The dangerous private capital party

The rush into shadowy markets is understandable, but many investors will probably rue their recklessness eventually

Robin Wigglesworth 

© Bloomberg

The frenzied boom in private markets is one of the biggest trends in the global money management industry. 

It will leave many investors bitterly disappointed and could ultimately cause wider, long-term economic problems.

The party in this opaque corner of the financial system — which includes unlisted and untraded assets like venture capital, real estate, private equity, infrastructure and direct lending — is hard to miss.

As Apollo’s Marc Rowan gushed at the firm’s investor day last week: “This is just an amazing time for our business.” 

To underscore the point, Blackstone is now reportedly seeking to raise as much as $30bn for its next flagship buyout fund.

Can anything quell spirits? 

It seems not. 

In a recent report examining how long the “golden age of private markets” can last, Morgan Stanley analysts argued that concerns that less accommodative central banks will curtail the private capital party next year are “overdone”. 

They forecast that the $8tn industry will grow by double digits annually for at least the next five years.

It is hard to disagree. 

Even if major central banks start ratcheting back their bond purchases and some maybe even contemplate lifting interest rates in 2022, it is difficult to see how that could do anything but temporarily dent the private capital momentum.

In a world with punchy stock market valuations and bond yields seemingly rooted at near zero for the foreseeable future, private markets at least offer investors the hope that they might be able to hit their return targets. 

Unfortunately, these hopes are likely to be dashed.

Private capital strategies have over the past two decades outperformed their public market counterparts, yet at least some of that simply derives from the leverage embedded in them. 

They cannot diverge forever from the underlying returns of mainstream public markets.

Private capital returns are also even more heavily skewed by top performers than they are in traditional investment vehicles. 

In financial argot, the “dispersion” is greater. 

That makes the average return look artificially attractive to a lot of desperate pension plans, which might instead end up paying enormous fees for something that in practice is little more than fool’s gold.

Yes, studies have shown that the “persistence” of returns is greater in private capital. 

In other words, top performers tend to remain so more often than in other corners of the investment world. 

But investors cannot simply pick top-quartile performers and expect that they will continue to do well.

Firstly, top-performing private capital firms tend to be circumspect in capping the size of their funds, which means they cannot absorb all the money now gushing about. 

That is likely forcing investors to allocate money to more mediocre, riskier or unproven players.

Secondly, a study published by the National Bureau of Economic Research last year found that the apparent persistence of private equity performance is not as clear-cut as commonly thought (evidence that elite venture capital firms consistently outperform remained strong, however). 

Thirdly, there is now so much money being chucked at private markets that it seems overwhelmingly likely that returns for everyone will soften in the coming years, even for the industry’s rock stars.

The end result is that many investors praying that mammoth allocations to private capital will save their results in the coming decade are likely to end up disillusioned and ruing their decision.

Yet that is not the only worrisome issue thrown up by the boom. 

Securities and Exchange Commission commissioner Allison Herren Lee raised another, broader problem in a thoughtful speech earlier this month.

She pointed out that the growth of private capital meant that wide swaths of the US economy was “going dark” and becoming increasingly inscrutable not just to investors, but even regulators and policymakers. 

This is worrisome, as opacity can lead to massive misallocation of capital, widespread fraud and the build-up of systemic risks.

This is what happened in the 1920s. It eventually led to the US Securities Acts of 1933 and 1934, which enshrined the duty of regular audited reports for companies seeking to raise money from the public. 

Herren Lee argued persuasively that it is high time for the SEC to act decisively again, and help keep the gathering darkness at bay.

After all, as she noted: “What happens in capital markets, doesn’t stay in capital markets — faultlines on Wall Street can crack and spread across the entire country upending the lives of all Americans.” 

Banks’ Debt Sales Are Driving the Corporate Bond Market

Financial institutions account for more than one-third of all the investment-grade debt issued this year

By Ben Eisen

Bank of America has more than twice as much money in deposits than it has lent out. / PHOTO: AMIR HAMJA/BLOOMBERG NEWS

U.S. banks are overrun with cash. So they are loading up on debt.

The six largest U.S. lenders have issued some $314 billion of bonds so far this year, already the most for any year since 2008, according to Dealogic.

Since banks reported their third-quarter financial results earlier this month, Goldman Sachs Group Inc., GS 0.10% Morgan Stanley MS 0.11% and Bank of America Corp. BAC -0.13% have all come out with multibillion-dollar bond sales. 

In April, Bank of America and JPMorgan Chase & Co. completed the largest-ever bank debt sales.

Banks are playing a greater role in propelling the corporate bond market, which has otherwise slowed from last year’s pandemic-induced debt bonanza. 

Financial institutions are the issuers behind more than a third of U.S. investment-grade debt so far this year, according to Dealogic, the highest share for any year going back to the dawn of the modern megabank.

The record debt sales might seem unnecessary because banks are already up to their eyeballs in cash. 

The biggest consumer and commercial banks have collected trillions of dollars of deposits since the pandemic started.

But deposits are only one part of the liability equation for the biggest banks. 

They are also required to keep a certain share of their liabilities in long-term debt. 

Because of that, the ratio of debt to other liabilities can get out of whack when deposits grow as much as they have. 

So banks are issuing more bonds to navigate the regulatory hurdles.

Requirements that long-term debt make up a minimum share of banks’ liabilities is a consequence of regulations after the financial crisis of 2008-09. 

The idea is that a layer of long-term debt makes banks less susceptible to panic in short-term funding markets, which was a key reason for the demise of Lehman Brothers.

It doesn’t hurt, too, that banks selling debt today are able to lock in low, long-term borrowing costs. 

That could help bolster profits down the road should short-term rates rise in the future and lending picks up steam.

At the moment, though, loan demand has been weak. 

During the pandemic, consumers cut back on spending and received federal stimulus payments, which gave them money to pay down loan balances. 

That has made it tough for banks to make use of the cash sitting on their balance sheets. 

Bank of America, for example, has more than twice as much money in deposits than it has lent out.

Goldman Sachs and Morgan Stanley don’t have large deposit bases but have been selling bonds to support growth. 

Goldman said in third-quarter results that it has been growing its equity and fixed-income financing businesses. 

Bank of America is also issuing debt partly to support capital markets activity.

Investors, meanwhile, sense opportunity in bank debt. 

Tom Murphy, head of investment grade credit at Columbia Threadneedle Investments, said he currently likes banks and has participated in some of their debt sales this year.

Bank bonds trade at a higher yield relative to industrial company bonds with similar ratings, which means Mr. Murphy can pick up as much as an extra 0.3 percentage point in yield over industrials for no more credit risk.

At the same time, banks should benefit if higher inflation keeps pushing up interest rates. 

“The macro backdrop should be good for these institutions,” Mr. Murphy said.

Bank stocks also have been popular this year. The KBW Nasdaq Bank Index, which measures shares of the largest banks, has risen 45% this year, more than double the S&P 500’s gain. 

The rally has continued this month after banks reported profit growth across the board for the third quarter. 

The Revenge of Supply

Policymakers should not have been caught off guard by surging prices and shortages of goods and labor. Practically the entire post-pandemic agenda is built around policies that stoke demand and discourage work, making supply-side constraints entirely predictable.

John H. Cochrane

STANFORD – Surging inflation, skyrocketing energy prices, production bottlenecks, shortages, plumbers who won’t return your calls – economic orthodoxy has just run smack into a wall of reality called “supply.”

Demand matters too, of course. 

If people wanted to buy half as much as they do, today’s bottlenecks and shortages would not be happening. 

But the US Federal Reserve and Treasury have printed trillions of new dollars and sent checks to just about every American. 

Inflation should not have been terribly hard to foresee; and yet it has caught the Fed completely by surprise.

The Fed’s excuse is that the supply shocks are transient symptoms of pent-up demand. 

But the Fed’s job is – or at least should be – to calibrate how much supply the economy can offer, and then adjust demand to that level and no more. 

Being surprised by a supply issue is like the Army being surprised by an invasion.

The current crunch should change ideas. 

Renewed respect may come to the real-business-cycle school, which focuses precisely on supply constraints and warns against death by a thousand cuts from supply inefficiencies. 

Arthur Laffer, whose eponymous curve announced that lower marginal tax rates stimulate growth, ought to be chuckling at the record-breaking revenues that corporate taxes are bringing in this year.

Equally, one hopes that we will hear no more from Modern Monetary Theory, whose proponents advocate that the government print money and send it to people. 

They proclaimed that inflation would not follow, because, as Stephanie Kelton puts it in The Deficit Myth, “there is always slack” in our economy. 

It is hard to ask for a clearer test.

But the US shouldn’t be in a supply crunch. 

Real (inflation-adjusted) per capita US GDP just barely passed its pre-pandemic level this last quarter, and overall employment is still five million below its previous peak. 

Why is the supply capacity of the US economy so low? 

Evidently, there is a lot of sand in the gears. 

Consequently, the economic-policy task has been upended – or, rather, reoriented to where it should have been all along: focused on reducing supply-side inefficiencies.

One underlying problem today is the intersection of labor shortages and Americans who are not even looking for jobs. 

Although there are more than ten million listed job openings – three million more than the pre-pandemic peak – only six million people are looking for work. 

All told, the number of people working or looking for work has fallen by three million, from a steady 63% of the working-age population to just 61.6%.

We know two things about human behavior: First, if people have more money, they work less. 

Lottery winners tend to quit their jobs. 

Second, if the rewards of working are greater, people work more. 

Our current policies offer a double whammy: more money, but much of it will be taken away if one works. 

Last summer, it became clear to everyone that people receiving more benefits while unemployed than they would earn from working would not return to the labor market. 

That problem remains with us and is getting worse.

Remember when commentators warned a few years ago that we would need to send basic-income checks to truck drivers whose jobs would soon be eliminated by artificial intelligence? 

Well, we started sending people checks, and now we are surprised to find that there is a truck driver shortage.

Practically every policy on the current agenda compounds this disincentive, adding to the supply constraints. 

Consider childcare as one tiny example among thousands. 

Childcare costs have been proclaimed the latest “crisis,” and the “Build Back Better” bill proposes a new open-ended entitlement. 

Yes, entitlement: “every family who applies for assistance … shall be offered child care assistance” no matter the cost.

The bill explodes costs and disincentives. 

It stipulates that childcare workers must be paid at least as much as elementary school teachers ($63,930), rather than the current average ($25,510). Providers must be licensed. Families pay a fixed and rising fraction of family income. If families earn more money, benefits are reduced. 

If a couple marries, they pay a higher rate, based on combined income. 

With payments proclaimed as a fraction of income and the government picking up the rest, either prices will explode or price controls must swiftly follow. 

Adding to the absurdity, the proposed legislation requires states to implement a “tiered system” of “quality,” but grants everyone the right to a top-tier placement. 

And this is just one tiny element of a huge bill.

Or consider climate policy, which is heading for a rude awakening this winter. 

This, too, was foreseeable. 

The current policy focus is on killing off fossil-fuel supply before reliable alternatives are ready at scale. 

Quiz: If you reduce supply, do prices go up or go down? 

Europeans facing surging energy prices this fall have just found out.

In the United States, policymakers have devised a “whole-of-government” approach to strangle fossil fuels, while repeating the mantra that “climate risk” is threatening fossil-fuel companies with bankruptcy due to low prices. 

We shall see if the facts shame anyone here. 

Pleading for OPEC and Russia to open the spigots that we have closed will only go so far.

Last week, the International Energy Agency declared that current climate pledges will “create” 13 million new jobs, and that this figure would double in a “Net-Zero Scenario.” 

But we’re in a labor shortage. 

If you can’t hire truckers to unload ships, where are these 13 million new workers going to come from, and who is going to do the jobs that they were previously doing? 

Sooner or later, we have to realize it’s not 1933 anymore, and using more workers to provide the same energy is a cost, not a benefit.

It is time to unlock the supply shackles that our governments have created.

Government policy prevents people from building more housing. 

Occupational licenses reduce supply. 

Labor legislation reduces supply and opportunity, for example, laws requiring that Uber drivers be categorized as employees rather than independent contractors. 

The infrastructure problem is not money, it is that law and regulation have made infrastructure absurdly expensive, if it can be built at all. 

Subways now cost more than a billion dollars per mile. 

Contracting rules, mandates to pay union wages, “buy American” provisions, and suits filed under environmental pretexts gum up the works and reduce supply. 

We bemoan a labor shortage, yet thousands of would-be immigrants are desperate to come to our shores to work, pay taxes, and get our economy going.

A supply crunch with inflation is a great wake-up call. 

Supply, and efficiency, must now top our economic-policy priorities.

John H. Cochrane is a senior fellow at the Hoover Institution.