Are The Private Markets Are Getting Too Crowded?

Since the financial crisis the flows into passively managed funds have caused many in the industry to predict that we’re in an index fund bubble. I think too many people throw around the term ‘bubble’ without considering what an actual bubble is, but it’s quite possible they’re looking in the wrong place.

Private investments have quietly exploded in size in the past few years. Here are some stats from the most recent edition of the Mutual Fund Observer:

No, I mean the other 24,725 private funds, the existence of which is revealed in unintelligible detail in a recent SEC staff report entitled Private Fund Statistics, 4th Quarter 2014 (October 2015). That roster includes:

• 8,625 hedge funds, up by 1,100 since the start of 2013
• 8,407 private equity funds, up by 1,400 in that same period
• 4,058 “other” private funds
• 2,386 Section 4 private equity funds
• 1,789 real estate funds
• 1,541 qualifying hedge funds
• 1,327 securitized asset funds
• 504 venture capital funds
• 69 liquidity funds
• 49 Section 3 liquidity funds, these latter two being the only categories in decline

The number of private funds was up by 4,200 between Q1/2013 and Q4/2014 with about 200 new advisers entering the market. They have $10 trillion in gross assets and $6.7 trillion in net assets.

I’m not suggesting we’re in a bubble in this space, but it’s certainly getting crowded. Private markets used to be fairly inefficient, but now the competition has changed the game. Here’s the Wall Street Journal on the war chest of capital waiting to be deployed in private equity:

Dry powder, the unspent capital that private equity firms have available globally, has risen from $1.2 trillion in December 2014 to $1.34 trillion as of October 26. The figure has increased steadily since late 2012, when it stood at $940 billion. Europe-focused funds are sitting on $327.9 billion of unspent money, according to data provider Preqin.

The high levels of capital are causing problems for buyout firms, which are reluctant to overpay for assets.

Competition for deals has increased, particularly from strategic bidders and the option for vendors to list companies on the public markets, which has also led to deal valuations creeping up.

That $1.34 trillion amount may be a little misleading given that these types of investments are typically spread over up to ten years out, but it’s a huge number nonetheless with no where to go.

So why are we seeing such enormous growth in the private markets? My guess is part of it has to do with the low interest rate environment. Competition among investors is so fierce these days that allocators of capital are looking for outperformance anywhere they can find it. Giant pension funds have also made a huge push into private investments over the past decade or so because they need to increase their return expectations.

Whether these higher returns materialize is another matter altogether, but I do think that there are a number of unintended consequences with this push by investors to go private:

Fraud.  It’s much easier to defraud your investors in a private fund structure. In The Hedge Fund Mirage, Simon Lack says, “If you want to defraud people, a slightly mysterious trading strategy with an apparent strong history of performance in an LP [Limited Partnership] structure generally outside the regulatory framework is one of the best ways to do it.” My sense is most of the due diligence on these types of fund structures is severely lacking and most don’t really understand what they’re getting themselves into.

Liquidity. A number of very large institutional funds got burned by having too much exposure to private fund structures during the financial crisis and not enough liquidity to meet short-term needs. I would have thought this would have caused these large allocators of capital to re-think their investments in this area. Instead, many have doubled down and only increased their allocations to LP structured funds. I’m curious to see how the funds with heavy alt exposure try to survive the next downturn with such an illiquid profile.

Painful Transition Periods. Harvard’s endowment fund is on its fourth CIO in the past decade. I think one of the reasons the new people stepping in have been having such a hard time is because they’ve all been dealing with legacy assets from the previous CIOs. Private investments are typically invested over a period of 5-10 years. The distribution phase can last just as long. Once you’re locked up in these funds it’s very difficult to get out unless you sell on the secondary market for pennies on the dollar. It becomes nearly impossible to have any continuity in your investment plan if someone else steps in.

Operational Headaches. The majority of investors don’t have the resources, expertise or due diligence process in place to be able to thoroughly vet these types of investments. Not only that but they can be a nightmare from an operational perspective if you don’t have the back office in place to deal with auditors, handle the cash flows, figure out the marks on the investments and understand how to track and measure the performance. There aren’t many rules of thumb or industry standards in this space.

The rallying cry for investing in private markets has always been that they’re inefficient and offer investors an illiquidity premium. The top 5% or so of funds that have built-in competitive advantages will likely be just fine. For everyone else in this space the competition means fewer opportunities for outperformance and the potential for higher risks to get there.

Sources:
November Mutual Fund Observer
Firms Get Creative to Spend $1.34 Trillion Cash Pile (WSJ)

Further Reading:
Are Private Equity Returns Overstated?