A recent Financial Times opinion piece laid out how illiquidity makes private equity hazardous for investors. The Bank of England’s Nathanaël Benjamin warns private equity illiquidity is a systemic risk to the financial system. The investment research firm Markov Processes International says it threatens the solvency of Ivy League university endowments. Public pension watchdog Equable Institute worries that valuation lags caused by private equity illiquidity lead to chronic underfunding.
People usually grow anxious when asset classes that are supposed to be liquid — Treasuries, money market funds, large-cap stocks, commercial paper, major commodity futures — freeze up. Investors counting on these assets for cash might be unable to make payments, leading to cascading failures and confusion. But since private equity is known to be illiquid, how can there be negative surprises? In fact, the whole point of private equity is to remove the short-term pressure of generating earnings, allowing a company’s managers to focus on creating long-term value.
Part of the confusion is that private equity is often lumped with “liquidity premium” investments like venture capital, private credit, real estate and hedge funds; when in fact it is the opposite. Liquidity premium assets are supposed to sell at lower prices than comparable publicly traded assets, and, therefore, pay investors a higher return to compensate for tying up investments for extended periods.
But private equity does the opposite, paying high publicly traded stock prices — plus takeover premiums — for public companies, and converting them to illiquid form. They lose money by giving up that liquidity, but promise to make it back from improved management, leverage and other tools. They are negative liquidity premium investments.
The two main drivers of concern around private equity currently are increased interest rates and moribund deal markets. Higher rates suck cash out of levered private equity deals, which are generally funded with short-term or floating rate debt, quickly increasing the required payments during times of tightening monetary policy. The added interest expense hurts company earnings, which reduces their sale value. Higher rates combine with higher equity valuation multiples to make new private equity deals unattractive.
The lack of deals means private equity firms are sitting on unprecedented levels of cash, but also they are not returning expected cash to investors from sales of their portfolio companies. Some of them have resorted to adding a new layer of debt (called net asset value, or NAV, loans) to their overall portfolios, exacerbating liquidity concerns, but investor pressure seems to have curtailed the practice.
When investors commit to a private equity fund, they typically promise an amount of capital that the fund can call for as it finds deals. The shortage of new deals means investors are saddled with unprecedented levels of future commitments. Combined with reduced cash flows from private equity funds, this can leave investors in precarious positions. If they keep committed capital in cash, their portfolios will be underallocated to equities. If they put the committed capital in equities, they risk it being called at a time when valuations are low.
There are many ways for the pressure to ease without pain. Interest rates could come down. Equity valuation ratios could decline. Deal-making could resume. Company earnings and cash flows could grow. Secondary markets for private equity commitments and shares could get larger and more efficient. At the moment, the market is putting the probability of a Federal Reserve rate cut in September at nearly 100%, and is pricing in soft-landing scenarios for equities and the economy. So, optimists who trust markets can rest easy.
On the other hand, critics see an Armageddon scenario in which none of those things happen. Company earnings and cash flows could plunge with central banks unable to respond with rate cuts due to inflation concerns. Private equity firms could be unable to service debt for some portfolio companies, causing those firms to go bankrupt. Reduced portfolio values could trigger bankruptcies of NAV loans. Both defaults could inflict large losses on creditors. Banks are highly exposed both directly and indirectly via loans to private credit entities. Investors could lose not just their investments but perhaps their commitments as well. Those who borrowed against private equity holdings would be in the worst shape.
Even if the situation never gets this bad, if things teeter on the brink for too long, cash flow problems could emerge for investors at a time when borrowing to cover portfolio cash shortfalls is expensive or perhaps unavailable. Something similar happened in 2008. The difference this time is it might be triggered by a much smaller earnings and equity price decline than the historical crash of the financial crisis.
I don’t see private equity as a likely trigger of the next financial crisis. The sector is too diverse, flexible and well managed to slide thoughtlessly into disaster. Contracts are structured without assumptions of liquidity, investors consider the long-term nature and uncertain cash flows when limiting their private equity portfolio allocations. But private equity is a huge reservoir of risky debt, both financial debt and contractual commitments that represent economic debt, and complex financial engineering. It won’t be the first domino to fall in a future crisis, but if a cascade of smaller dominos reach it, it could be the biggest domino to fall.
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