As private markets evolve, there is a prevalent sentiment among investors that they offer a new and enduring opportunity. However, this confidence may be misplaced. Current indicators suggest that private markets are in a late-cycle phase, reflecting conditions historically associated with financial instability. Three key characteristics highlight these concerns: the segmentation of risk, the alignment of incentives throughout the investment chain, and a widely accepted but flawed perception of private markets.
This analysis is informed by over two centuries of financial history, particularly lessons from the global financial crisis of 2008-2009. It scrutinizes the entire private market ecosystem, examining the roles of institutional allocators, wealth advisors, fund managers, and other stakeholders. While these parties may act rationally within their domains, they may inadvertently heighten systemic risks.
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The structure of systemic risk
Understanding speculative phenomena in finance is akin to analyzing a manufacturing process. Throughout various financial crises, three fundamental attributes consistently emerge. These attributes are particularly evident when considering the global financial crisis as a case study.
Risk segmentation
The segmentation of risk is a defining feature of systemic financial crises. Each segment in the investment process introduces additional risk, yet individual participants often lack the visibility required to grasp how these risks accumulate across the system. For example, during the global financial crisis, mortgage originators relaxed lending standards to increase loan production. These loans were then repackaged into mortgage-backed securities by investment banks before being sold to institutional investors. While each party recognized the risks associated with their specific transactions, few understood how their actions exacerbated the overall risk within the financial landscape.
Incentive alignment
A second critical attribute related to systemic crises is the near-perfect alignment of incentives among participants. In the context of the global financial crisis, mortgage originators, investment banks, and asset managers all had a vested interest in maximizing mortgage production and the issuance of mortgage-backed securities. This alignment extended to ratings agencies and financial media, which also benefited from increased securitization activities. Notably, there was little incentive for major players to slow down the process, as fee structures and compensation models encouraged continued growth. Understanding this web of incentives is crucial; had any key segment been motivated to restrict production or tighten lending standards, the crisis could have been significantly mitigated.
Flawed assumptions and their consequences
At the heart of every speculative episode lies a prevalent yet fundamentally incorrect belief. For instance, during the 1810s, many Americans invested heavily in farmland, convinced that wheat prices would remain high indefinitely. Similarly, in the late 1920s, investors felt secure in purchasing stocks on margin, believing equity prices would not experience substantial declines. In the global financial crisis, there was a widespread assumption that residential real estate prices would never decline on a national scale.
This shared yet erroneous belief allows participants in the financial system to underestimate the risks they contribute to. When such assumptions go unchecked, they create a psychological safety net, enabling unchecked risk accumulation. Historically, these three characteristics have been present before significant financial upheavals, and their current resurgence in private markets raises concerns.
The evolving landscape of private markets
Over the last quarter-century, institutional investors have significantly increased their allocations to alternative assets, particularly private equity and private credit funds. This trend gained momentum as allocators aimed to replicate the exceptional returns of the Yale University Endowment from 1985 to 2000, often misunderstanding the nuances that made Yale’s strategy successful.
As demand for alternative assets surged, the motivations behind allocations subtly shifted. Instead of focusing on identifying genuine opportunities, many professionals became more concerned with preserving their roles within the investment landscape. This shift linked compensation and career advancement to the complexity of portfolio allocations rather than the actual performance of those investments. With entrenched incentives, the proliferation of private market allocations continued, while the risks associated with moderation became increasingly pronounced.
Consultants and their role
Investment consultants, who emerged in the 1960s to provide independent performance reporting, have significantly expanded their influence in the investment decision-making process. Initially evaluators of portfolio performance, they have evolved into architects of institutional portfolios. This evolution has introduced a conflict of interest, as consultants now assess the outcomes of strategies they design.
This analysis is informed by over two centuries of financial history, particularly lessons from the global financial crisis of 2008-2009. It scrutinizes the entire private market ecosystem, examining the roles of institutional allocators, wealth advisors, fund managers, and other stakeholders. While these parties may act rationally within their domains, they may inadvertently heighten systemic risks.0
This analysis is informed by over two centuries of financial history, particularly lessons from the global financial crisis of 2008-2009. It scrutinizes the entire private market ecosystem, examining the roles of institutional allocators, wealth advisors, fund managers, and other stakeholders. While these parties may act rationally within their domains, they may inadvertently heighten systemic risks.1
