Where the next financial crisis could emerge

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The recent growth of the private market is a case in point. Indeed, private funds, which include venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activity. Private market assets under management, according to consultancy McKinsey reached $13.1tn by mid-2023 and growing at close to 20 percent annually from 2018.

Over the years, private markets have raised equity more than public markets, where share buyback and takeover activity has not been offset by declining volumes of new issues. The vibrancy of private markets means that companies can remain private indefinitely, with no worries about getting access to capital.

One result is a significant increase in equity markets and proportions of the economy that are not transparent to investors, policymakers and the public. Note that disclosure requirements are largely contractual rather than regulatory.

Much of this growth has occurred against a backdrop of ultra-low interest rates since the 2007-08 financial crisis. McKinsey notes that about two-thirds of the total return for buyout deals entered into in 2010 or later and exits in 2021 or earlier can be attributed to market valuation multiples and broad moves to leverage rather than improved operating efficiency.

Today this windfall profit is no longer available. Tighter monetary policy has driven up borrowing costs, and private equity managers have found it difficult to sell portfolio companies in a less buoyant market environment. Yet institutional investors have a growing appetite for liquid alternative investments. And big 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 ensures greater oversight and accountability than the quoted sector. Meanwhile, half of funds surveyed by the Official Monetary and Financial Institutions Forum, a UK think-tank, said they expect their exposure to private debt to increase over the next 12 months – up from around a quarter last year.

At the same time, politicians, particularly in the UK, are adding stimulus to these headaches by encouraging pension funds to invest in riskier assets, including infrastructure. Across Europe, regulators are relaxing liquidity rules and price caps on defined contribution pension plans.

Investors are debating whether to cut a significant liquidity premium in this heady market. a joint Report Research by asset managers Amundi and Creat highlights high fees and charges in the private market. It outlines the opacity of investment processes and performance evaluations, high frictional costs due to premature exits from portfolio companies, high dispersion of final investment returns and an all-time high level of dry powder — money allocated but not invested, waiting for opportunities to rise, the report warns. Large inflows into assets can reduce returns.

There are broader economic questions about the growth of the private market. Like Alison Herren Lee, former commissioner of the US Securities and Exchange Commission indicated Out, private markets depend substantially on the ability to free ride on information and price transparency in public markets. And as public markets continue to shrink, so does the price of that subsidy. According to Herren Lee, private market opacity can lead to misallocation of capital.

Nor is the private equity model ideal for some types of infrastructure investment, such as experiences British Water Industry Demonstrating that Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst kind of owners for an underlying long-term good or service. This is because they have no incentive to sacrifice the short term for long term innovation or even maintenance.

Much of the dynamic behind the move to the private market is regulatory. After the financial crisis, stricter capital adequacy requirements on banks led to more lightly regulated non-bank financial institutions lending. This was not a bad thing in the sense that there were helpful new sources of credit for small and medium-sized firms. But the associated risks are 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 liquid nature of loans, and potential maturity mismatches. With the requirement for limited partners (investors) to withdraw funds.

For its part, the IMF has argued that rapid growth in private debt, increasing competition from banks in large deals and pressure to deploy capital could lead to deterioration in pricing and non-pricing terms, including lower underwriting standards and weakening. contracts, increasing the risk of future credit losses. No prizes for guessing where the next financial crisis will originate.