Is the $12tn private market the ‘next shoe to drop’?

Nothing in finance has been hotter than private capital over the past decade — with growth even surpassing that of passive investing — but some think a reckoning is now coming.

This is the theme that Jefferies analyst tackle in a report they published earlier today, titled Alts: The Next Shoe to Drop? Obviously, the sellside gonna sell, so Jefferies’ analysts put a positive spin on things:

As investors scan financial markets for the “next shoe to drop”, some fear it might be found in the $12tn private markets. There are legitimate areas of concern from the impact of higher rates, to the appropriateness of asset marks and potential reversals in favourable allocation tailwinds. Inevitably, there will have been pockets of over-exuberance, but we think listed alts firms are likely to prove considerably more resilient than they are given credit for.

That’s the general tone of the entire report. “Still early innings for alts firms looking to tap retail channels,” for example. Or “recent survey data suggests asset owner demand trends are robust”. It may not surprise you to learn that private equity firms in particular are mammoth fee-payers to investment banks.

However, the report does a good job of running through a lot of the interesting issues that confront private, unlisted markets and the firms that invest in them. And there are a LOT of things going on right now.

First of all, higher bond yields simply make all alternative assets less compelling. One of the biggest drivers of the trillions of dollars that have gushed into private capital in recent years is the yield evaporation that took place in fixed income, which forced many investors to take on more risks to hit their return bogeys.

That has now changed radically. Two years ago, you’d only get a 4 per cent average yield from US junk bonds — today you can get more than that in Treasury bills. The implications for asset allocators is huge.

Jefferies highlights what BlackRock’s Rob Kapito told analysts on the investment company’s third-quarter earnings call:

“If we go back to 1995, [in order] to get a 7.5% yield, which is what many institutions are looking for, a portfolio could be in 100% [invested in] bonds. If you fast-forward 10 years, in 2005, it had to be 50% bonds, 40% equities and 10% alternatives. Then move another 10 years and in 2016, you [could allocate] only 15% bonds, 60% equities and 25% alternatives. [ . . .] Now today to get that same 7.5% yield, a portfolio could be in 85% bonds and then 15% equities and alternatives.”

Kapito followed up on this at a conference in February, pointing out that:

. . . “Today, you can be 100% [invested] in bonds and get that 7.5% [target] return. And in fact, you can take the least amount of credit risk and the least amount of duration of price risk and get an 8% or 9% return in the shortest part of the curve where rates are. Not taking advantage of this is not doing a service for your clients.”

Secondly, a lot of truly dumb stuff happened when fundraising went parabolic and everyone could flip utter dross substandard companies to public markets through SPACs. This was most obvious in venture capital and growth equity, but there are probably some hilarious snafus lurking in many private debt and equity portfolios as well. Commercial real estate now also looks . . . dicey.

Jefferies notes that private capital allocations to technology and healthcare have been steadily increasing for the past two decades, That means that portfolios will be less stable than in the past, when duller, less cyclical companies dominated more. And prices paid crept up.

The investment bank’s analysts are sanguine over the danger of more “realistic” marks on private investments, noting that the pressure from auditors is usually the most intense around the fourth-quarter/end-of-year repots, which are now in the rear-view mirror.

As a result, “we would suggest that any immediate concerns of cliff-edge mark-downs are misplaced, particularly given little time pressure to dispose of asset at unfavourable valuations”.

But Jefferies does highlight Bain’s finding that valuation expansion accounted for over half of private equity’s returns in recent years. That kind of dumb beta uplift is trickier now.

It seems less likely that this benefit will persist in the coming years (although the downturn may offer some opportunity of attractive entry valuations), particularly if rates remain at elevated levels. This inevitably means that returns will need to be generated by revenue growth and margin expansion.

Thirdly, the flood of money that went into private markets is drying up, even forcing some financiers to swallow any ethical qualms they may have and go looking for money in new areas. “The Four Seasons in Riyadh is basically Palo Alto,” one VC told our mainFT colleagues recently.

Jefferies highlights a BlackRock client survey that indicates that a decent share of investors are still looking to increase their allocations to private capital funds (and only a minority looking to pare back).

However, the subsequent slump in public markets and the (cough) remarkable resilience of private marks mean that most investors are probably at or well above their allocations. The global average is now 24 per cent, which is astonishing.

The problem is, therefore, that private-capital investors kinda need private-capital firms to move their marks to nearer public market valuations. But if private-capital firms do that, they will make a lot of those long term IRR numbers they bandy about look a lot less sexy.