Private Finance – Opacity Is Not a Virtue

The rise in inflation has had significant effects in the U.S. and, in fact, around the world. Perhaps this is a good time to consider those effects—those that are now evident, and those that are not, as yet. They are pervasive and the range of them are such that we cannot do so relatively briefly.  We will limit ourselves to those that affect financial decisions. There are others that are at least as important, such as the varying effects upon different income levels in society, but those are beyond what we are engaged to do, which is to make investment decisions.

The return of inflation was sudden. It seemed particularly so because of its long decline. The Federal Reserve felt so confident in its submission that by 2012 they named a level of 2% as their definition of price stability, which is part of their dual mandate, along with full employment. Thus it was a shock that inflation could return with the force that it did. In retrospect it might not be surprising given the vigorous response by the federal government to the COVID pandemic in both monetary and fiscal policies, but a consensus had been forming over decades that higher rates of inflation were a thing of the past. That was not to be, as the first chart makes clear:

The chaos unleashed by the pandemic meant this was a difficult problem to analyze with speed. The long period of inflation’s somnolence made it appear risky to address immediately, and the Federal Reserve took a cautious stance (using the now-famous “transitory” label to describe their view of the problem). The result was that inflation had a head start—Chart 2 shows that the bond market started to raise bond yields before the Fed began their program of tightening:

One question, of course, is whether the bond market anticipates well, or the Fed tends to be late. We would choose the latter. In any event, once they began raising rates, they were serious about it. The inflation rate has been responding, with a typical time lag, as depicted by the drop in the inflation rate recently.

This raises what at this point may be the most important question, which is whether economic and financial conditions are likely to revert to conditions that existed before the pandemic—that is, reasonably well-behaved. But the alacrity of the Fed’s behavior has been such that it raises the issue of whether the Fed themselves become a source of instability. While the money supply was allowed to grow at an excessive rate to deal with the pandemic’s threat to growth, they have reversed policy so sharply that they risk becoming a contractionary force in the economy and particularly the financial markets:

This is the first time that the money supply is actually contracting measured relative to a year ago.

The rise in bond yields can be expected to have pervasive effects. Treasury bonds are the risk-free assets that are the basis for pricing all streams of future cash flows. While stocks have been surprisingly resilient in the face of the rise in bond yields in 2023, we should be cautious in the presence of the higher valuations that result. Other assets are at risk also, which would include streams of long-term cash flows of all kinds. Commercial real estate has been seriously affected, but part of that can be attributed to the apparently secular change in the office market. Single-family real estate benefited from the pandemic as lifestyle changes were set in motion, but higher mortgage rates have hurt that market, particularly in the western U.S. where price points had risen out of proportion to the rest of the country.

There is one asset class (or group of them) in which it is more difficult to see the effects of rising Treasury yields. That is the private asset markets. It is less clear that those markets are affected, not because there is anything about them that should withstand pressure from the risk-free rate, but because there is so little public information about them.

Private markets include private equity, where the sponsoring firm arranges buyouts of businesses typically financing the purchase with debt, and private credit, which provides such debt financing. Private markets grew rapidly in the decade following the Global Financial Crisis as interest rates fell to record lows, and the ample use of debt financing became ever more attractive. It includes other asset classes as well. Growth has been robust, particularly as interest rates fell:

It is not unusual for a period of rapid growth in an asset class to be followed by some unfavorable developments as the underwriting errors of the expansion period emerge. This has not occurred in any size so far in private markets. Whether that is due to unusual prescience in the sponsoring firms’ underwriting or, more likely, to the private nature of the funds remains to be seen. Their operations are largely out of view and may permit postponing discovery of reversals. Part of the attraction of the private markets was escaping the rising burden of regulation, and related costs, in the banking system following the GFC. Perhaps in reaction to that curious outcome, regulators are paying more attention. The International Organization of Securities Commissions (IOSCO) recently issued a report on the subject. (Note 1). We will quote them on the subject:

While in the inherent opacity in private finance provides investors with some insulation from the transparency costs faced in public markets, it could also jeopardize availability of information that regulators and investors require to effectively assess risks. This includes risks that could arise due to the way in which private finance firms conduct their activities (e.g., valuations, conflicts of interest), from their interconnections with the wider financial system, and from how macro-financial developments could impact the sector, the portfolio companies that receive finance, and the real economy.

The investment landscape has changed dramatically with the return of inflation and the rapid shift to interest rate normalization. This creates prospective challenges to funding models within private finance sectors that have relied on continuing access to cheap and secure sources of debt funding. Potential questions therefore arise in terms of these sectors’ ability to navigate this transition to the “new normal”.

If interest rates stay at (or near) current levels (or increase further) for longer than expected, it is likely that there will be a reduction in the availability of funding to support private finance activities. Portfolio companies are likely to face higher rates on existing borrowing, which is typically floating rate, as well as on new and refinanced borrowing. Market participants noted that these risks were especially stark over the medium to long-term.

We agree with their circumspection but tend to be more cautious on their time horizon. It may have begun sooner than they expected. In May of this year Envision Healthcare Corp. filed for bankruptcy and private equity investor KKR & Co. lost some number of billions on the filing. The latter had purchased the firm five years ago for a reported $9.4 billion. With the Fed having pursued a restrictive monetary policy for over a year and a half, the unfavorable side effects may appear more frequently. It may be that one of the unexpected effects of inflation’s return is its opening a curtain on the opaque world of private finance.

1. IOSCO September, 2023 Thematic Analysis: Emerging Risks in Private Finance.