Who Drives The Private Capital Markets?

The capital markets are a vital aspect of economic growth and innovation.  As a student of the markets I am constantly monitoring and learning from the ever changing capital markets.  Specifically, I have a keen interest in the private capital markets and how this particular aspect plays into development of industries.  The question I want to propose is the following:

Do the private markets follow innovation or do the private markets generate innovation?

The private and public markets are highly influenced by institutional investors.  Large pension plans and sovereign wealth funds have great impact on what happens in the capital markets.  However, do their allocations and portfolio decisions impact how companies and entrepreneurs react or do institutional investors react to what companies and entrepreneurs are developing?  This is a vital question that must be answered by companies and entrepreneurs on a regular basis in order to utilize the capital markets effectively.  I have proposed two examples below that illustrate both sides of the argument.

Before 2000, the cleantech industry was a little known niche in the market that only produced roughly $300 million in capital investment per year.  However, in 2004 the California Public Employees Retirement Systems (CalPERS) and the California State Teachers Retirement System (CalSTRS) allocated $1.5 billion to the cleantech industry to help reduce carbon emissions and the overall reliance on fossil fuels.  This created a chain reaction in the institutional investor world and many of the large institutional investors in the country began to allocate to this small industry niche.  This created a buzz in the capital markets and a reaction from the venture capital and private equity community to move towards new allocations.  Many of the brand name venture capital groups in the Silicon Valley started separate cleantech funds and many serial entrepreneurs began exploring this new arena for opportunities.  As a result, in 2006 the cleantech industry grew to $2.5 billion in investment capital.  This is a great example of institutional investors driving a market through capital allocations.  Ultimately, the source of this allocation came from legislation in California.  California passed AB35 which  requires a 25 percent reduction in state CO2 emissions by 2020.  Even though CalPERS and CalSTRS are independent of the legislature the entities want to be in alignment with their states initiatives, thus, policy can be a major contributor to capital allocations.

However, a seperate argument can be made for such innovative movements that were born not from capital allocations but from pure foresight from out of the box thinkers.  We are currently seeing a perfect example of this in the market today with social media.  Social media has exploded onto the scene in the last 24 months mainly from small injections of capital from angel and seed investors.  Now the market is moving quickly to respond to the great demand of this new market segment.

In 2011 JP Morgan quickly developed a $1.2 billion social media fund for the opportunity to invest into companies like Twitter and Facebook.  The details of the JP Morgan social media fund are not public but the fund is most likely comprised of institutional investors/limited partners from the private and public pension world.  Thus, this shows that institutional investors are reacting to the market by mandating new allocations in their portfolio’s for social media.  This could be the start of a new age that will make the capital markets more reactive to entrepreneurs.  This shift can be contributed to the development of new technology and the growth of Angel and Super Angels in the capital markets.  Furthermore, the movement towards SaaS (service as a software) and the cloud are eliminating the need for manufacturing or inventory, thus, companies can literally build to substantial forces on practically no capital.  There is little opportunity or time for institutional investors to predict these micro movements and as a result their allocations will have to be more opportunistic in the future.

The above examples illustrate the ever evolving movement of the capital markets.  I open the floor to insights and discussion on this matter because we know that everything could change tomorrow and that is why all individuals, companies, investors and institutions must constantly monitor the capital markets for the next great opportunities.