After a Bank of England warning in April, you could be forgiven for thinking the whole $8 trillion Private Equity market and the even faster-growing Private Credit market is about vanish up its own fundament in a massive market meltdown of the worst order since 2008! Run for the hills!… Er… Probably not… Relax… for now. The papers overdid it – as they so often do!
But it is worth considering just what the current risks and opportunities are in the Alternative Private Capital Markets space.
Rebecca Jackson of the BoE, spoke about the conclusions of its’ “Thematic Review” of the risk frameworks used around Private Equity. You can find her speech on this link and it’s well worth a read. Rebecca is Executive Director of the Prudential Regulatory Authority, part of The Bank, and runs Authorisations, RegTech and the International Supervision Directorate (ARTIS). She supervises banks and investment firms operating in the UK, but headquartered abroad. She’s been active in the supervision of the Private Equity market for nearly 20-years.
Quite rightly she is concerned at the pace and growth of the now $8 trillion Private Equity sector, describing “a Cambrian explosion in the variety and complexity of financing”. (If it’s going to talk about fossils I’m all ears – being just about old enough to be one.) Among the issues she identifies is how the scale of bank financing to the private equity sector through capital market loans and bonds, (plus they also provide enormous amounts of other leverage via warehousing arrangements), has grown. She notes the critical importance to the sector of being able to “finance acquisitions and refinance debt”.
That is what the market really fears – a liquidity crisis. If the flow of finance into the private capital markets, especially refinancing, were to stop… then $8 trillion of the $100 trillion global economy could grind to a thumping stop as highly levered firms find themselves cash strapped and headed for default, creating a Tsunami of corporate bankruptcy across the whole financial markets, resulting in a massive liquidity shock for global banking, necessitating yet more bailouts…. Oh dear… been here before….
One of the key aspects of potential pain Jackson spots is how complexity – the emergence of “leverage on leverage”, including Net Asset Value (NAV) loans secured on fund assets, and deals backed on LP interests. If this all sounds very like 2007 and the launch of CDPOs and CDOs-Cubed… yep, then you get the gist.
But of course, a global crisis like that could never happen again… Banks are so much smarter today… Er. No. Today you never read about a bank in crisis because a massive industrial firm suddenly collapses. Nope, its far more likely to be crisis within a large fund (possibly one you never even heard of till it collapses) that suddenly croaks because of the complexity of its bad investment strategies – that’s when banks hurt. From LTCM, through the 2008 GFC, Archegos, H2O and onwards, be very aware it’s the financial sector that hurts most when financial firms go down.
The emergence of the now massive Private Credit markets has been a factor as much of regulation as of anything else. In the wake of the 2008 Global Financial Crisis banks were effectively constrained from lending by increased capital requirements, and forced to de-risk. They effectively no longer take much of the risks lending directly to industry, commerce and manufacturing – but have transferred that risk to the investment management sector. The critical thing is how that risk in the asset management sector is financed – much but not all through banks.
From my personal experience, I would now argue the risk management teams in the brightest and best private equity and private credit firms are better and cleverer than any of the institutionalised bank credit departments ever were. It’s a culture thing: risk takers in funds are paid very well – risk managers in banks rank below front office deal doers.
Risk cannot be destroyed – it can be transformed or transferred. While the financial funds running the commercial risks of the global economy are now making a majority of lending decisions (including into the corporate bonds they hold), they fund themselves through their savers, customers, but also the banks and capital markets – creating the circularity a good systemic crisis needs to thrive.
Although Banks have off-loaded much of the risk of lending to financial institutions by selling PE owned companies bonds to the market (another form of risk transfer) they remain exposed to the real economy through other complex lending arrangements such as collateral, warehousing and leverage to the same funds taking the direct risk. Doh!
The conclusion of the Bank of England PRA thematic review is many banks are failing to properly assess the risks inherent in PE related lending and financing: “Some firms had almost no ability to aggregate data or even appreciate its crucial importance. Given how the private equity market has developed over the past decade, this isn’t terribly surprising – though it is disappointing,” said Ms Jackson. She added: “In short, banks cannot holistically identify, measure, manage, or monitor the risks emanating from their private equity financing businesses.”
The fact is banks lack of data connectivity means they are tripping over themselves in the risk management of PE exposures. Jackson gives an example: “Where a bank has a derivatives receivable from a portfolio company, and also provides NAV financing to the fund that owns the portfolio company, the credit risks of both contracts are indirectly linked. The NAV financing facility is secured against a component of collateral that is effectively subordinated to the banks’ own derivatives receivable claim. And where banks also provide limited partner interest financing to investors in the same fund, the value of the collateral backing this facility would, in turn, be affected, adding a further layer of complexity to credit risk analysis.”
Can anyone say there are truly surprised at her conclusions? Not if you’ve been in finance as long as some of us. What does all this mean the whole Private Capital market? Is it acutely vulnerable to a crash should something go wrong?
The risk is a liquidity crisis – where suddenly everyone wants to exit PE. That would be comparable to the Mortgage-backed and CDO crisis in 2008 – everyone wanted out, but markets were offered only. Yet most of the underlying loans did fine, and those brave enough to hold, or bottom fish the market were paid out. The same thing would likely happen in a PE crisis – a panic, but the smart money holding and bottom fishing panicked bargains.
This is a multi-dimensional problem. It’s not just a liquidity problem, it’s also a price-distortion problem. The whole Private Capital Market has sprung to life as a result of the post GFC crisis regulatory decisions, but also on the back of insanely low interest rates that enabled the whole sector to stage a Big-Bang level expansion on zero-interest rates. Therein lies a second problem – refinancing the private credit sector at higher “normalised” interest rates, while finding the expectations on how much debt private equity companies could bare has been dramatically over-estimated in today’s higher rate environment.
That doesn’t mean there are not great Private Equity and Private Credit deals out there – that’s my day job where I marketing some superb transactions (email for a discussion on current opportunities in sub debt, facility lending, construction risk, aviation, MedTec, Bio-Tech, Agri and I’m sure I’ve forgotten some!) – but it does mean investors have to remain very, very selective on what they are funding from within the PE vaults.
And should things go really badly wrong – my new firm Wind Shift Capital is there to advise on Alternative Assets – and that includes finding deal exits.
Out of time and off to the day job…
