Where the next financial crisis could emerge

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The recent growth of private markets has been a phenomenon. Indeed, private funds​​​​, which include venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activity. According to the consultants McKinsey, the assets of the private markets ​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​ arrived $13.1tn by mid-2023 and have grown close to 20 percent annually since 2018.

For many years, the private markets have risen more in the equity of the public markets, where the decrease due to the purchase of shares and the acquisition activity has not been made by a decreased volume of new problems. The liveliness of private markets means that companies can remain private indefinitely, without worries about gaining access to capital.

One result is a significant increase in the proportion of the equity market and economy that is not transparent to investors, policy makers and the public. Note that disclosure requirements are largely a matter of contract rather than regulation.

Much of this growth has been against the backdrop of ultra-low interest rates since the 2007-08 financial crisis. McKinsey indicates that about two-thirds of the total return for buyout deals entered into in 2010 or later and exited in 2021 or earlier can be attributed to broader movements in market valuation multiples and leverage, rather than a improved operational efficiency.

Today, these invented earnings are no longer available. Borrowing costs have risen thanks to tighter monetary policy, and private equity managers have had difficulty selling portfolio companies in a less dynamic market environment. Yet institutional investors have an ever-growing appetite for illiquid alternative investments. And big asset managers are trying to attract wealthy retail investors to the area.

With public equity near all-time highs, private equity is seen as offering better exposure to innovation in an ownership structure that ensures greater oversight and accountability than in the aforementioned sector. Meanwhile, half of the funds surveyed by the Official Monetary and Financial Institutions Forum, a UK think-tank, said they expected to increase their exposure to private credit in the next 12 months – by about a quarter of last year.

At the same time politicians, especially in the United Kingdom, are adding impetus to this peak race, with a view to encouraging pension funds to invest in riskier assets, including infrastructure. Across Europe, regulators are relaxing liquidity rules and price caps in defined contribution pension plans.

Whether investors will receive a substantial illiquidity premium in these heady markets is debatable. A joint report from asset manager Amundi and Create Research highlights the high fees and charges in the private markets. It also outlines the opacity of the investment process and performance evaluation, high frictional costs caused by premature exit from portfolio companies, high dispersion in final investment returns and a high level of of dry powder of all times – sums allocated but not invested, waiting for opportunities. to be born The report warns that huge inflows into alternative assets could dilute returns.

There are broader economic issues surrounding the growth of private markets. As Allison Herren Lee, a former commissioner of the US Securities and Exchange Commission, has pointed outside, private markets depend substantially on the ability to free ride on the transparency of information and prices in public markets. And as public markets continue to shrink, so does the value of that subsidy. The opacity of private markets could also lead to a misallocation of capital, according to Herren Lee.

Nor is the private equity model ideal for certain types of infrastructure investments, such as the experience of the British water industry it demonstrates Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst type of owner for a long-term good or service. This is because they have no incentive to sacrifice in the short term for long term innovations or even maintenance.

Much of the dynamic behind the shift to private markets is regulatory. Tighter capital adequacy requirements for banks after the financial crisis drove lending to more lightly regulated non-bank financial institutions. This was not bad in the sense that there were useful new sources of credit for small and medium-sized companies. But the associated risks are more difficult to track.

According to Palladino and Karlewicz, private credit funds pose a unique set of potential systemic risks to the broader financial system due to their interrelationship with the regulated banking sector, the opacity of loan terms, the illiquid nature of loans and potential maturity discrepancies. with the needs of limited partners (investors) to withdraw funds.

For its part, the IMF argued that the rapid growth of private credit, coupled with the increasing competition of banks on large deals and the pressure to deploy capital, may lead to a deterioration of prices and terms of prices, including lower and weakened underwriting standards. covenants, increasing the risk of credit losses in the future. No prizes for guessing where the next financial crisis will emerge.