$4 Trillion Bloat? The Fed Hits the Panic Button, and Private Markets May Be the Problem

So, I just listened to the ALL-IN podcast talking about the Fed's 50 point cut.

And it has me wondering, why did the Fed not cut 25 points? And then another 25? Probably because they're seeing something and are rushing to stimulate things. If a downturn is coming, it's coming from the Private Markets, and unfortunately I think it's close!

The Private Markets have grown from $3 Trillion in 2008 to $13 Trillion in 2023. Amazingly in 2023, family office allocation to Private Markets surpassed their allocations to Public Markets for the first time, according to Preqin.

Performance in the Private markets is at an all time low. Distributions paid back to investors, typically sits at 25% each year. In 2022 it plunged to just 14.6%. Then fell even further in 2023 to just 11.2%, the lowest since 2009. And I'm afraid 2024 is no better (reporting below 10%).

There is still a huge gap between the prices at which investors are willing to buy on one side, and sell on the other. Acceptance is the mantra of the year and investors will have to practice this eventually.

More worryingly though, the incentives are all wrong.

Fund managers charge management fees on their Assets Under Management, so they are hugely incentivised not to mark down investments. As Charlie Munger says “Show me the incentives, and I'll show you the Outcome”.

As an example, at Wayflyer we raised at a $1.6bn valuation previously. Naturally with multiples retrenching we wouldn't be worth that today.

Similarly, look at the buyout of Twitter. The $44bn acquisition was made with $13bn of debt and $31bn of equity. The bankers holding the debt couldn't sell it even at $6bn, so the equity is essentially worthless today.

I doubt either are marked down in many investors portfolios. Why? They want to collect their management fees on the last valuation.

Taking the above into account, there has got to be bloat of say $4 trillion (~30%) in the $13 trillion Private Markets number. For context, the cost of the 2008 financial crisis was $2 trillion. Bleak reading, I know.

This isn't like the last recession which was driven by mortgages with fixed repayment dates. With these funds, they are open ended for many years. So they'll be keeping investments marked up as long as they can and crossing their fingers for some magic that isn't coming I'm afraid.

Public markets are performing ok, but they are buoyed up by the biggest companies who have been increasing their prices drastically across the board (Amazon, Meta etc). This works in the short term, until the economy turns and SME’s start failing.

In 2007, people were slinging houses and cashing commissions. The last few years, funds have been slinging investments, raising new funds and cashing in on their management fees.

This is going to lead to so much disruption at the Investment Fund level!

The Positives (there are some):

• Incentive structures will shift from encouraging rapid deployment of capital, back to a focus on making good investments with stronger performance incentives.

• Fund managers will need to be more than just capital allocators. They will have to be able to impact the success of the companies they invest in.

• There will be tonnes of Innovation at the Fund Level around (1) Incentive Structures, and (2) How they Operate.

The Downsides:

• More Regulation! For better or worse, it's always gonna be more regulation.