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The writer is a former banker and author of A Banquet of Consequences — Reloaded and Fortune’s Fool
Just as US subprime mortgages were at the heart of the 2008 financial turmoil, a future crisis may centre around booming private markets.
Believing they had found the latest formula for success, investors have ploughed about $9.8tn into unlisted equity, private credit and early stage or new venture funding. Alongside well-known problems — overvaluation, optimistic assumptions, aggressive accounting and high debt levels, there are additional concerns.
First, as private investments are inherently illiquid, investors cannot cauterise losses easily. Monetisation, largely reliant on initial public offerings and trade sales, is now difficult, especially at previously anticipated prices.
Where investments are made through funds, there may be mismatches between the redemption rights granted to ultimate investors and the ability to realise underlying assets. In such scenarios, investors can become exposed to forced distressed sales or trapped by restrictions on withdrawals resulting in opportunity costs.
Second, the lack of market prices means opaque valuations, which frequently misstate investment or fund values. Unlisted equity valuation models rely on comparable traded companies and private financing rounds. The discrepancies between these values and market prices can be large. After being valued in 2021 at $46bn, a 2022 $800mn funding round valued Klarna at $6.7bn (an 85 per cent fall). As the disappointing initial public offerings of Uber and WeWork highlight, the case is not isolated.
Private real estate or infrastructure, generally treated as leveraged bond-like investments, are sensitive to growing uncertainty over once predictable revenues, assumed “terminal” values at a point in time, funding costs and the often complex options embedded in the investment structures.
Subjective approaches and difficult to verify inputs can result in large variations in private investment valuations. Values derived from transactions between different in-house managed funds or with other asset managers are affected by potential conflicts of interest as manager remuneration is based on investment values and performance. Infrequent valuations mean prices lag behind changing market conditions, resulting in real gains and losses for investors buying into or withdrawing money from funds.
Third, private equity originally focused on long holding period investments purchased with substantial borrowings in traditional industries that offered undervalued shares, strong cash flows, low operating risk and the potential for business improvements. Today, many of these elements, other than leverage, are frequently absent.
Consistent with industrial shifts outside of property and infrastructure, transactions are not secured by hard assets such as real estate, plant or equipment but supported by intellectual property such as internet platforms or software.
The latter are harder to value and more exposed to economic cycles. Asset recovery values under distressed conditions are less predictable as the replacement cost of tangible items no longer provides a price floor. Limited covenant protection in many transactions increases the risks.
Fourth, for non-profitable or cash-flow-negative enterprises, availability of follow-on funding necessary for operations is presumed. Other private investments, typically with sizeable borrowings, face refinancing risks. All are vulnerable to market disruptions, especially if prolonged.
Finally, private markets exhibit complicated layers of risk. After 2008, when securitised debt and off-balance sheet structures aggravated shocks, the so-called shadow system of banking outside traditional lenders regrouped.
Today, investments are frequently held through tiers of funds, some with borrowings from banks or private providers. Securitisation of private equity loans and non-bank credit display familiar opacity and exacerbate leverage in the system. Falls in asset value anywhere can create instability elsewhere within the financial system.
The recent history of highly managed money supply, low interest rates and artificially suppressed volatility encouraged investors to take on often unquantifiable and poorly understood hazards. The rush into private assets was predicated on the continuous availability of cheap capital as a sustainable investment strategy. It also ignored the immutable positive correlation between risk and return.
To crib from US actor and humourist Will Rogers, it seems that financial markets advance by finding new ways to lose money, which is surprising given that the old ways continue to work just as well.
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