As the new year unfolds, the belief that private markets provide a safe haven for investments is gaining traction. However, a detailed examination suggests that this optimism may be misplaced. Current private market trends exhibit late-stage behaviors reminiscent of those preceding previous financial downturns. This article outlines three significant characteristics contributing to this precarious situation: the segmentation of risk, a concerning alignment of incentives across the investment chain, and a widespread but erroneous belief in the stability of private markets.
Drawing from over two centuries of financial history, particularly the global financial crisis of 2008-2009, we will explore the interconnected dynamics among institutional investors, consultants, fund managers, and other stakeholders, illustrating how their individual rational actions can collectively escalate systemic risks.
Table of Contents:
The segmentation of risk
A fundamental aspect of systemic financial crises is the segmentation of risk throughout various stages of investment processes. Each segment introduces additional risk into the system, yet participants often lack the visibility to understand how these risks accumulate. During the global financial crisis, for example, mortgage lenders relaxed underwriting standards, leading to increased loan volumes. These loans were subsequently packaged and sold as mortgage-backed securities, reaching both institutional and retail investors. While each actor recognized the incremental risks associated with their segment, the cumulative effect often went unnoticed.
The challenge lies in the isolation of each segment, which obscures a comprehensive understanding of the entire system. In the film The Big Short, it was not merely intelligence that distinguished investors like Michael Burry and Steve Eisman; it was their unique perspective that allowed them to identify looming dangers that others overlooked.
Incentive alignment in crises
Another critical factor contributing to systemic crises is the near-perfect alignment of incentives among participants throughout the investment ecosystem. This alignment often extends beyond immediate actors. During the global financial crisis, mortgage originators, investment banks, and fund managers all shared a vested interest in maximizing mortgage production and securities issuance. They were not alone; rating agencies, insurers, and financial media also benefited from higher volumes, creating a feedback loop that incentivized risk-taking over caution.
This collective incentive structure discourages participants from exercising restraint. With fee structures, compensation models, and market pressures favoring increased activity, it becomes nearly impossible for anyone within the system to advocate for reduced production or stricter underwriting standards. Had any segment of this chain been incentivized to act differently, the crisis might have been mitigated or averted altogether.
Flawed assumptions and their consequences
At the core of many speculative bubbles lies a deeply rooted yet fundamentally flawed assumption. For example, in the 1810s, investors believed that farmland prices would remain high indefinitely; in the late 1920s, there was a widespread belief that stock prices would never experience prolonged declines; and during the global financial crisis, many insisted that residential real estate values would not drop on a national scale. These misconceptions can lead participants to underestimate the risks they contribute to the overall system.
This trend presents a daunting challenge: as these flawed beliefs persist and are reinforced by recent experiences, they create psychological comfort that allows unchecked risks to fester. Historically, such conditions have preceded significant financial upheavals, raising alarms about the current state of private markets where similar dynamics are now at play.
The evolving landscape of private markets
In recent years, resource allocation to alternative asset classes, particularly in private equity and credit funds, has notably increased. This surge began as institutional investors sought to replicate the success of prominent endowments, such as Yale University, which enjoyed remarkable returns in the late 20th century. However, as allocations grew, the focus shifted from capitalizing on genuine opportunities to preserving the professional roles created by these opportunities.
Consequently, the incentives for investment professionals became increasingly tied to the complexity of their portfolios rather than the actual performance achieved. This shift created a self-reinforcing cycle, where any deviation from established practices carried significant career risks, making it challenging for allocators to moderate their approaches.
The role of investment consultants
Drawing from over two centuries of financial history, particularly the global financial crisis of 2008-2009, we will explore the interconnected dynamics among institutional investors, consultants, fund managers, and other stakeholders, illustrating how their individual rational actions can collectively escalate systemic risks.0
Drawing from over two centuries of financial history, particularly the global financial crisis of 2008-2009, we will explore the interconnected dynamics among institutional investors, consultants, fund managers, and other stakeholders, illustrating how their individual rational actions can collectively escalate systemic risks.1
Drawing from over two centuries of financial history, particularly the global financial crisis of 2008-2009, we will explore the interconnected dynamics among institutional investors, consultants, fund managers, and other stakeholders, illustrating how their individual rational actions can collectively escalate systemic risks.2
