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In any major financial disruption, the other shoe takes some time to drop.
For example, since the outbreak of the coronavirus, Australian pension funds have written down the value of private assets, such as infrastructure, property and private equity, by up to 10%. Softbank, essentially a private capital concern, has been forced to adjust carrying values of its investments. Significant adjustments in the values of privately held assets may lie ahead.
Private markets match entities seeking capital with select investors. These backers provide debt and equity for early-stage and expansion funding, and benefit myriad industries including technology, infrastructure, resources and real estate. According to recent estimates, the private market’s size is around $6.5 trillion, an increase of $4 trillion over the past decade. Just over $900 million of new funds were raised in 2019 alone.
Investors have boosted allocations to private transactions believing they offer better returns driven by privileged access to information and deal flow within their contacts and networks. Other factors include the reduction in the size of public equity markets as a result of mergers and acquisitions and share buybacks. Private debt also has supplemented bank lending, affected by the need to rebuild balance sheets after the 2008 losses and more stringent regulations.
Capital users, meanwhile, are attracted by easier regulatory rules, especially over reporting and disclosure. Nowadays there is less scrutiny of corporate behavior, such as the purchase of private jets and related-party transactions. Private markets permit both founders and deal sponsors to maximize the value of their investments by delaying public offering of shares. Private markets also are better able to meet the funding needs of new ventures.
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Fund managers, especially private-equity firms, have used the opportunity to increase assets under management and earn higher fees for these so-called new investment classes. The U.S. regulatory environment encouraged private capital by loosening the anti-fraud rules governing share sales and increasing the number of investors allowed in private-market funds.
As a result, the public markets have largely been reduced to a vehicle for original investors to liquefy themselves via IPOs and public fundraising. By now the bulk of value has been extracted by private investors.
Private markets, public problems
The rise of private markets is problematic. First, the process lacks transparency and consistency. Returns are highly variable between individual funds and across vintages.
Second, assets prices are model-, not market-, based. Some are tied to present value cash flow methods, with subjective assumptions. These are sensitive to the terminal value or on the IPO exit multiple used. Values are affected by projected usage statistics for infrastructure and the discount rate applied. Successive rounds of private financing, often between closely related parties or funds, are used to establish artificial values. Complex vanity metrics provide misleading measures of a business’ progress. The disparity between the valuation in private transactions and eventual IPO, for example in WeWork and Uber, is striking.
Third, in recent years, valuations have become overextended. This reflects the strong flow of money into private markets and asset managers using deal heat to boost prices.
Fourth, instead of reducing agency costs arising from the different interests of shareholders and company managers, private capital replaces them with the conflicting objectives of investors and private asset managers. The later tension is harder to manage due to the opacity of the private market process and the lack of formal regulation or governance mandated in public markets.
Fifth, unlisted private equity and debt are illiquid. They must essentially be held to maturity or until they are liquidated by the underlying cash flows. Liquefaction through IPOs or a trade sale is vulnerable to market disruption.
As the coronavirus pandemic works its way through the global economy, these problems will be exposed. Many private-market business assets, chosen ironically for stability of income and cash flows, such as commercial property, toll roads and airports, have seen sharp drops in revenue — far greater than those during the Great Recession. Moreover, private market assets are generally highly leveraged, increasing their vulnerability to lower cash flows, higher credit costs and disruption to financing access.
Taking pleasure at how private markets are a problem for wealthy high-net-worth individuals, their family offices and endowments is unwise. In fact, many public pension funds that represent workers and ordinary individuals are exposed to private markets via holdings in feeder funds or publicly traded mutual funds.
The problems of private markets highlight the ways risk moves around the global financial system, often fitfully. In a period of highly managed capital flows, low returns and artificial market drivers such as abundant liquidity and low rates, the search for adequate returns encouraged investors to take on different and frequently unquantifiable risks. The promise of higher returns did not recognize the only immutable rule of finance: that risk and return are positively correlated.
Satyajit Das is a former banker. His latest book is “A Banquet of Consequences” (published in North America as “The Age of Stagnation”). He is also the author of “Extreme Money” and “Traders, Guns & Money.”
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