Private Markets Liquidity, a Warning…
Public markets are arguably over-owned and overpriced. To understand why you have only to look at one of the newest phenomenons in the global financial system, the massive artificial creation of cash or, Quantitative Easing by the world’s central banks. This has for the most part been a coordinated reaction to the financial crisis of 07/08, the Euro crisis of 12 and the Covid 19 pandemic beginning in 2019 which is still raging today. The unusual financial environment that came about from this, so much easy money sloshing around the system has pushed investors to search for more under-owned and less expensive assets primarily, but not exclusively, in the realm of the private (unlisted equity) markets. Assets under management in Private Equity funds have exploded globally. According to a report by McKinsey, PE AUM has grown by an astonishing $4 trillion in the decade 2010 to 2020, an increase of 170%. This is all well and good as everyone surfed the bull cycle which has driven public equity markets, but what happens when the cycle turns, as it surely will? Specifically, what happens to liquidity in private markets? In a crash or a bear market cycle stock markets will a provide a relatively transparent price discovery mechanism and (good) liquidity; you may not like the price but at least you can exit. Private markets liquidity, sometimes challenging even in unstressed environments, could be a very different ball game when the bear cycle arrives.
As this bull cycle has developed, early private equity investors have been offloading investments, not just to industry related buyers but also to newly established PE funds who believe there is still lots more juice in a particular acquisition. The market has effectively been feeding on itself. Given this relatively recent exuberance for unlisted equity, a market disruption event will have a potentially dramatic effect on valuations and liquidity? There is currently no transparent mechanism to establish prices in these assets.
Then, there is the issue of leverage; “L’affaire Archegos” has been a timely reminder of just how dangerous leverage can be when the bad times roll round and the PE industry is right up there with the best of them when it comes to debt financed trading. Put baldly, when this cycle turns a lot of PE funds will be left holding highly leveraged assets with no hope of establishing a price for them and little or no hope of finding buyers in what could be a fire sale scenario.
Fortunately, the world of Financial Technology may be on the brink of providing some solutions to this liquidity crisis when it arrives. There are small start-ups out there working on technology platforms that could electronify the price discovery mechanism for private market assets and cast the net far wider in terms of potential investor base. Making use of these new technologies could provide some transparency on valuation and maybe even facilitate the offloading of a portfolio constituent to an investor you would never have considered to be in your market. Once again, you may not like your exit price but at least you have an exit.