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Mounting risks in a $14 trillion corner of financial markets are a threat to economic stability, research firm says
Private markets have ballooned in size in recent years and are brimming with hidden risks, Rosenberg Research said this week.
The risks cropping up in private markets, coupled with a growing equity bubble , threaten the broader financial system, the firm's vice president and senior economist, Dylan Smith, wrote in a note .
"A combination of the current bubble in public equities (to which private valuations are benchmarked) and the incredibly complex and interlinked layers of leverage in the opaque private market system deserve attention as a potential source of serious financial and economic risk," Smith said.
Private markets encompass the world of investments in non-public companies as well as startups, real estate, infrastructure, and direct lending.
Those markets quickly emerged as big beneficiaries of the era of near-zero interest rates following the global financial crisis of 2008, Smith said. Cheap borrowing costs drove a surge in private equity buy-outs and boosted valuations, which helped funds lock in returns upon exiting those investments.
Another surge in dealmaking during the COVID-19 pandemic added further fuel to the industry, quickly turning private markets from a niche investment arm to a financial giant that will top $14 trillion this year, he says.
But higher interest rates in the last two years have led to a drought in dealmaking as high valuations became tougher to justify and higher leverage costs made deals more expensive.
The result is $4 trillion in "dry powder," or funding committed by investors but yet to be deployed by funds. That funding puts massive pressure on the sector to find deals under tough market conditions, Smith says.
The industry has had to get creative as a result, adding on debt to existing leverage, and in increasingly opaque forms. That's where the risk likely lies, Smith said.
"Private asset management is fundamentally a leverage game. And that leverage is rising," Smith wrote, adding that fund managers "are resorting to an ever more creative array of temporary fixes, all of which are having the effect of raising the total leverage of the system, increasing the interdependence and circular lines of credit between parties in the system."
Those fixes range from adding additional capital into problematic portfolio companies rather than realizing losses on bad deals in the hope that conditions will improve down the line, to craftier approaches like payment-in-kind loans, where portfolio companies struggling to pay interest simply add the outstanding amount to their balance instead of paying back cash.
These increasingly complex and overlapping lending channels make for an overwhelming amount of risk as it gets tougher to assess the underlying quality of the assets, Smith says.
Now that the Fed has kicked off its easing cycle, though, that could provide some relief, Smith said, as long as it reduces interest rates fast and low enough so the system's overall leverage is tolerable, and strained underlying assets can avoid defaults.
But if it keeps interest rates restrictive, a likely scenario given president-elect Donald Trump's proposed tariffs , that could dial up pressure on the funds to deliver returns.
"Eventually, the system could collapse under a spate of portco defaults, especially if the broader economy slows down," Smith says, adding it would likely be a gradual realization among banks of the assets' poor underlying quality, rather than a sudden collapse.
Smith says the Fed and other government agencies are responsible, and they should examine the industry more closely.
"It's a major issue that the Fed is 'flying blind' with regard to what its policy settings mean for this integral part of the financial system. It is not the financial market or asset bubbles bursting that triggers recessions, but the onset of a recession creating the conditions for cash-flow impairment, which generates a negative feedback loop and eventual crisis," he wrote.
Read the original article on Business Insider