Unlock Editor’s Roundup for free
Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
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 consultants McKinsey, private markets assets under management reached $13.1 trillion by mid-2023 and have grown by nearly 20 percent annually since 2018.
For many years, the private markets have raised more capital than the public markets, where the contraction resulting from share repurchases and takeover activity has not been ameliorated by a declining volume of new issuance. The boom in private markets means that companies can stay private indefinitely, without having to worry about gaining access to capital.
One result is a significant increase in the proportion of the stock market and economy that is non-transparent to investors, policymakers and the public. Note that disclosure requirements are primarily a matter of contract rather than regulation.
Much of this growth has occurred against a backdrop of very low interest rates since the 2007-08 financial crisis. McKinsey notes that roughly 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 improving operational efficiency.
Today these windfalls are no longer available. Borrowing costs have risen thanks to tighter monetary policy, and private equity managers have struggled to sell portfolio companies in a less buoyant market environment. However, institutional investors have an ever-increasing appetite for alternative illiquid investments. And major asset managers are looking to attract wealthy retail investors to the area.
With public equity near all-time highs, private equity is seen as 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 Forum of Monetary and Financial Institutions, a UK think-tank, said they expected to increase their exposure to private credit over the next 12 months – up from around a quarter a year past.
At the same time, politicians, particularly in the UK, are adding to this relentless 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 on defined contribution pension plans.
It is debatable whether investors will reap a significant illiquidity premium in these heady markets. A joint report from asset manager Amundi and Create Research highlights high fees and charges in private markets. It also describes the ambiguity of the investment and performance evaluation process, high frictional costs caused by premature exits from portfolio companies, high dispersion in ultimate investment returns, and an all-time high level of dry dust. – amounts allocated, but not invested, waiting for opportunities to arise. The report warns that large inflows into alternative assets could dilute returns.
There are broader economic questions about the flourishing of private markets. As Allison Herren Lee, a former commissioner of the US Securities and Exchange Commission, has pointed out, private markets depend crucially on the ability to move free of information transparency and prices in public markets. And as public markets continue to shrink, so does the value of that subsidy. According to Herren Lee, the opacity of private markets can also lead to a misallocation of capital.
Nor is the private equity model ideal for some types of infrastructure investment, as the experience of the British water industry shows. Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst kind of owners for an inherently long-term good or service. This is because they have no incentive to sacrifice in the short term for long term innovation 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 led to 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 small and medium-sized companies. But the associated risks are harder to track.
According to Palladino and Karlewicz, private credit funds present a unique set of systemic risks to the broader financial system due to their interconnectedness with the regulated banking sector, the ambiguity of credit 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 has argued that rapid growth in private credit, coupled with increased competition from banks for large deals and pressure to deploy capital, could lead to a deterioration in price and non-price conditions, including lower underwriting standards and weakening covenants, increasing the risk of future credit losses. There are no prizes for guessing where the next financial crisis will come from.
