The writer is a former banker and author of A Banquet of Consequences — Reloaded and Fortune’s Fool
Just as subprime mortgages in the United States were at the heart of the financial turmoil of 2008, a future crisis could center on the rise of private markets.
Believing they had found the ultimate formula for success, investors plowed $9.8 billion in unlisted equity, private credit and start-up financing or new venture capital. Besides the well-known problems – overvaluation, optimistic assumptions, aggressive accounting and high debt levels, there are other concerns.
First, because private investments are inherently illiquid, investors cannot easily cauterize losses. Monetization, largely dependent on IPOs and commercial 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 end investors and the ability to realize the underlying assets. In such scenarios, investors may be exposed to distressed forced selling or trapped by restrictions on withdrawals resulting in opportunity costs.
Second, the absence of market prices means opaque valuations, which often distort the value of investments or funds. Unlisted stock valuation models rely on comparable listed companies and private financing rounds. The differences between these values and market prices can be significant. After being valued in 2021 at $46 billion, an $800 million funding round in 2022 valued Klarna at $6.7 billion (an 85% decline). As the disappointing IPOs of Uber and WeWork underscore, this is not an isolated case.
Private real estate or infrastructure, generally assimilated to leveraged bond-type investmentsare sensitive to growing uncertainty about once predictable revenues, assumed “terminal” values at any given time, financing costs and often complex options embedded in investment structures.
Subjective approaches and hard-to-verify inputs can lead to wide variations in private investment valuations. The values derived from transactions between different internally managed funds or with other asset managers are affected by potential conflicts of interest because managers’ compensation is based on the values and performance of the investments. Infrequent valuations mean that prices lag behind changing market conditions, leading to real gains and losses for investors buying or withdrawing money from funds.
Third, private equity originally focused on long-holding-period investments purchased with substantial debt in traditional industries that offered undervalued stocks, strong cash flow, low operating risk, and the potential for business improvements. Today, many of these elements, other than leverage, are often missing.
In line with industrial shifts outside of property and infrastructure, transactions are not secured by durable assets such as real estate, plant or equipment, but backed by intellectual property such as internet platforms or software.
The latter are more difficult to value and more exposed to economic cycles. Salvage values of assets in distressed conditions are less predictable because the replacement cost of tangible items no longer provides a price floor. Covenant protection in many transactions increases risk.
Fourth, for businesses that are unprofitable or have negative cash flows, the availability of follow-on funding necessary for operations is assumed. Other private investments, usually with large borrowings, face refinancing risks. All are vulnerable to market disruptions, especially if they are prolonged.
Finally, private markets present complex levels of risk. After 2008, when securitized debt and off-balance sheet structures compounded the shocks, so-called shadow banking outside of traditional lenders coalesced.
Investments today are often held through fund tiers, some with borrowings from banks or private vendors. Securitization private equity loans and non-bank credit display a familiar opacity and exacerbate leverage in the system. Declines in asset values anywhere can create instability elsewhere in the financial system.
The recent history of a highly managed money supply, low interest rates and artificially suppressed volatility has encouraged investors to face risks that are often unquantifiable and poorly understood. The rush into private assets relied on the continued availability of cheap capital as a sustainable investment strategy. He also ignored the immutable positive correlation between risk and return.
To quote American actor and comedian Will Rogers, it seems that financial markets are advancing by finding new ways to lose money, which is surprising given that the old ways continue to work so well.