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The surge in private markets has been nothing short of extraordinary. These sectors—covering venture capital, private equity, private debt, infrastructure, commodities, and real estate—are now at the forefront of financial activity. McKinsey consultants report that, by mid-2023, private markets boasted $13.1 trillion in assets under management, expanding nearly 20% per year since 2018.
For quite some time, private markets have been outperforming public ones in equity fundraising. The latter has seen a decline due to massive share buybacks and takeover activities, coupled with a decrease in new issues. This vibrancy allows companies to remain private indefinitely without concerns about accessing capital.
However, this has led to a larger portion of the equity market and economy becoming less transparent to investors, policymakers, and the general public. Unlike the public domain, disclosure requirements in private markets are primarily contractual, not regulatory.
This remarkable growth has largely taken place in an era of exceptionally low interest rates following the 2007-08 financial crisis. McKinsey’s analysis reveals that about two-thirds of the total return from buyout deals concluded between 2010 and 2021 can be linked to favorable market trends in valuation multiples and increased leverage, rather than improved operational efficiency.
Today, those kinds of gains are harder to come by. With borrowing costs climbing due to stricter monetary policies, private equity managers face challenges in unloading portfolio companies amidst less favorable market conditions. Nonetheless, institutional investors are more eager than ever for illiquid alternative investments, and major asset managers are striving to draw wealthy retail investors into the fold.
Amidst near-record public equity values, private equity is appealing for its perceived superior access to innovation within a structure that supposedly offers more oversight and accountability than listed sectors. According to a survey by the Official Monetary and Financial Institutions Forum, around half of the funds expect to increase their private credit investments over the next 12 months, up from a quarter last year.
Politicians, particularly in the UK, are fueling this rapid expansion, encouraging riskier asset investments like infrastructure through pension funds. Across Europe, regulators are easing liquidity rules and price caps on defined contribution pension plans.
Whether investors can secure a meaningful illiquidity premium in today’s exuberant markets is debatable. A collaborative report by Amundi and Create Research raises concerns over the high fees and charges associated with private markets. It also critiques the complexity of assessing the investment process and outcomes, the higher transaction costs from premature exits, the significant variation in final investment returns, and the record-high levels of “dry powder”—allocated but uninvested funds awaiting opportunities. Such massive inflows into alternative assets might diminish potential returns, the report cautions.
Beyond finances, there are economic implications following this boom in private markets. As pointed out by Allison Herren Lee, a former U.S. Securities and Exchange Commission commissioner, private markets heavily rely on the transparency of data and pricing in public markets. With public markets shrinking, that transparency’s benefit decreases. This opacity could also lead to capital misallocation, Herren Lee suggests.
Moreover, the private equity model may not be suitable for certain infrastructure investments, as seen in the British water industry. Researchers Lenore Palladino and Harrison Karlewicz from the University of Massachusetts argue that asset managers do not make ideal stakeholders for inherently long-term assets or services, as they lack motivation to compromise short-term gains for long-term innovation or maintenance.
The shift towards private markets is significantly driven by regulatory changes. Post-crisis, stricter capital requirements for banks have pushed lending towards less-regulated non-bank financial entities. While this shift provided new credit avenues for smaller enterprises, it also obscured related risks.
According to Palladino and Karlewicz, private credit funds bring unique systemic risks to the financial ecosystem due to their ties with regulated banks, opaque loan terms, illiquid nature, and potential mismatches between loan maturities and investors’ withdrawal needs.
Meanwhile, the IMF has raised concerns that the swift expansion of private credit, coupled with banks’ stiff competition for large deals and pressure to invest capital, could weaken pricing terms and standards, potentially leading to future credit losses. It’s not hard to imagine where the seeds of the next financial crisis might be sown.
