Earlier this month, we initiated a discussion about 2023 economic and investment outcomes. Our initial foray considered forecasts that, while possible, are unlikely to materialize. Specifically, we explored the improbability of ‘immaculate disinflation’ (falling inflation without economic or financial pain) and a US debt default.
This week we turn our attention to a more plausible scenario—a 2023 dislocation in private markets. It may not be likely, but it is conceivable. And if it occurred, it could have significant impacts on financial markets and the world economy.
Will private markets freeze up in 2023?
There is a familiar saying on Wall Street. It goes something like this: if investors have any chance of anticipating the next financial crisis, they should start by following the money. So, where have investors piled in?
In the early 1990s that trail would have led to emerging markets. Five years later, it would have pointed to the dotcom sector. And a decade later, it would have wound its way to sub-prime lending and the ensuing collapse of residential real estate.
The logic is straightforward. A good investment idea promises above-average returns. It initially delivers, drawing in investors. Success repeats, leading to euphoria, which generates even stronger capital inflows. Enthused investors borrow to boost returns. But, as increasing amounts of capital are allocated to the idea, returns begin to fall. When, inevitably, disappointment arrives, money moves out. Sometimes, however, the exits are narrow, or even shut. Then the rush turns ugly, often leading to cascading asset sales as investors try to cover losses, with selling pressures compounded as creditors come calling. In extreme cases, parts, or even all, of the capital markets freeze up.
Private equity and private credit markets are candidates for such disruption. Partly, that’s because they have attracted so much capital over the past decade. According to data from McKinsey, for example, annual inflows into private equity have grown nearly four-fold since 2010 to an estimated $1.2 trillion in 2022. Annual inflows into private credit are smaller but have grown 8-fold since 2010 to nearly $200 billion last year, a record year for the segment. Total private assets under management now exceed $10 trillion.
The draw of private markets is alpha, the incremental return over the benchmark. According to data compiled by CAIA, from 2000 to 2021, private equity investments made by pension funds produced an annual average rate of return—net of fees—of 11.0%, trouncing public equity returns over those 21 years by an annual average of 4.1%. The story is much the same for private credit. Based on the Cliffwater Direct Lending Index (CLDI), private credit indices have generated average annual returns of 9.2% since 2008, some two percentage points per annum higher than high yield indices, which have been the best performing public sector fixed income allocation over the past 14 years.
But the appeal of private markets goes beyond absolute and relative returns. Because private investments are illiquid and their returns are ‘marked to market’ infrequently, it is difficult to know their volatility. Their opacity means that returns and volatility may be prone to ‘smoothing’ designed to enhance their attractiveness. Belatedly, perhaps, regulators—including the SEC—are beginning to ask questions and raise awareness about the industry’s reporting standards. Some skeptics have wondered, for example, about how in the first 11 months of 2022, as public equity markets plunged more than 20%, private equity funds reported only modest declines.
The other side of a lack of ‘mark to market’ can be pernicious as well. In late 2008, some leading endowments – including Harvard University – faced a crisis exacerbated by the illiquidity and uncertain value of their private markets holdings. As stocks and bonds fell from the mortgage meltdown that led to the global financial crisis, some endowments that were fully invested faced margin calls on their public holdings which forced them to sell their illiquid private equity positions at heavy discounts.
In short, high returns, accompanied by low reported volatility, have underpinned the rapid growth of private investing. At some point, which may have already arrived, absolute and relative returns will decline as opportunities dwindle and weaker investment managers join the fray. By some estimates, there are approximately 10,000 general partners (GPs) today. That is one reasons, as studies have shown, that the dispersion of returns between good and bad managers may be rising. Moreover, picking good managers is becoming more difficult, as ‘hot hands’ tend not to persist.
A powerful decade of inflows, a flood of new managers, increased dispersion of returns, and the inability of good managers to stay on top could be first signs that the ‘salad days’ for private markets are over. That alone, however, is not sufficient cause to believe that a crisis is imminent. Rather, as history suggests, ‘stuff’ only happens when a crisis reveals that returns are riskier than previously thought and when excessive leverage leads to forced selling.
Here, too, there are grounds for concern. Private equity and credit investments often embed leverage, both within the target firms for private investors and on the part of those same investors as they borrow to increase the size of their allocations.
Indeed, a chunk of the excess return on private equity stems from leverage. Private equity owned companies, for example, have higher average indebtedness than public firms. While some observers have argued that higher leverage is warranted (even ‘optimal’), historical experience suggests that leverage exacerbates losses when they occur, makes an exit more difficult, and can lead to broader financial repercussions as a disorderly unwind occurs.
Crucially, the past fifteen years of rapid growth in private investing has taken place during a period of unprecedently low and stable interest rates. Companies and investors have been able to borrow cheaply and with confidence, that funding costs would remain low when, inevitably, debt needed to be refinanced. That is no longer the case, given the rapid rate hikes initiated by central banks over the past year. Only now are debt-laden companies and leveraged investors confronted by rising re-financing costs and rollover risk. At the very least, higher company borrowing costs are likely to lower returns to private investors. They may even force some to pare their holdings.
History suggests, however, that disorderly market conditions are typically preceded by an unexpected event, one that suddenly raises the risk of losses for many investors. Thus far, private markets have avoided their ‘Thai baht’, ‘Enron’ or ‘Bear Stearns’ moment. But if, as economic growth slows and corporate profitability falls, a pillar of private markets unexpectedly runs into trouble, the defining characteristics of private markets—huge inflows, opacity, and leverage—could spark a shift in investor sentiment from ‘prudent greed’ to outright fear. If so, the repercussions could produce ructions across private and even public markets.
As noted, it might not happen in 2023. But a private market ‘event’ is entirely plausible. And because the associated risks are considerable, investors and regulators would be wise to watch this space closely.