Where the next financial crisis could emerge

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The recent growth of private markets has been a phenomenon. Indeed, private funds, which include venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activity. According to consultants McKinsey, private markets’ assets under management reached $13.1tn in mid-2023 and have grown at close to 20 per cent a year since 2018.

For many years private markets have raised more in equity than public markets, where shrinkage as a result of share buybacks and takeover activity has not been made good by a dwindling volume of new issues. The vibrancy of private markets means that companies can stay private indefinitely, with no worries about gaining access to capital.

One outcome is a significant increase in the proportion of the equity market and the economy that is non-transparent to investors, policymakers and the public. Note that disclosure requirements are largely a matter of contract rather than regulation.

Much of this growth has taken place against the background of ultra-low interest rates since the 2007-08 financial crisis. McKinsey points out that roughly two-thirds of the total return for buyout deals entered in 2010 or later and exited in 2021 or before can be attributed to broader moves in market valuation multiples and leverage, rather than improved operating efficiency.

Today these windfall gains are no longer available. Borrowing costs have risen thanks to tighter monetary policy, and private equity managers have been having difficulty selling portfolio companies in a less buoyant market environment. Yet institutional investors have an ever-growing appetite for illiquid alternative investments. And big asset managers are seeking to attract rich retail investors into the area.

With public equity close to all-time highs, private equity is seen as offering better exposure to innovation within an ownership structure that ensures greater oversight and accountability than in the quoted sector. Meanwhile, half of funds surveyed by the Official Monetary and Financial Institutions Forum, a UK think-tank, said they expected to increase their exposure to private credit over the next 12 months — up from about a quarter last year.

At the same time politicians, most notably in the UK, are adding impetus to this headlong rush, with a view to encouraging pension funds to invest in riskier assets, including infrastructure. Across Europe, regulators are relaxing liquidity rules and price caps in defined contribution pension plans.

Whether investors will reap a substantial illiquidity premium in these heady markets is moot. A joint report by asset manager Amundi and Create Research highlights the high fees and charges in private markets. It also outlines the opacity of the investment process and performance evaluation, high friction costs caused by premature exit from portfolio companies, high dispersion in ultimate investment returns and an all-time high level of dry powder — sums allocated but not invested, waiting for opportunities to arise. The report warns that the huge inflows into alternative assets could dilute returns.

There are wider economic questions about the burgeoning of private markets. As Allison Herren Lee, a former commissioner of the US Securities and Exchange Commission, has pointed out, private markets depend substantially on the ability to free ride on the transparency of information and prices in public markets. And as public markets continue to shrink, so does the value of that subsidy. The opacity of private markets could also lead to a misallocation of capital, according to Herren Lee.

Nor is the private equity model ideal for some types of infrastructure investment, as the experience of the British water industry demonstrates. Lenore Palladino and Harrison Karlewicz of the University of Massachusetts argue that asset managers are the worst kind of owners for an inherently long-term good or service. This is because they have no incentive to sacrifice in the short term for long-term innovations or even maintenance.

Much of the dynamic behind the shift to private markets is regulatory. Tougher capital adequacy requirements on banks after the financial crisis drove lending into more lightly regulated non-bank financial institutions. This was no bad thing in the sense that there were helpful new sources of credit for small- and medium-sized companies. But the related risks are harder to track.

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

For its part, the IMF has argued that the rapid growth of private credit, coupled with increasing competition from banks on large deals and pressure to deploy capital, may lead to a deterioration in pricing and non-pricing terms, including lower underwriting standards and weakened covenants, raising the risk of credit losses in the future. No prizes for guessing where the next financial crisis will emerge from.