TRAPPED CAPITAL: WHAT IT MEANS TO BE ILLIQUID / THE ECONOMIST

Trapped capital

What it means to be illiquid

Investors are learning how hard it is to get money out of private equity and venture capital

On Wall Street, the investment bankers who arrange mergers and public offerings are the first casualties of economic uncertainty. 

Coaxing wary corporate bosses to raise and spend capital is, unsurprisingly, much less fruitful than encouraging bullish ones. 

Mergers have stalled. Initial public offerings, including those of Klarna, a “buy now, pay later” lender, and StubHub, a ticket-resale website, have been postponed. 

Bankers say they are “cautiously optimistic”, which is what business-school graduates mumble when they fear for their jobs.

If volatile policymaking is bad news for bankers, it is worse for their biggest clients. 

Private equity and venture-capital firms have struggled to sell their existing investments since 2022, when central banks raised interest rates. 

When sketched, the balance of payments of an investor in such funds should resemble what academics call a J-curve but ordinary folk recognise as a Nike swoosh: funds quickly “call in”—or demand—the capital investors have promised in order to make deals (the short, cresting wave) before returning it gradually with profits (the long, soaring tail). 

The second part is proving difficult. 

Since 2023 private-equity funds have returned 3.3% of the value of investments each quarter, well below the long-term average of 5.6%. 

Things are bleaker in venture capital, which relies more on public markets for its exits (see chart).

The point of no returns

The first wave of private-equity buy-outs—highly leveraged, often hostile, targeting large public companies—peaked in 1989 when KKR bought RJR Nabisco, a conglomerate whose holdings included Winston cigarettes, for $25bn. 

That year Michael Jensen, an economist, predicted the decline of the public company in Harvard Business Review. 

Empire-building corporate managers tend to enrich themselves at the expense of shareholders, he argued; rather than erecting unwieldy conglomerates, private-equity funds pulled them apart. 

America’s industrial conglomerates have since disappeared. 

Its private-equity industry has not. 

Instead, it has grown large and cumbersome, in some ways reflecting the firms it used to target. 

After the financial crisis low interest rates enabled the sector to quadruple in size: debt was cheap, valuations went up and investors were short of places to put their capital.

That money machine is broken. 

Even before the tariffs, private-equity fundraising had slowed down, reducing the amount of capital searching for new deals. 

(Last year, assets managed by private-equity funds recorded a modest fall, to $4.7trn.)

All manner of techniques have been used to create liquidity, many of them seen in a surge of deals in secondary markets where positions in funds or companies change hands. 

(The value of such deals grew 39% last year to $152bn according to Lazard, an investment bank.) 

Tactics deployed include: continuation funds, where funds sell assets to themselves; net-asset-value loans, where a fund borrows against its value to pay dividends or allow investors to cash out; and even collateralised-fund obligations, where pools of illiquid positions in funds are smashed together in the hope of creating something more appealing. 

Only naive or delusional institutional investors see these developments as anything other than signs of distress.

Venture capitalists seek salvation in the next big thing

The biggest private-equity firms, meanwhile, have speedily diversified into private lending (though they mostly lend to firms owned by private-equity funds) and other activities. 

Investors seem to think they have not diversified quickly enough. 

Their valuations have fallen dramatically in recent months; the share price of Blackstone, the largest private-market asset manager, has fallen by 30% since its high in November.

Whereas private-equity firms find solace for their troubles in financial engineering, venture capitalists seek salvation from their own liquidity crunch in the next big thing. 

Counterintuitively, their capital woes coincide with a dealmaking boom. 

In America the value of funding rounds in which startups raised large sums from VCs hit a record during the first quarter of the year, according to PitchBook, a data provider. 

Artificial-intelligence startups absorbed most of the cash (a $40bn funding round for OpenAI was the largest in history). 

Silicon Valley’s new interest in the defence industry is also generating mega deals, and some mega-size companies: Elon Musk’s SpaceX, whose lucrative government contracts are expected to grow under the Trump administration, is worth $350bn.

None of this will comfort investors who might need a quick exit strategy. 

America’s elite universities have long been a top customer for private equity: their endowments have extended time horizons and vast riches. 

But Donald Trump’s assault on academia, including threats to research grants and to the tax-exempt status of universities, is putting pressure on their finances. 

Huge investments in private markets have left them uniquely unsuited to face a liquidity crunch, as they suffered during the financial crisis. 

Almost 40% of the $190bn of Ivy League universities’ endowments is invested in private equity. 

At Yale, where David Swensen, who previously ran the university’s endowment, led the charge into private markets, that figure is 45%. 

The university reportedly plans to sell $6bn of investments in private-equity funds. 

(Last year all endowments combined sold less than $9bn, according to Evercore, another bank.) 

It doesn’t take an Ivy League education to know that will be tough.