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Private market funds are finding creative but little-regulated quick fixes to avoid defaults under tighter monetary policy.
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Those strategies make it tough to assess the underlying quality of the assets, Rosenberg Research says.
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The firm warns that without more scrutiny from regulators, private markets pose a systemic risk.
Private markets have ballooned in size in recent years and are brimming with hidden risks, Rosenberg Research said this week.
The risks cropping up in private markets, coupled with a growing equity bubble, threaten the broader financial system, the firm’s vice president and senior economist, Dylan Smith, wrote in a note.
“A combination of the current bubble in public equities (to which private valuations are benchmarked) and the incredibly complex and interlinked layers of leverage in the opaque private market system deserve attention as a potential source of serious financial and economic risk,” Smith said.
Private markets encompass the world of investments in non-public companies as well as startups, real estate, infrastructure, and direct lending.
Those markets quickly emerged as big beneficiaries of the era of near-zero interest rates following the global financial crisis of 2008, Smith said. Cheap borrowing costs drove a surge in private equity buy-outs and boosted valuations, which helped funds lock in returns upon exiting those investments.
Another surge in dealmaking during the COVID-19 pandemic added further fuel to the industry, quickly turning private markets from a niche investment arm to a financial giant that will top $14 trillion this year, he says.
But higher interest rates in the last two years have led to a drought in dealmaking as high valuations became tougher to justify and higher leverage costs made deals more expensive.
The result is $4 trillion in “dry powder,” or funding committed by investors but yet to be deployed by funds. That funding puts massive pressure on the sector to find deals under tough market conditions, Smith says.
The industry has had to get creative as a result, adding on debt to existing leverage, and in increasingly opaque forms. That’s where the risk likely lies, Smith said.
“Private asset management is fundamentally a leverage game. And that leverage is rising,” Smith wrote, adding that fund managers “are resorting to an ever more creative array of temporary fixes, all of which are having the effect of raising the total leverage of the system, increasing the interdependence and circular lines of credit between parties in the system.”
