How private markets became an escape from reality

The writer is chair of Rockefeller International

If a bubble is a good idea gone too far, the $10tn global market for private investing in everything from debt to companies to real estate may be one.

The rage for private investing began in the early 2000s, after the success of the Yale University endowment fund led by David Swensen, who embraced private investments to diversify away from stock and bond markets and stabilise returns in the long run. Swensen’s definition of “long” was decades — not a mere ten years, much less the next turn from bear to bull market. He looked for private managers who were building companies rather than stripping and flipping for a quick profit. Swensen defined his job as generating multigenerational wealth to support Yale, which he assumed to be “immortal”. But his approach also had the potential to free money managers from daily pressure in the markets, and transcend the short-term thinking that was infecting modern capitalism.

What started as a sound idea has become an escape from something else entirely: reality. In return for the promise of superior returns, private funds typically “lock in” client money for up to 10 years, then report to clients much less frequently than public funds do — quarterly at most, not daily. In the new tight money era, with losses spreading across asset classes, private channels have become a way for money managers to conceal losses from clients — typically capital allocators at pension funds or other big savings institutions — who are often content in the dark. They don’t want to face the agonies of daily volatility either.

It is a conspiracy of silence, built on hope. The economic consensus is that Federal Reserve tightening may trigger a recession soon, but it will be shallow and short. If privates can hang on just a few more months, the conspiracy will have achieved its purpose, papering over losses in this bear market.

This head-in-the-sand tactic has worked for many private funds in recent recessions. After public markets peaked in 2007, buyout funds delayed reporting until after recovery began in 2009, which meant they never had to reveal the full depth of their losses. And as Covid-19 spread in early 2020, private equity managers quietly bet that the market would recover before their clients could flee — and it did, instantly, when the Fed came to the rescue.

But now, with inflation likely to be stickier than before, the easy money era is over. A new tight money era has begun. If the Fed does not come to the rescue quickly, the next downturn will not be short and shallow.

There is no good idea that too much money can’t spoil. Unlike Swensen and other pioneers of private investing, who bought low in private markets and sold high in public markets, private managers — flush with an overabundance of new funds — are chasing deals, buying high and hoping to sell even higher and running up record debt in the process. The typical company owned by a private equity firm has debts of more than five times its earnings, versus one to three times for publicly traded companies.

Today, nearly 100 per cent of the loans private funds use to finance buyouts are “covenant lite”— condition free — up from about zero per cent a decade ago. Investors are piling into private deals which the doors are closing on, as the market for initial public offerings evaporates. Many of the late arrivals are retail investors, a classic bubble warning. Swensen, who died last year, advised small investors to avoid private markets — just too complicated and costly for outsiders.

Since 2000, the assets managed by private markets have risen elevenfold — over four times faster than stock markets. That gap has widened particularly fast since 2018, when a period of market volatility ended with the Fed abandoning a turn to tighter monetary policy. Though many investors are drawn to private funds due to their superior reported returns, those returns are juiced by heavy leverage and the valuations are often based not on market prices but on guesstimates by private firms of what the companies they own will be worth years from now.

These calculations are drawing scepticism for both overstating and “smoothing out” results. Private equity firms reported gains of about 3 per cent this year, when public markets were down 20 per cent or more and tighter money battered all markets similarly. Use realistic returns, subtract fees, and private funds may end up returning less than public funds.

Yet private equity funds raised more than $1tn last year, up a record 20 per cent, according to the most recent data. Investor Cliff Asness wrote recently of the “mind blowing” possibility that investors now knowingly accept lower returns “for the privilege of not being told the prices”.

Hiding from reality creates an illusion that private investments are less risky than their debts clearly demonstrate, which draws in more money, raising risk further. The moment of reckoning likely comes when and if the downturn drags on, and private markets have to finally reveal losses in a down market. The shock could trigger a stampede toward the exits. While some private managers will continue to provide long-term capital to help build companies, many others will be exposed as financial engineers who built careers on a thin foundation of easy money.

In the end, there will be nowhere to hide in a tight money era. And private markets, which largely built returns on heavy and loose borrowing, are more vulnerable than public markets in this new age.