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The recent growth of private markets has become a phenomenon. In fact, private equity funds, including venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activity. Assets under management in private markets reached $13.1 trillion in mid-2023, growing nearly 20% annually since 2018, according to consultants McKinsey & Company.
For years, private markets have raised more shares than public markets, and the public market’s shrinkage from share buybacks and acquisition activity has not been offset by fewer new issuances. The dynamism of private markets means companies can remain private indefinitely without worrying about access to capital.
One result has been a significant increase in the proportion of the stock market and economy that is opaque to investors, policymakers and the public. Note that disclosure requirements are primarily a contractual rather than regulatory issue.
Much of this growth has occurred against a backdrop of ultra-low interest rates since the 2007-08 financial crisis. McKinsey noted that about two-thirds of the total returns from acquisitions that entered in or after 2010 and exited in or before 2021 can be attributed to broader changes in market valuation multiples and leverage, rather than operating efficiencies. improve.
Today, these windfalls are no longer available. Private equity managers have been having trouble selling portfolio companies in a depressed market environment as monetary policy tightens and borrowing costs rise. However, there is growing interest from institutional investors in illiquid alternatives. Large asset managers are looking to attract wealthy retail investors to the region.
With public equity near all-time highs, private equity is seen as offering better opportunities for innovation within an ownership structure that ensures tighter oversight and accountability than the public industry. Meanwhile, half of the funds surveyed by the Forum of Official Monetary and Financial Institutions, a British think tank, said they expected to increase investment in private credit over the next 12 months – up from about a quarter last year.
At the same time, politicians, particularly in the UK, are giving impetus to such rash investments, encouraging pension funds to invest in riskier assets such as infrastructure. Across Europe, regulators are relaxing liquidity rules and price caps for defined-contribution pension plans.
The jury is still out on whether investors will receive large liquidity premiums in these exciting markets. A joint report from asset managers Amundi and Create Research highlighted high fees and charges in private markets. Also outlined are the opacity of the investment process and performance measurement, the high frictional costs of premature exits by investee companies, the high dispersion of final investment returns, and unprecedented levels of dry powder – allocating but not investing, waiting for opportunities to arise. The report warned that huge inflows into alternative assets could dilute returns.
The boom in private markets also raises broader economic questions. As former Securities and Exchange Commission Commissioner Allison Herren Lee has pointed out, private markets rely heavily on being able to free ride on public market information and price transparency. As public markets continue to shrink, so does the value of subsidies. Herren Lee said opacity in private markets can also lead to misallocation of capital.
Experience from the UK water industry shows that the private equity model is also not ideal for certain types of infrastructure investment. Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst owners of goods or services that are long-term in nature. This is because they have no incentive to sacrifice long-term innovation or even maintenance in the short term.
Much of the impetus behind the shift to private markets comes from regulation. Tighter capital adequacy requirements for banks after the financial crisis resulted in loans flowing to non-bank financial institutions with looser regulations. In a sense, this is not a bad thing, as SMEs have a useful new source of credit. But the associated risks are harder to track.
Palladino and Karlewicz argue that private credit funds pose a unique set of potential risks to the broader financial system due to their interrelationships with the regulated banking industry, the opacity of loan terms, the illiquidity of loans, and potential maturity mismatches. Systemic risk satisfies the need of limited partners (investors) to withdraw funds.
The International Monetary Fund believes that the rapid growth of private credit, coupled with increasing competition from banks for large transactions and pressure to deploy capital, may lead to a deterioration in pricing and non-pricing terms, including lower underwriting standards and weakening strength. Increase the risk of future credit losses. There are no prizes for guessing where the next financial crisis will occur.
