Everyone loves a dramatic blow-up in markets — a big moment that we can all point to and say “Look! This thing was silly!” and regulators can stroke their chins and say lessons must be learnt.
The finest example in 2022 was, of course, crypto, where the collapse of exchange FTX demonstrated the absurdity of an industry built on top of an asset class with an intrinsic value of zero.
Second prize (and it’s a close race) goes to the UK’s mercifully short-lived government debt crisis. The brief rule of former prime minister Liz Truss showed the world what happens when you take bond investors for granted in a high-inflation regime.
It makes sense now to look for the next blow-up, and private markets are one area under the microscope.
Private debt and equity were the Next Big Thing this time last year. At the time, bond yields were nailed to the ground — this really was a joyless place for asset allocators to try and make any money for their stakeholders. Instead, many ventured into private markets in search of higher returns.
Often this means locking up funds for several years, for example in private equity vehicles, real estate or infrastructure, in exchange for the prospect of a juicy payout. The best or worst thing about this, depending on your viewpoint, is that locked-up private investments do not throw out real-time price movements. You do not get constant moves on a screen to say your money is growing or, more likely last year, shrinking. Instead, you wait from one quarter to the next to see how the value of investments has changed.
Some observers, such as Ruchir Sharma, chair of Rockefeller International, have called this a “conspiracy of silence, built on hope”.
“The moment of reckoning likely comes when and if the downturn drags on, and private markets have to finally reveal losses in a down market,” Sharma wrote for the Financial Times in December. It certainly seems very likely that the next round of quarterly statements will make grim reading for big investors that have parked money in some private markets.
Common sense says this industry will face a tougher time in 2023, and not just because yields on safer stuff such as government bonds have swept higher. Two other big things have changed: first, public markets — stocks, bonds and the like — have had a terrible year. Suddenly that means institutional investors’ relatively small and conservative allocations to private markets make up an uncomfortably large chunk of their portfolios.
Second, the explosive gilt market crisis in the autumn showed in practical terms just how important liquidity is. When you need money in a hurry to pay a collateral call, it is unhelpful to have too much squirreled away in assets that are hard to sell.
All this could produce some kind of flash point in 2023. But the more likely outcome is a low-drama multi-year slow puncture.
True believers in markets like private debt still have faith, and with decent reason. Randy Schwimmer, senior managing director at Churchill Asset Management in New York, fully acknowledges the challenges to the sector. “But once the Fed begins to taper (and eventually concludes) rate hikes, markets will return to more normality” and the now-generous yields on public debt will fade, he said in a recent note.
“Buying private credit now, or adding to an existing position, further insulates portfolios against future price shocks,” he said.
Sadly for those who thrive on drama, that underlying support from mainstream funds and specialists alike is one of the reasons why the private markets craze is likely to calm down sensibly rather than pop.
Sure, if big investors are worried that too big a slice of their portfolios is tied up in private markets, they could sell up. It is more likely, though, that they will just stop or slow any accumulation, in part to avoid crystalising losses.
“People have already made commitments” to asset classes like private equity, says Dan Morris, chief investment officer for systematic investments and solutions at Allspring – the asset manager carved out of Wells Fargo just over a year ago. “I think they’ll stick to them. I don’t think there will be much of a selloff,” he added. Instead, funds with large private market holdings will think more carefully about what they can sell and when in the event of an urgent demand for cash.
Still, the next time the sharply dressed private equity sales person calls up with an idea for a fresh allocation, the answer from many mainstream funds will be no thanks, he suspects, especially with US government bond yields standing at more than double where they were this time last year.
Another likely outcome is that investors seek out a middle ground. A lot of asset allocators are likely to stop snapping up more private assets but still seek some kind of exposure through listed proxies and infrastructure-related corporate bonds, says Altaf Kassam, European head of investment strategy and research at State Street Global Advisors.
I will look daft, and not for the first time, if private markets implode in 2023. But right now, even the sceptics think that is unlikely.