Where could the next financial crisis emerge?

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The recent growth of the private market has been phenomenal. Indeed, private funds, including venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activity. According to consultant McKinsey, private market assets are managed obtain $13.1 trillion by mid-2023 and has grown nearly 20% annually since 2018.

For many years, the private market has raised more equity capital than the public market, where the decline due to share buybacks and takeovers has not been overcome by the number of new issues increasingly decreasing. The vibrancy of private markets means companies can stay private indefinitely without worrying about access to capital.

One result has been a dramatic increase in the share of the stock market and the economy that is opaque to investors, policymakers, and the public. Note that disclosure requirements are largely a matter of contract rather than regulation.

Much of this growth has occurred against a backdrop of ultra-low interest rates since the 2007-08 financial crisis. McKinsey points out that about two-thirds of the total return on acquisitions made in 2010 or later and ending in 2021 or before can be attributed to broader moves in market valuation multiples and leverage, rather than improved operating efficiency.

Today these unexpected benefits no longer exist. Borrowing costs have risen as monetary policy tightens and private equity managers struggle to sell portfolio companies in a less buoyant market environment. However, institutional investors increasingly demand illiquid alternative investments. And major asset managers are looking to attract wealthy retail investors to the region.

With public equity near an all-time high, private equity is seen as offering better access to innovation in ownership structures that ensure better oversight and accountability compared to the cited field. Meanwhile, half of the funds covered by the Official Monetary and Financial Institutions Forum, a UK think tank, said they expected to increase their exposure to private credit in Next 12 months – up from about a quarter last year.

At the same time, politicians, especially in the UK, are adding momentum to this long-running race to encourage pension funds to invest in riskier assets, including infrastructure. floor. Across Europe, regulators are relaxing liquidity rules and price caps in defined contribution pension plans.

Whether investors will reap significant liquidity premiums in these attractive markets remains a matter of debate. One joint report by asset manager Amundi and Create Research highlight high fees and charges in the private market. It also outlines the lack of transparency of the investment process and performance evaluation, the high cost of friction due to early exits from portfolio companies, the high dispersion in ultimate investment returns, and all-time high dry powder – money allocated but not invested, waiting for opportunities to arise. The report warns that huge capital flows into alternative assets could reduce returns.

There are broader economic questions about the development of private markets. As Allison Herren Lee, former commissioner of the US Securities and Exchange Commission, did sharp In addition, private markets depend significantly on the ability to benefit from the transparency of information 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 the private market can also lead to misallocation of capital.

The private equity model is also not ideal for some types of infrastructure investments, as experienced by British industry prove. Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst kind of owner of a long-term capital good or service. This is because they have no incentive to make short-term sacrifices for long-term innovations or even maintenance.

Much of the impetus behind the move to the private market is regulatory. Stricter capital adequacy requirements for banks after the financial crisis have prompted more lenient regulation of lending to non-bank financial institutions. This is not a bad thing because there are new sources of credit that are useful for small and medium-sized companies. But the risks involved are harder to track.

According to Palladino and Karlewicz, private credit funds pose a range of potential systemic risks to the broader financial system due to their interrelationships with the regulated banking sector, of the loan terms, the illiquid nature of the loans and potential maturity mismatches. with the need of limited partners (investors) to withdraw funds.

For its part, the IMF argues that the rapid growth of private credit, coupled with increasing competition from banks for large transactions and pressure to deploy capital, could lead to a slowdown. valuation and non-pricing provisions, including lower underwriting standards and weakened valuation conditions. contracts, increasing the risk of future credit losses. There are no prizes for guessing where the next financial crisis will emerge from.