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The recent growth of private markets has been phenomenal. Indeed, private funds, including venture capital, private equity, private debt, infrastructure, commodities, and real estate, now dominate financial activity. Assets under management in private markets will reach $13.1 trillion in mid-2023, according to consultant McKinsey & Co., and have grown by nearly 20 percent annually since 2018.
For many years, private markets have raised more equity than public markets, where shrinkage from share buybacks and acquisition activity has not been ameliorated by a decline in new issuance. The vibrancy of private markets means that companies can remain private indefinitely without worrying about access to capital.
One result is that the proportion of the stock market and economy that is opaque to investors, policy makers, and the public has increased significantly. Note that disclosure requirements are primarily a contractual rather than a regulatory issue.
Much of this growth has occurred against a backdrop of the lowest interest rates since the 2007-2008 financial crisis. McKinsey finds that approximately two-thirds of the total revenue from buyout transactions entered into after 2010 and exited before 2021 is attributable to wide fluctuations in market valuation multiples and leverage, rather than improvements in operating efficiency. It points out that there is a possibility.
Now, those windfall profits are no longer available. Tight monetary policy has raised borrowing costs, and private equity managers have struggled to sell portfolio companies in weak market conditions. However, institutional investors are increasingly interested in illiquid alternative investments. And major asset management companies are trying to lure high-net-worth individual investors to the region.
With public equity nearing record highs, private equity is seen as offering better exposure to innovation within an ownership structure that ensures better oversight and accountability than the listed sector. Meanwhile, half of the funds surveyed by UK think tank Official Currency and Financial Institutions Forum expect their exposure to private credit to increase over the next 12 months, up from around a quarter last year. .
At the same time, politicians, particularly in the UK, are accelerating this rush to encourage pension funds to invest in riskier assets, including infrastructure. Across Europe, regulators are relaxing liquidity rules and price caps for defined contribution pension plans.
Whether investors can enjoy a substantial illiquidity premium in such a hectic market is debatable. A joint report by asset management firms Amundi and Create Research highlights the high fees in private markets. Also, opacity in the investment process and performance evaluation, high frictional costs caused by early exits from portfolio companies, wide dispersion in final investment returns, and record levels of dry powder (allocated but uninvested). It also outlines the amount of money waiting for an opportunity. get up. The report warns that large inflows into alternative assets could dilute returns.
There are broader economic issues regarding the rapid growth of private markets. As former Securities and Exchange Commission Commissioner Alison Herren Lee pointed out, private markets rely heavily on free riding on the information and price transparency of public markets. And as the public market continues to shrink, so does the value of that subsidy. Helen Lee said opacity in private markets could also lead to misallocation of capital.
As the experience of the UK water industry shows, the private equity model is not ideal for some types of infrastructure investment. Lenore Palladino and Harrison Karlewitz of the University of Massachusetts argue that asset managers are essentially the worst kind of owners for long-term products and services. This is because there is no incentive to make short-term sacrifices for long-term innovation or maintenance.
Many of the dynamics behind the move to private markets are regulatory. Tighter capital requirements for banks after the financial crisis led to an increase in lending to less regulated non-bank financial institutions. This was not a bad thing in the sense that there was a new source of credit that was beneficial to small businesses. But the associated risks are more difficult to track.
According to Palladino and Karlewitz, private credit funds have a negative impact on the broader financial system due to their interaction with the regulated banking sector, opaque loan terms, loan illiquidity, and potential maturity mismatches. It is said that this poses a unique potential systemic risk. Because limited partners (investors) need to withdraw their funds.
Meanwhile, the IMF believes that rapid growth in private credit, as well as increased competition from banks on large deals and pressures to deploy capital, are leading to deterioration in pricing and non-price conditions, including lowering or weakening underwriting standards. claims that it is possible. Covenants increase the risk of future credit losses. There are no prizes for guessing where the next financial crisis will come from.
