The Unforeseen Impact of Private Capital Markets on the Economy
As we navigate through a period of economic uncertainty, characterized by the Federal Reserve’s aggressive rate hikes and an inversion of the yield curve in late 2022, one would expect an imminent economic downturn. However, this anticipated downturn has yet to materialize, leaving economists puzzled. The aftermath of the COVID-19 pandemic has undeniably contributed to this unique economic cycle. Still, there are deeper, slower-moving forces at play that have led to a disconnection between the economy and traditional economic indicators.
One of the hidden yet potent forces influencing the economy is the transformation of the credit formation process. Over the past decade, private capital markets, spanning venture capital, private equity, real estate, infrastructure, and private credit, have experienced exponential growth, reaching nearly $15 trillion today. While this amount is only a fraction of the $50.8 trillion public equity market, it is significant as the public market increasingly includes investment vehicles like ETFs and is dominated by large corporations that do not fully reflect the broader economy.
The Allure of Private Markets
The allure of private markets has intensified as traditional economic indicators have become less reliable in predicting market behavior. With rolling bank crises and public market volatility, private capital markets have gained traction by offering stability to borrowers and delivering substantial returns to investors through higher rates for long-term capital. This shift has diversified the landscape of capital providers, granting borrowers more options while also creating challenges in selecting the appropriate capital partner for their businesses. The process of credit formation, historically overseen by Wall Street firms, plays a pivotal role in matching lenders and borrowers in the evolving capital markets.
The Trade-Off
Investors seeking low-volatility returns have increasingly turned to the less liquid investment opportunities in private capital markets, where managers can provide stable capital solutions to portfolio companies over an extended period. This shift has minimized the impact of public market volatility on the real economy, as the cost of capital from pension funds, endowments, and insurance companies in the private markets holds more weight than short-term market fluctuations. Consequently, liquidity risk has been supplanted by credit risk in the broader economy, reshaping investment strategies and emphasizing the importance of narratives over fundamentals.
The Changing Playbook
Companies are redefining the playbook for funding and expansion, opting to remain private longer as they secure long-term investments in the private markets. The M&A landscape has shifted, with a dwindling number of publicly traded companies transitioning to private ownership and new financing structures emerging to facilitate these transactions. Acquirers now have access to a diverse range of capital providers, from hedge funds to private equity firms, offering a comprehensive suite of corporate financing solutions.
Looking ahead, as private markets gain popularity, there will be a push to democratize access to these lucrative investments. However, democratization may lead to increased liquidity, potentially compromising managers’ ability to provide long-term capital solutions and delaying fundamental realization events. This could ultimately recalibrate the credit and liquidity risk trade-off, restoring the link between traditional economic indicators and the real economy.