The EconomistFebruary 1st 2020 Finance & economics 632 tively modest means, but they are required
to co-invest in their firm’s equity. By stack-
ing the firm’s capital structure with debt, a
smallish investment from managers can be
turned into a big slug of the total equity.
Their stake is at risk should the firm falter.
Just as private firms are run better, say
boosters, so private-debt markets operate
in a way that is superior to public ones. In
the 1980s buy-outs were financed by junk
bonds. But the fuel for many private-equity
deals today is leveraged loans, packaged by
banks and sold to investors, and a kind of
public-private hybrid. A broadly syndicat-
ed leveraged loan might have 75-100 buyers
and be traded as much as a listed bond. A
purely private bond might be sold to a
handful of lenders or even just one. Speed
is part of the appeal. If a private-equity firm
can line up private-debt finance quickly it
can steal a march on its rivals. Private-cred-
it funds often prefer to be the sole debt-fi-
nanciers of a deal, if they like the terms and
judge the company a good risk. Should the
loan sour it is easier to cut a deal that limits
your losses when you are the only creditor.
Once again, control—agency—is prized.
Too far, too fast
The private-investment boom shows little
sign of stopping. Low interest rates mean
that a global hunt is on for higher returns.
The boss of a big American state-pension
scheme says he wants to allocate more to
private investments in order to try to plug
the pension scheme’s gaping funding defi-
cit. Like many sovereign-wealth funds,
South Korea’s National Pension Service has
a target to raise its allocation to alternative
investments, to 15% from 12% in 2018.
Yet anyone running a big investment
organisation should worry about three
things. First, as even more capital floods
into private markets, returns will inevita-
bly suffer. In their big study Mr Kaplan and
his colleagues find that while buy-outs’ re-
turns beat the s&p 500 in nearly all vintages
before 2006, they have more or less
matched public-equity returns since. Priv-
ate-equity funds used to buy businesses
that were much cheaper than listed firms.
But the big beasts of private equity are be-
coming ever bigger. They have large fixed
costs to cover: to meet those, there will be
pressure to do deals that would not have
passed muster in the past.
This pressure is already visible in ven-
ture capital. Very few new firms are world-
beating. Lots of capital has gone to startups
that are variations on established themes:
enterprise computing; platforms that
bring providers of services (taxis, lodgings,
office space) and consumers together; and
retail sales via the internet. As more and
more capital seeks a piece of the action, the
valuations of firms are inflated. “You have a
lot of zero-sum expenditure,” says a Silicon
Valley bigwig. “Think of all those subsi-dised taxi journeys from Uber and Lyft.”
A second concern is liquidity. In princi-
ple, there are rewards for tying up money
for five to ten years. It affords time for Sili-
con Valley to turn fledglings into global
firms and for private-equity firms to trans-
form sluggish businesses into world-beat-
ers. But even long-horizon investors have
ongoing demands on their cash, for exam-
ple paying the beneficiaries of a pension
scheme, meeting commitments to put
fresh cash into buy-outs, or (for universi-
ties) paying for research grants and bursa-
ries. It is a headache for investors to man-
age their liquidity needs when a large
chunk of their assets are private and illi-
quid. Payment flows are unpredictable.
And capital calls often come at the worst
time: during recessions. It is only then that
a lot of investors discover that they are less
patient than they had believed themselves
to be when liquidity was plentiful. Illiquid
assets cannot easily be sold to take advan-
tage of low prices in public markets, for in-
stance during crises, when other investors
are forced to sell.
The final concern is agency costs. Pri-
vate capital may be a solution to the age-old
agency problem between shareholders and
company bosses. But it also creates anotherone between institutions (the limited part-
ners) and the private-asset managers (the
general partners) to whom they supply cap-
ital. Fees are high. And private-capital
managers enjoy a great deal of discretion
over how they value their assets and the
timing of buying and selling decisions. Just
as there are costs of monitoring the man-
agement of public firms there is a cost to
monitoring your private-capital manager.
In some regards, private shareholders
can be more lax. The 1980s buy-out boom
was powered by a backlash against the im-
perial ceo, who was more interested in em-
pire-building than profits. An irony is that
the clubby nature of the venture-capital in-
dustry seems to have fostered a new kind of
imperial founder-manager—whose behav-
iour is brattish, and who takes investors for
granted, or even for a ride. The managers of
vcfirms “don’t want to piss the ceooff, be-
cause they can’t be badmouthed in startup
circles,” says a Silicon Valley figure. So “you
end up with a list of enablers at board lev-
el.” Agency costs are still alive and kicking.The limits of privacy
What will people make of today’s rush into
private markets in a few years’ time? Per-
haps it will prove itself a truly superior
form of asset ownership. But it might also
be revealed as a creature of sluggish growth
and rock-bottom interest rates. A near-zero
cost of risk-free capital allows for venture-
capital-backed business models that are
loss-making but have lots of potential to
grow. Private equity, meanwhile, has
thrived in an era of ever-lower borrowing
costs, ever-higher asset values and low pro-
ductivity growth. It is well suited to
squeezing more juice from the corporate
lemon. An era of rising interest rates and
faster growth would surely be a harder test
for private markets, as would a recession.
But neither examination may have to be
faced soon—or, at least, that is what a quea-
sily large number of investors are banking
on with ever more abandon. 7Private’s progress
Global private capital, assets under management
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