Private Equity Could Cause The Next Liquidity Crisis

Lack of liquidity of private equity and infrastructure investments will soon haunt institutional investors.

Billions invested in private equity invested in recent years will result in asset and liability mismatch for pensions and other large funds.

Private equity performance inflated by unsustainable valuation scheme.

Everyone seems to agree the stock market is overbought, but watching CNBC I frequently hear comments like: ‘We aren’t worried, job growth is solid and the economy is in good shape.‘ Another correction doesn’t worry me, but worse is likely coming or might be here already.

Most crises are unexpected. A fuse of some sort creates panic-selling, assets decline in value, balance sheets deteriorate and more selling is necessary to generate liquidity needed for solvency. The problem is that nobody wants those assets declining in value. When the last fool buys the asset (thinks he/she is getting a great deal at a discount), liquidity dries up completely (the ‘no bid’ scenario). At this point, the better quality assets are put on the auction block.

The amount of money invested in startups, infrastructure and real estate has ballooned in recent years. Many institutional investors (pension plans, banks & insurance companies, and especially private equity funds) have boasted of outstanding performance thanks to this asset category. The massive dollars governments have spent and are spending to either help fund new ventures or provide subsidized real estate for incubators remind me of times gone by – when venture capital (now renamed startup or private equity) was in vogue. Their efforts then eventually proved to be a quantum waste of our tax dollars. Governments (and banks) are a great contrarian indicator – sectors to avoid when the public sector scrambles to get on the bandwagon. When central banks are actively buying gold bullion – avoid it. When governments are investing in the energy sector – avoid it.

So what’s the issue? How is private equity ‘performance’ measured? A few of the many non-publicly traded investments become publicly-traded resulting in a big score. Of course, unless the stock was disposed of (hard for a committee to do when it is worth lots) it’s just a paper gain. But for investments that remain private, a version of the greater fool theory bolsters performance data. New investors (and legacy investors) keep providing funds but at higher valuations. As we know, this works fine until… well we know what happens when there are no more investors willing to invest.

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The amount of capital raised by 2019 vintage funds, or those that began investing last year, was about $465 billion, according to data compiled by Bloomberg. Leverage associated with private equity investing will also contribute to a liquidity crisis.Consider the following quote from last year:”Private equity is booming, thanks in large measure to private credit, a rapidly growing slice of the debt markets where ever-growing pools of capital supplied by large investors are mobilized outside of traditional lending channels. Private credit has supplied the leverage that’s helped private equity buy the businesses that have expanded its collective portfolio to its current $4 trillion.”

As of March 31, 2019, the Canada Pension Plan had $302 billion in net assets. Private Equities accounted for 93.1 billion or 23.7% of these assets. Real Assets (real estate, infrastructure etc.) slightly more than this – hardly what I’d consider ‘liquid’ assets but that’s just my opinion..(

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Infrastructure fundraising grew 17 percent globally and 59 percent in Europe, backed by a long-term secular need for investment.

Source: McKinsey Global Private Markets Review 2019

In a recession, infrastructure investment will generate cash flow, but in the event the investor needs hard cash to match lower asset valuations to liabilities these assets will certainly be less liquid than they are at present.

Of the Ontario Teachers Pension Plan’s over $200 billion in assets, 17% are non-publicly traded equities (SourceHome – Ontario Teachers’ Pension Plan). I’ve seen other huge pension plans in the U.S. that intend to bump their private equity allocations.

The following screenshot shows CalPERS lists their commitment to private equity partner funds just for 2019 to June 30th. The IRR posted for all private equity is 10.8%. Of course, the IRR doesn’t provide much information.

Private Equity Program Fund Performance Review as at June 30 2019

It seems there are nearly 12,000 private equity funds out there (that are accounted for). And these funds have raised an awful lot of money. Of course, much of that cash may not be invested yet, but their mandate is to put the money to work, and I agree with this quote from Bloomberg:

Firms may find it hard to replicate their past gains, however. The tide of new money has pushed up asset prices at the expense of returns — a pattern that’s occurred across all areas of the market, said Jill Shaw, managing director at Cambridge Associates, which manages funds on behalf of wealthy families and pension, endowment and foundation clients.

Quote from: Private Equity Is Starting 2020 With More Cash Than Ever Before By Melissa Karsh and Benjamin Robertson January 2, 2020.

Where I might differ from the above opinion is that past returns may have to be revised down if it turns out that private businesses and assets that were expected to make money just aren’t going to.

Now that you’ve seen the size of these numbers, consider that the OECD (Financial Market Trends 2008) estimated the size of losses from the Subprime Crisis to be USD 350 billion-420 billion. Clearly, the total fallout across the global economy that crisis caused was one heck of a lot bigger. It was, as all crises are, a matter of assets simply turning out to be worth much less than everyone thought they were worth. But the damage to global wealth (financial markets, consumer demand, capital spending and so on) is catastrophic.