Where the next financial crisis is likely to occur

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It has been a recent phenomenon of private market growth. Indeed, private funds, venture capital, private equity, private debt, infrastructure, commodities and real estate, now dominate financial activity. As consultants McKinsey, private markets assets under management has arrived 13.1tn by mid-2023 and an annual growth rate of nearly 20% from 2018 onwards.

For many years, private markets have raised equity more than public markets, with the decline due to buybacks and buybacks not being offset by the volume of new issues. The revival of the private market means that companies can remain private indefinitely without having to worry about raising capital.

One result is a large increase in the size of the equity market and the economy, which is not transparent to investors, policy makers and the public. Note that disclosure requirements are mostly a matter of contract rather than regulation.

Much of this growth has occurred against a backdrop of ultra-low interest rates since the 2007-2008 financial crisis. McKinsey suggests that for buyout deals entered into in 2010 or later and exited in 2021 or earlier, about two-thirds of the total return can be attributed to market valuation multiples and leverage rather than improved operational efficiency.

Today, these windfall profits are no longer available. Borrowing costs have risen thanks to tighter monetary policy, and private equity managers have struggled to sell portfolio companies in a weak market environment. However, institutional investors have a growing appetite for illiquid alternative investments. And big asset managers want to attract wealthy retail investors to the area.

With public equity near all-time highs, private equity appears to offer better exposure to innovations in an ownership structure that ensures greater control and accountability than the sector itself. Meanwhile, around half of UK think tanks surveyed by the Official Money and Financial Institutions Forum say they will increase their exposure to personal credit in the next 12 months – up from almost a quarter last year.

At the same time, politicians, particularly in the UK, are adding more impetus to this long rush to invest in riskier assets, including pension fund infrastructure. Across Europe, regulators are relaxing liquidity rules and pricing reforms in defined contribution pension plans.

It is doubtful whether investors will reap a significant illiquidity premium in these major markets. Joint Report Research by asset manager Amundi and Create highlights high fees and charges in private markets. In addition, transparency of the investment process and performance evaluation, high conflict costs caused by premature exit from portfolio companies, high distribution of high investment returns and always a high level of dry powder – allocated but not invested, waiting for opportunities. took off. The report warned that high inflows into alternative assets could reduce earnings.

There are broader economic questions about the expansion of the private market. According to former US Securities and Exchange Commission Commissioner Alison Herren Lee pointed out Private markets depend on the free circulation of information and price transparency in public markets. And as public markets shrink, so does the value of that subsidy. Private markets can also lead to a lack of transparency in capital allocation, Herren Lee said.

Or the private equity model is not suitable for some infrastructure investment, according to experience British water industry It shows. Lenore Palladino and Harrison Karlevich of the University of Massachusetts argue that wealth managers are naturally the worst owners for long-term utility. Because they have no incentive to sacrifice long-term innovations or maintenance in the short term.

Much of the dynamic behind the transition to private markets is regulatory. After the financial crisis, stricter capital adequacy requirements on banks led them to lend to non-bank financial institutions. This was no bad thing, as there were new sources of credit that were helpful to small and medium-sized companies. But related risks are difficult to track.

According to Palladino and Karlewicz, private credit funds pose a unique set of systemic risks to the broader financial system due to their ties to the regulated banking sector, the transparency of loan terms, the illiquid nature of the loans, and potential maturity mismatches. With the needs of certain partners (investors) to withdraw funds.

The IMF, for its part, has argued that rapid growth in private credit, coupled with increased competition from banks and increased pressure to deploy capital, could lead to inflation, including low underwriting standards and weakness in pricing and pricing terms. Commitments, increases the risk of future credit losses. No prizes for guessing where the next financial crisis will come from.