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The recent growth of private markets has been phenomenal. Indeed, private funds, which include venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activity. According to McKinsey consultants, private markets assets under management reached In mid-2023, it was 13.1 trillion dollars, and as of 2018, it was growing by almost 20 percent annually.
For many years, the private markets raised more capital than the public markets, where the reduction as a result of share buybacks and takeover activity was not offset by the declining number of new issues. The vibrancy of private markets means that companies can remain private indefinitely, without worrying about getting access to capital.
One outcome is a significant increase in the share of the stock market and the economy that is non-transparent to investors, policy makers and the public. Note that disclosure requirements are largely a matter of contract rather than regulation.
Much of that growth has occurred against a backdrop of extremely low interest rates since the financial crisis of 2007-2008. McKinsey points out that roughly two-thirds of the total return for repurchase agreements entered into in 2010 or later and exiting in 2021 or earlier can be attributed to broader shifts in multiple market valuations and leverage, rather than improved operational efficiency.
Today, those windfalls are no longer available. Borrowing costs have risen thanks to tighter monetary policy, and private equity managers are struggling to sell portfolio companies in a less dynamic market environment. However, institutional investors have a growing appetite for illiquid alternative investments. And big asset managers are trying to attract wealthy small investors to the area.
With public equity near all-time highs, private equity is seen as offering better exposure to innovation within an ownership structure that provides greater oversight and accountability than in the listed sector. Meanwhile, half of 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 – up from about a quarter last year.
At the same time, politicians, most notably in the UK, are adding impetus to this headlong rush, with the aim of encouraging pension funds to invest in riskier assets, including infrastructure. Across Europe, regulators are easing liquidity rules and price caps in defined contribution pension plans.
The question of whether investors will reap a substantial illiquidity premium in these turbulent markets is not in dispute. Joint report asset manager Amundi and Create Research highlights high fees and charges in private markets. It also outlines the opacity of the investment process and performance evaluation, the high frictional costs caused by premature exits from portfolio companies, the high dispersion in final investment returns, and the ever-high level of dry powder — amounts allocated but not invested, waiting for opportunities to arise. The report warns that huge inflows into alternative assets could reduce returns.
There are broader economic questions about the rise of private markets. As did Allison Herren Lee, former commissioner of the US Securities and Exchange Commission pointed outside, private markets depend heavily on the ability to freely use 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.
The private capital model is also not ideal for some types of infrastructure investments, as experience shows the British water industry demonstrates. Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst kind of owners of inherently long-term goods or services. This is because they have no incentive to make short-term sacrifices for long-term innovation or even maintenance.
Much of the dynamic behind the transition to private markets is regulatory. Stricter capital adequacy requirements for banks after the financial crisis encouraged lending to more lightly regulated non-bank financial institutions. This was not a bad thing in the sense that there were useful new sources of credit for SMEs. But the associated risks are more difficult to monitor.
According to Palladino and Karlewicz, private credit funds represent a unique set of potential systemic risks to the broader financial system due to their interconnectedness with the regulated banking sector, the opacity of loan terms, the illiquid nature of loans, and potential maturity mismatches. with the needs of limited partners (investors) for withdrawing funds.
For its part, the IMF argued that rapid growth in private credit, coupled with increasing competition from banks in large deals and pressure to deploy capital, could lead to a deterioration in pricing and non-pricing conditions, including lower collateral standards and weakened covenants, increasing the risk of credit losses. in future. No prizes for guessing where the next financial crisis will come from.
