Where the next financial crisis could arise

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The recent growth of private markets has been a phenomenon. In fact, private funds, which include venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activity. According to consulting firm McKinsey, the assets under management are private markets reached As of mid-2023, they amounted to $13.1 trillion and have grown by almost 20 percent annually since 2018.

For many years, private markets have raised more equity capital than public markets, where declines resulting from stock buybacks and takeover activity could not be offset by a dwindling volume of new issuance. The vibrancy of private markets means that companies can remain private indefinitely without having to worry about access to capital.

One result is a significant increase in the share of the stock market and economy that is opaque to investors, policymakers and the public. Note that disclosure requirements are largely a matter of contract, not regulation.

Much of this growth has occurred against a backdrop of extremely low interest rates since the 2007-2008 financial crisis. McKinsey notes that about two-thirds of the total return on buyout deals completed in 2010 or later and completed in 2021 or earlier can be attributed to broader changes in market valuation metrics and leverage rather than improved operating efficiencies.

Today, these windfall profits are no longer available. Due to tighter monetary policy, borrowing costs have risen and private equity managers have struggled to sell portfolio companies in a less buoyant market environment. Nevertheless, there is an increasing appetite among institutional investors for illiquid alternative investments. And large asset managers are trying to lure rich private investors to the region.

With public equity nearing an all-time high, private equity is expected to offer greater exposure to innovation within an ownership structure that ensures greater oversight and accountability than in the listed sector. Meanwhile, half of funds surveyed by the Official Monetary and Financial Institutions Forum, a British think tank, said they expect to increase their exposure to retail loans in the next 12 months – up from about a quarter last year.

At the same time, politicians, particularly in the UK, are ramping up this rush to encourage pension funds to invest in riskier assets, including infrastructure. Across Europe, regulators are easing liquidity rules and price caps for defined contribution pension plans.

Whether investors will reap a significant illiquidity premium in these turbulent markets is debatable. A joint report from asset manager Amundi and Create Research highlights the high fees and charges in private markets. It also lays out the opacity of the investment process and performance evaluation, the high frictional costs caused by early exits from portfolio companies, the wide dispersion of final investment returns, and a record level of dry powder – amounts allocated but uninvested, waiting for opportunities arise. The report warns that huge inflows into alternative investments could dilute returns.

There are broader economic questions about the emergence of private markets. Like Allison Herren Lee, a former commissioner of the US Securities and Exchange Commission pointed As it turns out, private markets depend significantly on the ability to exploit the transparency of information and prices in public markets. And as public markets continue to shrink, the value of these subsidies will decline as well. The lack of transparency in private markets could also lead to the misallocation of capital, according to Mr. Lee.

Experience shows that the private equity model is also not ideal for some types of infrastructure investments the British water industry demonstrated. Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst kind of owners of an inherently long-term good or service. Because they have no incentive to make short-term sacrifices for long-term innovation or even maintenance.

Much of the dynamic behind the shift to private markets is regulatory. Stricter capital adequacy requirements for banks after the financial crisis led to lending to less regulated non-bank financial institutions. This wasn’t a bad thing in that there were helpful new sources of credit for small and medium-sized businesses. However, the risks involved are more difficult to track.

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

The IMF, for its part, has argued that the rapid growth of private credit, combined with increasing competition from banks in large deals and pressure to provide capital, could lead to a deterioration in price and non-price conditions, including lower underwriting standards and weakening covenants, which means that Risk of future credit losses increased. There is no prize for guessing where the next financial crisis will come from.

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