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Private market funds are finding creative but poorly regulated quick solutions to avoid bankruptcies under tighter monetary policy.
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These strategies make it difficult to assess the underlying quality of the assets, says Rosenberg Research.
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The company warns that without greater regulatory oversight, private markets pose a systemic risk.
Private markets have grown enormously in size in recent years and are packed with hidden risks, Rosenberg Research said this week.
The risks emerging in private markets, linked to a growing stock bubblethreaten the broader financial system, the company’s vice president and senior economist Dylan Smith wrote in a note.
“A combination of the current public equity bubble (against which private valuations are measured) and the incredibly complex and interconnected layers of leverage in the opaque private market system warrant attention as a potential source of serious financial and economic risk,” Smith said.
Private markets include the world of investing in non-public companies, as well as startups, real estate, infrastructure and direct lending.
Those markets quickly emerged as major beneficiaries of the era of near-zero interest rates following the 2008 global financial crisis, Smith said. Cheap financing costs spurred a surge in private equity buyouts and boosted valuations, allowing funds to maintain returns as they exited those investments.
A new wave of dealmaking during the COVID-19 pandemic further fueled the sector, quickly transforming private markets from a niche investment arm into a financial giant that will reach $14 trillion in revenue this year, he says .
But higher interest rates over the past two years have led to a drought in dealmaking as high valuations have become harder to justify and higher leverage costs have made deals more expensive.
The result is $4 trillion in “dry powder,” or financing committed by investors but yet to be deployed by funds. That financing puts enormous pressure on the sector to close deals under difficult market conditions, Smith says.
As a result, the industry has had to get creative, adding debt to the existing debt burden, in increasingly opaque forms. That’s where the risk likely lies, Smith said.
‘Private asset management is essentially a leverage game. And that leverage is increasing,” Smith wrote, adding that fund managers are “resorting to an increasingly creative range of workarounds, all of which have the effect of reducing the overall leverage of the system, reducing interdependence and circular lines of credit between the parties.” the system increases.”
