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The dangerous private capital party

The frenzied boom in private markets is one of the biggest trends in the global money management industry. It will leave many investors bitterly disappointed and could ultimately cause wider, long-term economic problems.

The party in this opaque corner of the financial system — which includes unlisted and untraded assets like venture capital, real estate, private equity, infrastructure and direct lending — is hard to miss.

As Apollo’s Marc Rowan gushed at the firm’s investor day last week: “This is just an amazing time for our business.” To underscore the point, Blackstone is now reportedly seeking to raise as much as $30bn for its next flagship buyout fund.

Can anything quell spirits? It seems not. In a recent report examining how long the “golden age of private markets” can last, Morgan Stanley analysts argued that concerns that less accommodative central banks will curtail the private capital party next year are “overdone”. They forecast that the $8tn industry will grow by double digits annually for at least the next five years.

It is hard to disagree. Even if major central banks start ratcheting back their bond purchases and some maybe even contemplate lifting interest rates in 2022, it is difficult to see how that could do anything but temporarily dent the private capital momentum.

In a world with punchy stock market valuations and bond yields seemingly rooted at near zero for the foreseeable future, private markets at least offer investors the hope that they might be able to hit their return targets. Unfortunately, these hopes are likely to be dashed.

Private capital strategies have over the past two decades outperformed their public market counterparts, yet at least some of that simply derives from the leverage embedded in them. They cannot diverge forever from the underlying returns of mainstream public markets.

Private capital returns are also even more heavily skewed by top performers than they are in traditional investment vehicles. In financial argot, the “dispersion” is greater. That makes the average return look artificially attractive to a lot of desperate pension plans, which might instead end up paying enormous fees for something that in practice is little more than fool’s gold.

Yes, studies have shown that the “persistence” of returns is greater in private capital. In other words, top performers tend to remain so more often than in other corners of the investment world. But investors cannot simply pick top-quartile performers and expect that they will continue to do well.

Firstly, top-performing private capital firms tend to be circumspect in capping the size of their funds, which means they cannot absorb all the money now gushing about. That is likely forcing investors to allocate money to more mediocre, riskier or unproven players.

Secondly, a study published by the National Bureau of Economic Research last year found that the apparent persistence of private equity performance is not as clear-cut as commonly thought (evidence that elite venture capital firms consistently outperform remained strong, however). 

Thirdly, there is now so much money being chucked at private markets that it seems overwhelmingly likely that returns for everyone will soften in the coming years, even for the industry’s rock stars.

The end result is that many investors praying that mammoth allocations to private capital will save their results in the coming decade are likely to end up disillusioned and ruing their decision.

Chart showing listed US private capital firms have a record amount of ‘dry powder’ to invest

Yet that is not the only worrisome issue thrown up by the boom. Securities and Exchange Commission commissioner Allison Herren Lee raised another, broader problem in a thoughtful speech earlier this month.

She pointed out that the growth of private capital meant that wide swaths of the US economy was “going dark” and becoming increasingly inscrutable not just to investors, but even regulators and policymakers. This is worrisome, as opacity can lead to massive misallocation of capital, widespread fraud and the build-up of systemic risks.

This is what happened in the 1920s. It eventually led to the US Securities Acts of 1933 and 1934, which enshrined the duty of regular audited reports for companies seeking to raise money from the public. Herren Lee argued persuasively that it is high time for the SEC to act decisively again, and help keep the gathering darkness at bay.

After all, as she noted: “What happens in capital markets, doesn’t stay in capital markets — faultlines on Wall Street can crack and spread across the entire country upending the lives of all Americans.”

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