the fund’s profits that are distributed to the GPs. It serves as an incentive for fund managers to generate strong returns.

   Carried interest is usually subject to a hurdle rate. This means managers receive a share of profits only after they achieve a certain threshold return.

2. Limited Liability Company

   LLCs combine elements of both partnerships and corporations. They’re quite flexible in terms of management and governance, especially in comparison to traditional partnerships.

   In the case of LLCs, the profit distribution can be customised on the basis of the operating agreement between the partners. The LPs and GPs can agree on various ways to allocate profits and losses.

3. Master-Feeder Structure

   This structure involves multiple smaller feeder funds that channel the capital into a single master fund. This means we can have feeder funds located in different jurisdictions all over the world.

   It makes it easier for investors from different locations to participate in the investment process!

   Feeder funds are designed, especially to cater to specific types of investors. For instance, separate institutions, tax-exempt entities as well and foreign investors can participate in these funds. Because of the structure, even investors with different regulatory requirements can invest in the same underlying assets.

4. Separate Accounts

   Separate accounts are more personalised. In this fund structure, there is generally only one investor. The investment strategy is designed to fit their specific needs.

   As you can imagine, separate accounts allow for a lot of flexibility. Investors can customise and control their investment portfolios. However, this customisation and control comes at a cost. The investor has to bear the entire expense of structuring and running the Separate Account.

5. Fund of Funds (FoF)

   A Fund of Funds (FoF) invests in other funds. As you can imagine, this is more of a derived investment asset. Instead of investing in the asset directly, FoFs invest in other investment funds.

   Please note that FoFs can function in both the private markets as well as in the public markets. In the former case, the funds invest in unlisted stocks while in the latter case, they invest in listed companies.

   Interestingly, fund managers in FoFs play the dual role of both LPs and GPs! They reach out to investors to pool the capital together in the same way a GP does. But, they also commit that capital to other funds in the alternative investment space just like an LP.

   ADVANTAGES	DISADVANTAGES
   Diversification: FoFs offer broad diversification across myriad funds, asset classes and investment strategies.	Fees: FoFs charge additional management fees on top of fees charged by the underlying funds. This means investors have to pay a double layer of charges.
   Professional Management: Investors can benefit from the expertise of the management team. This means the deployment of the capital and the monitoring of the portfolio will be delegated entirely.	Lack of Control: Investors have almost no control over the selection of individual investments. The portfolio creation and capital deployment is handled entirely by the fund managers.
   Risk Mitigation: Diversification automatically reduces the specific risk associated with any individual fund or asset class.

6. Open-Ended Funds

   Open-ended funds allow investors to enter and exit the fund periodically. They do not have a fixed maturity date.

   This means new investors can add their capital to the pooled investment amount at any time and existing investors can withdraw their capital and exit from the investment at any time.

   ADVANTAGES	DISADVANTAGES
   Liquidity: Investors can redeem their shares and withdraw their capital whenever required.	Redemption Pressures: Large redemptions are challenging for fund managers. They might be forced to sell assets at the wrong time, at the disadvantage of all the other investors.
   Flexibility: New investors can enter or exit the fund at any time, subject to the redemption terms.	In some cases, if the fund is holding highly illiquid assets, it might pause redemptions until it manages to sell the assets.
   Continuous Capital: Because of their nature, these funds can raise capital constantly from new LPs.

7. Closed-Ended Funds

   Closed-ended funds, as the name suggests, invest the fund amount for a fixed time period.

   Say, for instance, if the GP deploys the fund capital in an investment strategy that will be executed over 7-10 years, the entire amount is locked away. LPs must wait for the GP to return their capital when the strategy makes it possible.

   There is a specific investment lifespan in this case, and often, a specific exit strategy.

   ADVANTAGES	DISADVANTAGES
   Stability: As these funds don’t have to deal with frequent redemptions, they are more stable in nature.	Lack of Liquidity: Investors have limited liquidity and they cannot withdraw the invested capital before the fund matures.
   Long-Term Focus: The fixed term allows for a long-term investment horizon. Fund managers can deploy the capital for fixed periods.	Capital Constraints: These funds cannot raise additional capital from new LPs after their initial fundraising period.
   Exit Strategy: Because of their nature, these funds often have a predetermined exit strategy.	Limited Access: Investors who miss the initial offering may not be able to access the fund later on.