Private equity, private credit, and other private markets have enjoyed a golden era of growth since the Global Financial Crisis (GFC), fueled in part by cheap debt. Can these markets adapt to higher interest rates and increased uncertainty, or is the long boom at an end?
Private markets perform important economic functions.
- Venture capitalists finance early-stage companies not yet ready for public markets.
- Buyout funds reduce information asymmetry and agency costs, making it easier for companies to implement major changes.
- Private credit offers direct lending as an alternative to bank lending or debt issuance.
- Private infrastructure channels investment to assets that support essential services.
These activities fill gaps left by public markets and offer valuable opportunities to investors. Private market assets under management grew dramatically in the decade after the GFC, reaching $11.7 trillion in mid-2022.[i] In part, this growth was fueled by investors seeking higher returns in a low-yield environment. But low interest rates also facilitated the investment strategies of many funds.
Everything changed in June 2022, when the Federal Reserve and other central banks began increasing interest rates to combat persistent inflation. Higher interest rates hurt buyout funds, which rely on leverage to increase returns. They also reduce the present value of future cash flows, which hurts valuations. Add in heightened geopolitical tension and the risk of recession, and it is clear why tech crashed in the second half of 2022. These same factors cut the value of late-stage private companies, which had become a core component of venture capital portfolios, by more than half.[ii] Increased uncertainty also makes it harder for private funds to value their investments and achieve successful exits, which they must do to return funds to investors.
Global buyout value and deal count fell dramatically in the second half of 2022, late-stage and growth equity venture capital investment slumped, and exits slowed. Other private markets also suffered. Fund-raising is down, as firms find it harder to attract new capital. Their task is made more difficult by the denominator effect: the collapse in public markets reduced the overall value of investors’ portfolios, leaving many over-allocated to private markets. These conditions have persisted into 2023.
Still, it’s an ill wind that blows no good. Private markets are sitting on over $3 trillion of dry powder (i.e., capital committed by investors but not yet allocated to investments), which must go somewhere.[iii] The same factors that shut down IPOs and stalled exits caused banks to withdraw from syndicated lending, creating new openings for private credit; recent troubles in the banking sector may create more. Geopolitical tension, environmental concerns and persistent inflation produced the Inflation Reduction Act, aimed at boosting innovation and infrastructure investment linked to climate goals and the resulting energy transition. However, the ongoing fiscal drag on economic growth and negative impact on corporate profits from tax reform must still be managed[iv].
Venture capital may abandon its infatuation with late-stage unicorns and return to funding early-stage start-ups. And an end to FOMO (the fear of missing out) may encourage a return to plausible valuations, modest leverage and reasonable expectations. The old days may be gone, but private markets will no doubt adapt during this slower era of growth.
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[i] McKinsey & Company. 2023. Private Markets Turn Down the Volume. March 2023.
[ii] The Economist. 2023. “The Big Squeeze: How the Titans of Tech Investing Are Staying Warm Over the VC Winter.” The Economist, 4 March 2023.
[iii] Bain & Company. 2023. Global Private Equity Report 2023.