07 July 2023

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Unlocking the future of private financial markets

Luigi Campopiano

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Financial markets, especially private markets, appear to demonstrate resilience in relation to real economic conditions, or perhaps the real economy has not yet truly paid the toll of the situation. 

It's not a matter of downplaying the complexity of private market investment structures, which often employ highly sophisticated debt architectures and are therefore potentially more exposed to demand dynamics and interest rates. However, looking at the medium- to long-term, not only in terms of returns but especially in terms of the evolution of the private market, its products and solutions, actors and use cases, there may be some excellent surprises. This includes not only great opportunities but also some risks.

The trend of increasing integration and hybridization between public and private markets will continue at an incessant pace, and the latter will become a normal investment option with specific characteristics, albeit evolving from what we know today. 

A private market investment, defined by the Securities and Exchange Commission, or SEC, in the U.S., is an illiquid private fund with a limited lifespan. It does not continuously raise capital, nor does it redeem shares upon investor request. 

This type of investment has an operational strategy that involves distributing the cash linked to divestments to investors. It has limited exit opportunities for investors before the fund's liquidation and does not systematically purchase listed securities and derivative instruments as part of the strategy.

The specificities of the structure should not change as they represent the distinctive features, including structural illiquidity and self-liquidation, but the absolute return characteristics at maturity or liquidation may be better recognized, along with a better definition of their correlation with other investments. 

It is reasonable to expect that the attribute of decorrelation attributed to private markets or measuring the relationships between the performance of two or more markets, indices or asset classes will be seen as a simplified concept. The necessary transparency and regulation of the market will lead to greater emphasis on valuations of periodic net asset values of the funds.

The structure of future private investments could receive assistance from blockchain as the primary tool for fractionalization, transactions and settlements. It is reasonable to assume that blockchain will be the link between all markets, with smart contracts being used to obtain and demonstrate ownership of the underlying assets they represent. The evolution of private markets towards blockchain is subject to the investors' willingness to hold “smart” contracts.

However, blockchain alone will not be enough to make private capital investments liquid. Technical tradability is already possible using traditional methods of listed markets, starting from the simple use of Special Purpose Vehicles "SPV" and similar-certified listed instruments, but not necessarily liquid. 

The transactional simplicity that blockchain could bring is one of the two key elements of liquidity. The cornerstone of liquidity is the definition of prices that make it attractive and conveniently tradable for counterparties. Listed markets have market makers who ensure pricing by being able to assume, manage and hedge the risks of these positions. 

The future evolution of private markets relates to the comparability, fungibility and commoditization of various investment instruments, which must allow for the presence of market makers: selling the future return of a private fund requires either owning the underlying asset or being able to replicate it efficiently. Liquidity always exists when it is not needed but disappears when urgently required.

Access to private markets by retail investors globally has already begun but is still in its early stages. The possibility of reaching optimal allocation levels depends on the evolution of regulations — lowering access thresholds to these instruments — which in turn is conditioned by the evolution of product governance and risk management. 

A context of better liquidity would contribute to simplifying a broader democratization; the entire world of individual pension solutions requires daily pricing and liquidity.

Moving toward retail is a transformative event for the private markets industry that could attract huge resources from individual investors. The risk for sophisticated investors who are currently invested in private markets is a dilution of the risk premium for the asset class. However, the real economy's capacity to absorb these additional resources is substantial, with a potential market capitalization much larger than private markets and a progressive opening to private capital sources by the global entrepreneurial fabric.