Some trends are so powerful that even a global recession triggered by a pandemic does very little to change their course. The huge shift of investor money from mainstream public markets to more opaque corners of the financial system is only likely to accelerate in the coming decade.
“Private capital” is handy short code for virtually any asset that is not publicly traded like stocks and bonds. It ranges from the now-mainstream private equity and real estate, to more niche but fast-growing areas including infrastructure and “private credit” — bespoke loans arranged between corporate borrowers and investment funds.
The past decade has been exceptionally friendly to private capital, with institutional investors such as endowments and pension funds desperately seeking alternatives to compensate for plunging bond yields and the fading outlook for stocks, in the hope of earning an “illiquidity premium” for taking on the extra risks of hard-to-sell assets. The somewhat illusory steadiness of returns — as a result of smoother quarterly valuations rather than the daily volatility of public markets — was an additional attraction.
Given the exuberant growth, many observers had predicted the private capital industry would be hit hard in a downturn. After all, the history of finance is littered with examples of red-hot investment strategies falling apart when the inevitable reckoning comes. Effervescent private markets long looked like another prime candidate.
But perhaps this is merely the end of the beginning of a new era of private capital, rather than the beginning of the end.
The economic aftershock of the pandemic and the bankruptcies that are starting to emerge will undoubtedly hurt many private capital funds. Private equity firms are scrambling to rescue many investments, which have often been loaded up with hefty debt burdens in the process of trying to improve returns. Those loans are often extended by the private debt funds managed by other private equity groups, in a tangled, interdependent ecosystem. Swaths of the real estate and infrastructure world will also be affected by structural shifts that look inevitable in the wake of the pandemic, such as more people working from home or flying less.
Then there is the evidence that private capital funds seem to bring better returns for their managers than their investors, and make the companies in their charge less resilient to shocks. This is particularly true in the case of private equity, which accounts for the lion’s share of the broader private capital industry.
Ludovic Phalippou, a professor at Oxford university, recently caused a stir with his calculation that, after fees, private equity investors would on average have done almost as well by putting their money into a cheap index-tracking fund since 2006, and that the managers of their investments collected $230bn in fees over the same period.
Add political opprobrium about private equity’s willingness to cut jobs and pile debt on their investments and you have what looks like a perfect storm for the industry.
But at the same time, the current crisis supercharges many of the factors that have powered its growth.
The biggest driver was the post-2008 era of low interest rates, but many investors thought they were certain to go up again at some point. Today it is hard to find anyone who thinks that. This has major implications for asset allocations.
Before, investors could kid themselves that they could wait until bond yields approached normality, but normality has now been redefined. Most investors still hanker after returns in the 7-9 per cent range. Private markets are pretty much the only areas where this looks feasible.
At the same time, companies are tiring of the burdens and relentless daily scrutiny that goes with being publicly listed. The trend towards businesses remaining private is likely to be accentuated by the crisis. While more companies have been raising money in the bond market, it remains a viable option for big businesses only. Smaller ones are likely to turn to private debt funds in even greater numbers to cope with the downturn.
More scrutiny and government restrictions are a danger for the private capital industry, but for now, the regulatory landscape is favourable. Indeed, this summer the US Department of Justice indicated that the $9tn “defined contribution” pension plans could include private equity — opening a huge new growth area.
Blackstone’s shares highlight the shifting view of investors about the future of private capital. The money manager dramatically underperformed the equity market in the first stages of the crisis, nearly halving in value from a mid-February high to a late-March low. But since then, they have actually vastly outperformed the S&P 500.
Many may dislike the reasons and fear the consequences, but it seems more likely that we are on the cusp of a new era of growth for private capital, than at the start of its demise.