12 Special report Private markets TheEconomistFebruary26th 2022
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Economist.com/specialreportseffectiveresourceallocation.Astudyin 2020 lookedatwhathap-
penstopubliccompanieswhenpeinvestsintheirindustry:it
forcesrivalstorespondbybecomingmoreproductive.
Onjobs,astudyin 2019 ofpe-backedfirmsinAmericafound
thatemploymentdeclinedinexistingplantsby4%relativetooth-
ersinthesameindustry.Butinnewoperations,startedfrom
scratchoracquired,itincreasedby2.3%.Anotherstudyin 2021 of
9,800Americanbuy-outsbetween 1980 and 2013 concludedthat
employmentshrinks13%overtwoyearsafterbuy-outsofpublicly
listedfirms,relativetocontrolfirms,butgrowsby13%afterbuy-
outsofprivatelyheldfirms.Italsofoundpost-buy-outproductiv-
itygainsattargetfirmstobe“largeonaverageandmuchlargeryet
fordealsexecutedamidsttightcreditconditions”.
Criticstalkuppe’scostsandignoreitsbenefits.Whenciting
thestudyof9,800buy-outs,MsWarren’sofficefocusedonthe
jobslostatbought-outpublicfirms,notthoseaddedatprivate
ones.Butpeboostersplaydownallinstancesofrapaciousness,
employingthe“nobusinessiswithouttheoddbadapple”de-
fence.Tougherregulationlooms,inanyevent.ThethirdageBarbarians at a crossroads
S
uperreturn,adavosforpe,helditsannualbash in Berlin last
November. One session on “Winners and Losers” went well, re-
calls Alex Koriath of Cambridge Associates, though “there weren’t
really any losers to talk about.” A self-congratulatory air permeat-
ed the event. Nile Rodgers and his band, Chic, entertained buy-out
bigwigs with their hit “Good Times”.
Top-of-the-market stuff? Few would call the party’s end. This
year is unlikely to be as sweet as 2021, yet it may still be a record
year for private markets. Unlike last year, fund sponsors are likely
to look to raise more than investors are comfortable with, says Mr
Green at Lazard. Some may end up short of their targets, rather
than blowing through them again.
Big risks include inflation and interest rates. Inflation is a cu-
rate’s egg for pe; firms with pricing power do better than those
without. Higher rates can wreak havoc among leveraged buy-outs,
but also reflect higher growth. A rise of more than two or three per-
centage points could trigger defaults and bail-outs. On top of dear-
er debt, business faces wage pressures, supply-chain problems
and more covid-19 uncertainty. And private funds must contend
with more competition as public-market funds push into private
markets to meet demand for higher yields.
In less benign financial conditions, some pension funds, in-
surers and family offices that came late to private markets may re-
assess their tolerance of illiquidity. A tech slump, to which peis
more exposed than it was, would also test investors’ loyalty.
Given how heady price tags are in buy-outs, “no one is banking
on selling at higher multiples than today,” says one dealmaker. “It
will be all about growing underlying profits enough to make a nice
return on the same or a lower multiple.” The giants of petalk of
picking “themes”: energy transition, health-care technology, take
your pick. Choose the right one, and the right firms, and you can
do well regardless of today’s valuations, they say. Amazon is not
the only success story once viewed from the rubble of the dotcom
bust as having been wildly overpriced.David Swensen might disagree. At his last investment-commit-
tee meeting at Yale, he was “very bearish” on pevaluations, says
someone who was present. The ex-colleague also recalls Swensen
admitting “the possibility that everything he had learned was
wrong and we were now in a different world where valuations
could stay higher for longer.” But it didn’t sound like he believed it.
Swensen thought the best private funds could thrive in periods
of economic disruption, riding the cycle by acquiring under-
valued or distressed assets. But the idea that private markets are
greedy when others are fearful, and can profit accordingly, may be
wrong. Last year Sirio Aramonte and Fernando Avalos of the bis
studied risk-taking in private markets and concluded that they are
as procyclical as public markets. They found capital deployment
in both peand debt to be “positively correlated with stockmarket
returns, ie, more transactions are completed in bullish times.”
Whatever the short-term outlook for private markets, they
have become a large and permanent feature of global finance.
They have expanded and matured during the past decade’s hunt
for yield. Products have become more sophisticated. A secondary
market has blossomed. All this has made more investors, includ-
ing retail investors, comfortable with them.
With private markets representing less than a tenth of global
investable assets, there is plenty of room for growth. Some parts of
the world, particularly Asia, look underserved. China’s crackdown
on private enterprise has led some pefirms to cut back there. But
the region as a whole, long heavily reliant on bank finance, is a
market waiting to be tapped. Private funds are licking their lips at
the prospect of more corporate carve-outs from Asian conglomer-
ates, like those seen at Hitachi and Panasonic. Europe, also largely
reliant on banks and home to thousands of family-owned firms
approaching generational transfer, is fertile ground as well. Bar-
ring an interest-rate shock, “we’re not even close to starting the
shift towards more [private-markets] activity,” reckons Bruce
Flatt, boss of Brookfield Asset Management.
More competition will narrow outperformance over public
markets. For the biggest firms, lower returns come partly by de-
sign: they are becoming diversified asset managers, geared to stea-
dy management-fee income, with greater scale compensating for
lower returns. The industry’s metabolism is slowing as it seeks to
add longer-term capital that allows assets to be held for longer pe-
riods. Such capital already makes up almost a quarter of Black-
stone’s assets.
Making this pivot work is the biggest challenge for a new gen-
eration of buy-out bosses. Success implies asset-gathering on a
much larger scale, as Blackstone and other big firms try to get clos-
er in size and substance to BlackRock, the giant of global asset
management. That will alarm those who see peas capitalism red
in tooth and claw. But private markets are emerging as a viable al-
ternative—or stepping stone—to public ownership.The more so-
phisticated they grow, the greater the choice forfirms and inves-
tors alike. And that has to be good for capitalism.The future may well be bright. It will certainly
be less high-octane