Private Markets Face Liquidity Crisis Driven by Fear and Structural Shifts

Key Quotes

"the biggest topic this year driving everything is private markets i would categorize that in two ways the first is liquidity and the second is the changing structure of the industry so liquidity has been an issue for several years and it all comes down to why aren't dollars coming out the back end the way they used to it's a really tricky question because if you think about making a pizza you need dough and cheese and sauce and toppings and in private equity you need equity capital well there's tons of dry powder trillion two of dry powder you need debt capital and there's almost an infinite amount of corporate private credit available you need companies that are willing to transact and there's tens of thousands of private companies and now there's 10 000 private equity owned businesses a fair amount of which are later in the life of that investment chapter so there's a lot of businesses that need to transact you have all these ingredients in place so how come there's no pizza and the answer is the oven's not on"

The speaker, Ted Sids, identifies private markets as the dominant topic influencing the industry, breaking it down into liquidity issues and structural changes. He uses a pizza analogy to illustrate the paradox of having all the necessary components for private equity transactions (capital, companies) but lacking the mechanism to complete them, which he attributes to the "oven not being on." This highlights the core problem of stalled deal-making despite available resources.

"all investment either happens or doesn't happen because of greed and fear that's basic behavior you could say that private equity is frozen because of fear it's fear on the gp side of if they sell the returns aren't what their lps would have thought they're afraid they're not going to be able to raise their next fund so rather than say well let's just transact and move on if we hold it longer and the business continues to grow we'll get to our target we'll get to 1 8 we'll get to 2 0 it's just going to take a couple more years on the lp side you still have the aftermath of 2008 where you got too skewed to privates and there were liquidity challenges there aren't real liquidity challenges on the institutional lp side now but they don't want to go there so they say well you're holding for longer we're going to commit less there's fear on both sides"

Ted Sids explains that investment activity is fundamentally driven by greed and fear, and in the current private equity market, fear is paralyzing transactions. He details this fear on both the General Partner (GP) side, concerned about not meeting return targets and raising future funds, and the Limited Partner (LP) side, wary of past liquidity issues and extended holding periods. This dual fear is preventing deals from closing.

"the other is the structure of the industry you went from 25 years ago institutions had 0 private equity to today they're anywhere from 10 to 50 the institutions are where they want to be so the market share in terms of asset allocation is not changing if anything almost every ciu you'd talk to if their target is 30 they probably have 35 or 40 in private today it doesn't scare them but over the next five years they want to bring that down to 30 that's the institutional market which is what's fueled private equity for 25 years what the gps then look for is what are the next areas of growth two there's sovereign wealth funds and private wealth"

Ted Sids points out a significant structural shift in the industry, where institutional investors have dramatically increased their private equity allocations over the past 25 years, reaching their desired targets. He notes that these institutions now aim to reduce their private equity exposure, meaning the traditional growth engine is slowing. This forces General Partners (GPs) to seek new growth areas, specifically mentioning sovereign wealth funds and the private wealth channel.

"what does that mean for the middle market there's two things that could mean one it probably means there's a contraction there are a lot of private equity firms out there today who don't realize they've already raised their last fund but there's another side to that which is in theory if the largest funds are raising more and more money they need things to buy what are they going to buy well the business from the mid market sponsor that's been growing is now ready to be purchased by a larger asset manager so there should be an opportunity for returns"

Ted Sids discusses the implications of industry shifts for the middle market in private equity, suggesting a potential contraction where some firms may not be able to raise future funds. However, he also identifies an opportunity: as larger funds attract more capital, they will need to acquire businesses, potentially from mid-market sponsors. This dynamic could create opportunities for returns as larger managers acquire growing mid-market companies.

"most of the move to alternatives in the wealth channel has been in private credit there's a bunch of reasons for that one is it's a great vehicle for wealth it's really hard to lose money in a year so you make a portfolio of loans and let's say they're yielding 8 to 10 unlevelled let's call it 10 to make the math easy for you to lose money you'd need a 20 default rate at 50 severity almost never happens so the returns might not be great but you're never going to scare them out because you're just going to be making money the other piece of it is that the wealth channels used to liquidity and by design all of these alternative assets are less liquid than stocks and bonds well private credit creates its own liquidity through coupons so all of that has led to the design of structures like interval funds and all this money is going in"

Ted Sids explains the significant inflow of capital into private credit from the wealth channel, attributing it to its perceived safety and ability to generate consistent returns without large losses. He highlights that private credit offers a form of liquidity through coupon payments, making it attractive to investors accustomed to more liquid assets. This has led to the development of structures like interval funds to accommodate this capital.

"the biggest impact of that over the next couple of years is that when private markets unlock for liquidity the first wave of that money from the institutional market is going to go back to the public markets it's not going to get recycled in the private markets do the gps know that i think the public gps are hoping that's the case the private gps don't know it at all so that hasn't happened yet you see trickles of it but i think we'll start to see that this coming year then there's all the questions about the mag 7 and the valuation of companies facing ai is that a bubble price probably it's probably not a bubble in the underlying economic activity of the businesses but mag 7 went from these dominant cash flow machines to taking all the cash flow and spending it in something that has an unknown roi that's what a lot of people are thinking about in the public markets"

Ted Sids