Low Rates Transformed Private Equity and Credit. Here’s Why Higher Rates Won’t Change a Thing.

“I don’t think the momentum will be reversed,” says PGIM’s Taimur Hyat.

Luke MacGregor/Bloomberg

Luke MacGregor/Bloomberg

Over the last 10 years, private markets have grown into a multitrillion-dollar industry on the backs of allocators searching for a decent yield at a time when interest rates were close to zero. Choosing to invest in a direct lending fund over public fixed income, say, was a simple investment decision — but even though rates are now rising, private markets are here to stay.

That’s because the investment decisions of sovereign wealth funds, pension funds, endowments — and soon individuals — have altered the entire market ecosystem.

“Three different actors — banks, corporations, and their investors — have all changed their behavior in ways that have expanded not just the size, but the breadth, complexity, and depth of the private markets,” said Taimur Hyat, chief operating officer at PGIM, commenting on the reasons the firm undertook its latest research, called New Dynamics of Private Markets.

“It has created a much richer, bigger, permanently private sector where we feel it’s important for investors to understand what’s happening next,” he said. “I don’t think the momentum will be reversed.” U.S. public pension funds have doubled their allocation to alternatives to 20 percent since 2001. Private markets have $3 trillion in money, or dry powder, to invest.

The research from PGIM, the $1.3 trillion global asset management business of Prudential Financial, points out that some fundamental changes are behind the move from public to private markets. Some started years ago, including the frustration with being public, including costly regulations and the “quarterly drumbeat of earnings” that can put pressure on companies, in particular those with intangible assets like software that require years of R&D to become profitable. PGIM points out that more than 85 percent of the market value of the S&P 500 is now in intangible assets. At the same time, the amount of capital available for private companies and lenders has ballooned, making it realistic to stay private for an almost unlimited time.

Perhaps most importantly, after the global financial crisis, commercial banks and finance companies like GE Capital stepped back from riskier lending, leaving a hole for asset managers and long-term investors to fill. Of course, investors were also eager to benefit from the illiquidity premium that they could earn by locking up their money — even though PGIM points out that the “empirical evidence remains mixed” on that and the excess returns that could come from having direct control over companies.

While PGIM is optimistic about these markets, Hyat pointed out that there are still plenty of things that bear watching and that will be tested, now that markets are entering an environment with a heightened risk of recession.

For one, as investor interest in private credit began to rise, scores of new firms entered the business. “Newer direct lending players, particularly those who came from the hedge fund side, are untested across market cycles,” said Hyat. It’s not clear how skilled these firms are at workouts and recovery, expertise that veterans honed during 2008 or after the dot-com bubble burst, he said. In addition, Hyat says he’s watching AI and fintech platforms that have done deals with retail business to then give consumers access to credit. The AI-driven underwriting models haven’t been tested by a stressed environment.

Other things on PGIM’s list to watch are “credit managers that are overly reliant on sponsored lending…and are just kind of latching themselves [onto] the back of private equity deals. Because that private equity activity is really slowing down. And in a recession it will slow down even more,” said Hyat.

As lending moved from banks to asset managers and other non-bank lenders, there’s been plenty of talk about the risk to the overall financial system, even though regulators have enacted rules to encourage the transformation. PGIM notes that these systemic risks still haven’t been tested.

“The downfall of shadow banking in the GFC was primarily due to the fragility of their “borrow short, lend long” business model — raising funds in commercial paper markets and investing in illiquid long-term assets,” according to the paper. “Today’s private credit funds are far less reliant on short-term financing. They appear to have committed sources of capital in closed-end funds to match their illiquid assets so a “run on the fund” is less likely to happen.”

Shehriyar Antia, Head of Thematic Research and a principal researcher and author on the paper, said, “This is one of those issues where frankly, the more we thought about it, the less clear it seemed to become. Investors and analysts have limited visibility on basic aspects of the market — where credit risk is concentrated, how much leverage there may be in the system, and how well capitalized lenders and funds are. That lack of visibility, that lack of transparency can’t be good for overall financial stability.”

But there is reason to be optimistic. “Diversifying credit risk beyond a small number of too-big-to-fail commercial banks and disbursing risk to a broader array of actors potentially reduces some kinds of systemic risks,” Antia said.