Is private equity a problem? To what extent could this class of investment funds, which manages almost $9 trillion worldwide on behalf of everyone from wealthy individuals to California teachers, cause or propagate the next financial crisis?
That’s hard to know, because the funds operate largely in the shadows. Officials should urgently demand the information needed to provide a satisfactory answer.
Financial disasters in the making have some common elements. Investors become enamored with an innovation or trend, be it the promise of New World riches in the 18th century or subprime mortgages in the 21st. They pile in relentlessly, using borrowed money to amplify the expected returns. Eventually, the debt becomes far more than the realized income can support. Reckoning and collapse ensue.
Private equity is among the most consequential financial innovations of the past few decades. The idea is that motivated, actively involved owners can squeeze more value from companies than diffuse public shareholders can. Practitioners buy significant stakes with the aim of selling at a profit within several years. They typically load the targets with as much debt as possible, to magnify returns and exploit tax deductions on interest. Global assets under management have quadrupled since 2013, encompassing businesses ranging from Bumble Inc. to European bus operator Flix SE, with millions of customers and employees worldwide.
Lately, though, private equity has struggled to deliver the returns investors expect, as elevated interest rates have eroded profits and made companies hard to sell. The response: Generate cash by borrowing more, in myriad ways. Investors and managers borrow against their stakes in funds; funds borrow against investors’ commitments (subscription finance) and against their portfolios of companies (net asset value loans); companies borrow to pay shareholders (dividend recapitalizations) and creditors (payment-in-kind loans). Much of the lending comes from private credit funds, which have grown to manage more than $2 trillion globally (and tend to be connected with private equity firms).
The proliferation of leverage, all riding on the same underlying assets, naturally raises questions. Has it become too much for already maximally indebted companies to support? If so, who will bear the losses? Will they fall mostly on long-term investors, including pension funds representing millions of future retirees, or spill over into public markets? Will business investment suffer, depriving even healthy companies of the capital they need to operate? Will contagion spread to systemically important banks and insurers, destabilizing the broader financial system?
Answers to these questions are troublingly hard to find. On the positive side, private equity and private credit don’t typically entail the same combination of leverage and flighty funding that tends to cause contagion, and constraints on borrowing have become tougher since the 2008 financial crisis. But “private” means there’s not enough disclosure to properly tally up what’s owed, to whom, on what terms and based on what expected cash flows.
What little is publicly known isn’t comforting. By one estimate, portfolio companies’ capacity to cover their interest expense is at its lowest since 2008. Stakes in private equity funds trade at prices far lower than what they’re purported to be worth. Cracks are appearing in private credit, too. Taxpayer-backed depository institutions are entangled: In the US, as of 2022, banks had loaned or committed to lend almost $2 trillion to non-bank financial institutions, including private equity and private credit — and there’s reason to question their ability to assess the risks.
Regulators are rightly concerned. The European Central Bank and the Bank of England are scrutinizing banks’ exposure, and the US Securities and Exchange Commission has enhanced reporting requirements for private equity. But to get a fuller picture, global supervisors must demand and share more comprehensive information — including from private credit and insurers, and particularly on borrowers’ capacity to repay. They should also make enough data public, in aggregate form, to allow for independent analysis.
For the most part, private investors should be free to take whatever risks they want. But when their activities have the potential to inflict collateral damage, it’s reasonable and necessary to demand more transparency. Private equity has crossed that threshold.
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