The thing about private markets is that they are markets – or at least they’re about to be.
It is true that private equity has experienced unprecedented momentum and success since the global financial crisis. It is also true that the extent of that momentum and success has been fundamentally predicated on low interest rates and an ocean of central bank liquidity.
It’s well understood that the normalization of interest rates will introduce a natural friction in value accretion, and that the extraction of excess liquidity by the Federal Reserve will have profound effects on at least the medium-term fundamentals of pretty much every market under the sun. (Obligatory caveat: there are those sectors, such as the private debt market, that stand to benefit from higher interest rates, but that’s a topic for another time.)
Against that backdrop, gone will be the days – a decade’s worth – during which nearly everyone managed, somehow, to achieve “top quartile” results. That can’t continue.
Many current portfolio assets were acquired at the top of the market and will either need extensions and/or continuation funds to prove successful. Or fund managers may choose to leverage portfolios at the back end, say, with high-interest NAV loans. A fund finance pro speaking with Private Funds CFO earlier this year had observed some fund managers, already feeling the deceleration of valuations, using these instruments in order hit that golden “top quartile.” (Of course, adding leverage to an investment that turns out later to be fundamentally flawed only amplifies the eventual pain.).
Bottom line: what likely comes next is a significant tiering of fund managers as markets normalize. And it will come as the denominator effect could mean a pullback of institutional investors from private equity. Add to that a likely expansion or rebuilding of investment desks – bonds, for example – at pension funds and other institutional investors that have shrunk or gone dormant since the crisis.
This time is different
With the total AUM of the private equity industry standing at around $6.3 trillion globally in 2019, the industry has clearly amassed enough scale to be viewed as systemically important.
But none of this means there will be a ‘crisis’ of the kind we saw in 2008, as one op-ed by an asset manager recently posited. One key difference is that the real killer then – the thing that precipitated a true economic crisis – was not just vast and sudden uncertainty surrounding the true price point of mortgage-backed and other securities, but also the immediate and prolonged evaporation of an ocean of bank-provided liquidity in the face of that uncertainty.
It is true that, like then, securitization has transferred the credit risk to investors and away from lenders. And it has incrementally increased the potential supply of leverage in response to seemingly endless demand.
But there has been little, if any, synthetic magnification of risk in that market outside of credit default swaps, which are overwhelmingly used to hedge corporate borrower exposures. The volume of loans originated is, more or less, the volume of value at risk in the leveraged loan market. (That was some $3 trillion outstanding in 2021. Compare that to $11.2 trillion in residential mortgage debt in the US, according to the Federal Reserve, which is about $1 trillion more than in 2008.) And, arguably, the widespread disintegration of covenants in that market should give portfolio companies breathing room, stemming a potential wave of defaults in a market downturn.
And where the exposures are held should be easy to determine, compared with the bedlam of 2008. Fund managers’ flexibility in private markets also gives them some maneuvering room. And they aren’t reliant on day-to-day liquidity like banks. Fund defaults, where a fund misses a payment to investors, could happen, but that’s hardly equivalent to a bank going from marking hundreds of millions of securities to zero almost overnight as trustees scramble to foreclose on homes and borrowers search blindly for their mortgage owners.
Where lending capacity and liquidity evaporated during the GFC, the buyouts industry alone has some $900 billion in dry powder to deploy. These are funds that will pursue lower, more realistically valued targets. At the least, that means a sizeable opportunity for managers to prove their value-creation expertise. And unlike many of the mortgages at the base of the GFC, legitimate businesses have some inherent value.
It is certainly true, as some would argue, that 15 years after the GFC, a relative lack of institutional memory brings its own risk, as the financiers who have known only an environment when interest rates were near zero face manage investments in conditions they’ve only read about in books.
But the question isn’t whether institutional memory has been lost. The reality is that institutional memory hasn’t saved markets from previous crises, in part because crises are most often unique in their causes and characteristics, and in part because profits wear blinders. Most money races into a bubble, and flees its bursting, whether that money is ‘smart’ or not.
Not everyone can win
The real question the industry needs to confront is whether investors will tolerate the return of two-way markets – those long-forgotten places populated by winners and losers, where the task at hand isn’t just negotiating the best terms in the world where nearly everyone wins, but rather in making smart choices that put you above the fold.
Investors who, not long ago, were effectively held hostage by the fear of missing out on above-market returns in private equity are now having to recalibrate their appetite for the asset class. Throw into the mix the fact that certain of those institutions (ie pension funds) have considerable political firepower behind them, and the stage could be set for uncomfortable public reckonings in the event those funds post losses on investments that were supposed to help them offset long-term funding shortfalls.
Add to this the budding market for private funds products sold to individual investors, and legislators have everything they need to go on a real-time crusade of altruism against yesterday’s winners. The actions they take in the heat of any public unrest on the issue are not likely going to be to the benefit of value, done in real-time, when emotions are highest. And the blocking of this new source of capital as institutional investors pull back could intensify competition in an arguably overpopulated market.
And should the private equity industry respond to a downturn by stripping investments and selling them for parts – an obvious way to save value for investors – there could be serious consequences for the economy and a likely even more intense political blowback.
Much of this scenario sounds familiar. A market fueled by government (and thus taxpayer) money deflates at some scale; investors (those that lose capital or are simply unhappy with results) representing voters’ prospects for wealth creation and retirement beat their chests; and legislators temporarily find their inner representative-of-the-people altruism, resulting in punitive, probably not-particularly-well-thought-out regulation. (This is not to say that further regulation of the industry is necessarily a bad thing. It isn’t.)
But even in a severe iteration of the scenario outlined above, there should be no mass, acute, and profoundly necrotic ‘crisis’ in PE, the likes of which we saw in the last financial crisis.
Such an outcome should be mitigated by the factors enumerated above: the ability to manage out of problematic investments; the lack of widespread poor or nonexistent due diligence; the existence, unlike with many mortgages in the GFC, of fundamental residual value in most businesses; the longer timeline for potential losses to realize; the vast stores of dry powder awaiting soon-to-be undervalued investments; the near impossibility, by the very nature of the asset class, of a global liquidity crisis stemming from those losses; and the non-existence of synthetically magnified exposures, to name just a few.
Yet there will likely be a reckoning for investors and many of their managers alike. Blame will surely be bandied about when some, buoyed until recently by the reliable tide of free money, run aground.
It’s a comeuppance perhaps overdue. After all, investors in PE have spent a long time enjoying the top quartiles, however those were achieved. We can guess how they’ll feel about experiencing the other ones.
In a normal market, someone has to.