The rise and rise of private markets has a feeling of inexorability about it. Despite increased financing costs and an uncertain growth outlook, private market assets under management totalled $13.1tn on June 30 last year, having grown at nearly 20 per cent a year since 2018, according to consultants McKinsey.
While fundraising has declined from its 2021 peak, a recent survey by State Street found that a majority of institutional investors intended to increase their exposure to almost all private markets, including infrastructure, private debt, private equity and real estate.
Yet the boom in private markets since the 2007-2009 financial crisis, especially in the big buyout category, was built on ultra-loose monetary policy. Most of the returns came not from enhancing the efficiency of portfolio companies, but from selling assets at ever-increasing market multiples and through leverage, which increases the return on equity relative to the return on assets.
Today multiples are down, financing costs are up and balance sheets are weaker thanks to that leverage. Payouts to investors are low as managers are reluctant to sell assets and crystallise returns while multiples are depressed. As for private debt, its growth has been substantially driven by regulatory arbitrage, with banks facing tougher regulation since the financial crisis.
Governance shortcomings in private equity, overlooked in the cheap money bonanza, now look pressing as institutional investors query the values private equity managers put on portfolio companies. The valuation issue has been acute since the return of more normal interest rates. Private equity managers have tended to write down their assets’ value by far less than the falls in public markets. This is a nonsense given the higher leverage and illiquidity of the asset category. The writedowns should be far greater than for public equity.
Also of concern is last month’s decision of the US Fifth Circuit Court of Appeals to throw out the Securities and Exchange Commission’s new rules imposing greater transparency on performance and fees in private equity. There is no uniformity in disclosure, which is based on individual agreements between managers and their investors. Much controversy surrounds the calculation of internal rates of return and opaque backdoor fees that investors often unwittingly pay.
The SEC had also been worried about a lack of clearly defined valuation procedures and protocols for mitigating the industry’s innumerable conflicts of interest. These include a rash of continuation funds whereby managers sell portfolio companies to a new fund. This shelters them from valuations in the public markets. Such deals entail big increases in the buyout group’s fees.
Exposure to illiquid assets is leading to growing problems of portfolio balance for pension funds approaching the so-called endgame, where they transfer pension obligations and matching assets to insurers via buyouts or buy-ins. Insurers do not like taking on illiquid assets, and if they do accept them, they impose tough haircuts.
That said, the rise of private markets has been good for investors. They offer diversification benefits, subject to the endgame caveat above. There are huge opportunities in infrastructure arising from decarbonisation and digitisation. And venture capital provides an entrée into new technologies.
Less clear, given the huge sums pouring into private capital, is how much of an illiquidity premium remains to be harvested. Dry powder reserves, the amounts committed by investors but not yet deployed, stand at $3.7tn, a ninth consecutive year of growth.
Assessing the performance of private equity relative to public markets is difficult. Real returns can only be known when investments are finally realised. In the interim, everything rests on the managers’ valuations. Jeffrey Hooke of Johns Hopkins Carey Business School argues that private equity managers have cloaked middling investment returns in a mass of confidentiality and misinformation. They have, he says, taken a simple concept — borrowing money to increase equity returns — and shaped it into a massive commercial empire with little accountability.
The biggest question relates to costs. Private equity typically charges a 2 per cent annual management fee based on investors’ money committed to the fund, along with a 20 per cent share of the profits over a pre-agreed returns threshold of, typically, 8 per cent. This is a huge drag on performance relative to the fractional percentage costs of investing in passively managed quoted equity.
The days of easy windfalls from freakishly loose monetary policy are gone. Now, private capital is much more hazardous terrain for investors.