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Harnessing Private Capital as a Force for Global Economic Growth1

Many of the world’s most urgent short- and long-term economic problems require the attention of private capital providers. Whether the particular challenge is spurring innovation in the developed world, encouraging infrastructure growth in the developing world, promoting social enterprise, or solving traditional governance problems in developed markets, large amounts of patient capital combined with careful managerial oversight are required. Private capital providers are uniquely poised to deploy the resources to solve these problems because they command large pools of capital not typically subject to the high variability of valuations and sentiments associated with public capital markets

The Global Agenda Council on Private Capital brings together a wide range of actors operating in this space: General Partners who manage investment funds; Limited Partners who provide capital to these funds; sovereign wealth vehicles; private family wealth management organizations; international development agencies engaged in the deployment of private capital; and academics whose main area of research expertise is private capital. The Council is unique in its ability to bring together such a diverse group of actors. In so doing, it creates a rare and valuable opportunity to develop a global, system-wide perspective on many of the issues and challenges facing private capital markets today.

The Global Agenda Council on Private Capital is currently completing two strategy papers aimed at addressing the key challenges facing private capital today. The first piece, “Unleashing the Power of Private Capital for Economic Development and Growth”, identifies the key challenges facing the sector today and outlines the solutions to these challenges. The purpose of this document is to form a discussion platform for the development of op-ed pieces, discussion papers, seminars, and other discussion forums. By bringing policy proposals and solutions in front of key decision-makers, the Council’s goal is to become a positive force in developing the dialogue between practitioners and policy makers that will then shape the set of opportunities that private capital faces.

In the wake of the financial crisis of 2008 and the ensuing global economic slowdown, policy makers, pundits and observers in the media have painted many sources of private capital with the same broad brush that they have used to tar many of the speculative trading activities that have had a destabilizing effect on capital markets. This partly reflects a broad mistrust of many capital market actors – the tension in developed markets between “Wall Street” and “Main Street”. But it also reflects the inherent opacity of the sector.

One of the central imperatives of the Council, therefore, has been to devise strategies aimed at addressing this perception gap in private capital. One key to addressing this misapprehension is to increase the available information regarding private capital. This requires more data on the sector as well as a consensus on best practices for reporting private capital requirements. Council members have circulated relevant academic research papers, both within the Council itself and to a wide range of constituencies outside the Council.2

In addition, the Council endorses a number of initiatives in the marketplace that aim to promote transparency and clarity. One such initiative is being spearheaded by the Institutional Limited Partners Association (ILPA), which seeks to create more robust data sources to improve transparency between LPs and GPs. In 2011, they released two templates to create more standard reporting guidelines: (i) the Capital Call & Distribution Notice template; and (ii) the Quarterly Reporting Standards template. A second initiative is spearheaded by the Private Capital Research Institute (PCRI), which recently announced a data-sharing partnership with 15 leading private capital funds who have agreed to contribute “transaction and fund-level information” to a database that will be owned and managed by PCRI and available only to academics for research purposes.

In short, correcting misperceptions surrounding the role, function, and limits of private capital is a core policy imperative of our Council.

The Investment Life-Cycle

The key challenges facing the sector can be grouped according to the basic private capital life-cycle of investment, growth and harvest (see Figure 1).

The investment phase connects the limited partners who provide capital to private capital firms. Here, the perception gaps highlighted above can be especially acute. At the same time, this phase of the private capital life-cycle faces many other challenges, many of which are specific to particular sub-sectors of the private capital market.

For example, impact investors – who invest seeking to generate not only financial returns, but also to maximize the social, environmental or external impact of their investments – face informational challenges because they do not have metrics that allow them to readily compare the impact of alternative investments across different regions or economic environments.

In contrast, the private capital provider faces some challenges which are not part of the life-cycle of the regional or sector focus. One challenge is simply the amount of capital available going forward. For example, many pension funds face increasingly short-duration commitments, and because their pension obligations are drawing nearer, they are naturally going to scale back their PE investments.

The overall net effect of this withdrawal of capital is unclear. If it results in the exit of lower-quality private capital actors who are less able to identify profitable opportunities, execute them and deliver efficiencies to investors and other market actors, then the withdrawal of capital is probably a good thing. If it starves capable organizations of patient capital, it is probably a bad thing. Of course, as capital flows out of any sector, the remaining capital should earn a higher return. Therefore, if impediments such as opaque information can be alleviated, market forces can help the sector to reach a new equilibrium.

From Investment to Growth: Deploying Capital and Building Investment

When private capital organizations put capital to work in portfolio companies, they face a second set of challenges. Some challenges arise at the capital deployment stage. For example, regulatory and tax policy uncertainty distorts investment decisions by driving a wedge between the real economic value associated with an investment and the actual return earned after legal, tax and regulatory hurdles are cleared.

From Growth to Exit: Returning Capital

Private capital providers face a third set of challenges when they attempt to exit the investments they have made. In the developed world, exit opportunities for many early stage or otherwise highly innovative ideas have been severely constrained in the wake of the collapse of the NASDAQ market in late 2000. The regulatory changes surrounding the going-public process that occurred in the wake of this collapse created a “no-man’s land” or “valley of death” for small- or medium-sized technology firms that were too small to exit efficiently on to public capital markets, but at the same time were too large to be efficiently served by innovation-focused private capital.

The Council’s paper “Unleashing the Power of Private Capital for Economic Development and Growth” spells out these challenges, detailing the nature of the problem, the constituencies affected, the mechanisms currently in place to address the challenge, and critically evaluating what has and what remains to be done.

A second paper is being developed in conjunction with experts from the Entrepreneurship council, and addresses the need to promote “Regional Innovation Hubs”, which are localized clusters of resources – universities, large companies, mentorship networks, angel investors, and other capital providers – that are critical for launching sustainable businesses that harness disruptive technologies. The idea behind Regional Innovation Hubs is to pull together complementary resources in a geographically focused eco-system so that these resources can reach a critical mass, thereby attracting capital and generating exit opportunities.

While the policy design behind this idea is necessarily broad, so that it can be implemented in a wide variety of settings, the specifics of implementation will vary across industries, geographies, and economic contexts. Spurring innovation in the developed world will likely involve placing universities at the centre of the hub, and designing policies to facilitate capital flows from alumni donor/investors who might not otherwise qualify as high-net investors. The university would thus not only be a source of innovative ideas, and of high-talent technical and scientific labour to implement the innovation, but also a source of capital for getting the idea off the ground. In the context of a developing economy, a Regional Innovation Hub might centre around a faith-based actor who can broker exchange in the community focused on solving local economic challenges.

In conclusion, the financial crisis has had a far-reaching impact on the global economy. Private capital sources continue to be critical if we are to emerge from the global crisis with strong global economic institutions, sustainable growth in the developing world, and robust growth prospects in the developed world. The structural consequences of the developed world financial crisis for private capital include: (i) fewer capital intermediation channels to small- and mid-sized businesses; (ii) materially higher, but regionally inconsistent, regulatory burdens that have the potential to distort capital allocation away from its most productive ends; (iii) chronic underinvestment in developed world infrastructure; (iv) heightened concerns about the potentially destructive nature of short-term, speculative capital flows; and (v) increased risk of regional protectionist strategies.

Increasingly, the world is turning towards private sector actors for solutions to problems that previously have typically been addressed by public sector actors. It is no surprise then that private capital stands to play such a large role in the global economy. Tackling the challenges that face the private capital sector is critical if the sector is to realize fully its potential for addressing the world’s economic problems.

Figure 1: The Private Capital Investment Cycle

Disclaimer

The opinions expressed here are those of the individual members of the Council and not of the World Economic Forum or any institutions to which they are affiliated.