Private capital cannot avoid settling scores in the markets

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy.

At a conference of investment professionals I attended recently, several private equity funds argued with considerable force that this year’s big losses in public markets would attract even more investors.

They were confident their asset class would avoid the reckoning that stocks and bonds have been exposed to this year because they were structurally immune to disruptive changes in the investment landscape.

I’m afraid this may turn out to be too much bravado and misplaced self-confidence. Both the real economy and the financial system have entered an uncertain and destabilizing phase for both private and public market investors.

As Katie Martin recently noted in the Financial Times, “adherents to the classic portfolio split (60 per cent stocks and 40 per cent bonds) haven’t had it so bad in half a century”. Both stocks, generally called risky assets, and “risk-free” alternatives to government bonds have seen big losses this year.

In the traditional correlation between such assets, if stocks sold, government bonds rose. That correlation has been broken as all of these assets (understandably) suffered from concerns about higher interest rates and tighter financial conditions.

While there has been some reversion to more traditional correlation in recent weeks, that is not without its own problems. The reason is the growing concern about global growth and corporate profits. They point to increased volatility in equities, which make up the bulk of most public markets portfolios.

In contrast to the brutal sell-off in stocks and bonds this year, private equity valuations have remained strong. As its marketers often point out, the conventionally longer holding period reduces the disruptive influence of hot money looking to get out quickly. As is the fact that private equity investments are typically focused on single assets rather than indices, limiting the extent of contagion.

Such factors fuel expectations of an acceleration of what has already been a considerable multi-year increase in the strategic allocation of investment flows, and not just from public pension funds, foundations, endowments, and sovereign wealth institutions. Private equity fans are also hoping the asset class will get a boost from ongoing efforts to make private equity more accessible to retail money.

However, such optimism about the strength of the asset class may be excessive. Private equity valuations are updated much less frequently than those of public investments. In fact, historically, revaluations have tended to lag public markets by a minimum of six to nine months. Furthermore, several of the factors that have recently undermined public markets are also of concern to private capital.

Higher interest rates and tighter financing conditions will make it difficult to refinance private leveraged transactions. They make the paths back to the public markets less safe and the exit valuation less safe. They also dampen the enthusiasm of new investors to buy private equity holdings in the secondary market, putting pressure on both prices and volumes.

The worsening global economic outlook is also a problem. Recessions deprive businesses of real and future earnings, leading to a faster burn of cash reserves, a higher burden of debt relative to equity, and erosion of capital.

There are two additional risks that are specific to private equity in the coming period. First, that one of its oft-cited structural strengths, the lack of liquidity that cushions unfavorable price volatility, becomes a weakness; and second, that financial regulators and supervisors pay much more attention to conduct in private markets.

Private equity is likely to experience an operating paradigm shift this year as public markets have been experiencing: from a seller’s market to a buyer’s market. Indeed, both are in the process of emerging from a world of massive and predictable central bank liquidity injections that over-facilitated a seemingly endless flow of money into a smaller set of investment opportunities. What lies ahead is a world in which the cost of money will be higher and financial flows more selective as they become less extensive.

Over time, genuinely attractive value will be restored in the public and private markets. However, the process to do so is likely to be just as bumpy.

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