Despite problems, however, it is unlikely that pressure on the markets could come from this side. Swap transactions for bonds similar to those in Great Britain are not known. In addition, in case of doubt, claims of beneficiaries can be reduced or the companies behind the funds can be called in. And at the end of the day, there is still the Pension Protection Association, which could at least absorb smaller funds.
14. Private Equity (classic): low solvency risk
Private equity investors seem to have been largely spared the slide in the prices of publicly traded companies in 2022. While the private market index of the investment consulting firm Lincoln gained 3.2 percent in the first three quarters, the S&P 500 EV, i.e., as an index measured in corporate values excluding financial companies, lost a good 22 percent.24Should non-publicly traded companies have withstood inflation, rising interest rates and supply chain problems better? That may be true for individual companies, just as there were also crisis winners among publicly traded companies. But in the breadth of an index, it is first of all astonishing.
We suspect there is another reason behind this. While shares of companies from the S&P 500 are traded daily in large numbers and the share price thus reflects the expectations of market participants in a timely manner, the valuation of private equity is often based on individual models with their own assumptions on interest rates and projections of future cash flows.25 We therefore suspect that the earnings in the private equity sector are artificially smoothed by the valuation methods applied and that hidden burdens exist. The extent of this seems limited, however, if one takes the devaluations of the S&P 500 as a benchmark and considers that more long-term (and wealthy) investors are invested in this investment category with a market volume of around five trillion dollars.26
15. Market volume of shadow banks: uncertain liquidity risk
In a letter to the G20 heads of state, the chairman of the Financial Stability Board (FSB) points out possible risks from the area of so-called non-banking financial institutions, such as insurers or clearing houses. The term shadow banks is also used colloquially for this. In 2020, these held a total of 227 trillion dollars in financial assets (including derivatives and cash), which corresponds to 48 percent of all financial assets held worldwide. This means that they exceed the assets of banks and central banks combined.27
The FSB 2023 would like to pay special attention to the detection of "hidden leverage", i.e., transactions with debt capital that are not shown on the balance sheets of market participants. In addition, the FSB is looking at potential liquidity squeezes of investment funds. It cites a mismatch between fund pay-out modalities and the short-term liquid ability of assets as a problem in times of high volatility.28
A first example of such initially abstract distortions can currently be seen in American real estate funds. We will outline this in more detail in the next section:
In addition to the classic private equity market, which is characterised by purchases of unlisted and listed companies or parts of companies, there are other private investments: for example, in unlisted debt instruments (private debt), real estate and infrastructure. There is another 2.6 trillion dollars of investment capital in them. And unlike classic private equity funds, these instruments allow limited sales of shares.
The world's largest investor in commercial real estate by its own account, a well-known US private equity firm, manages a real estate portfolio of over 565 billion dollars for its investors alone. This includes a 70-billion-dollar real estate investment trust (REITs) for reasonably wealthy ordinary investors, which invests in student flats and casinos, among other things.
Should difficulties arise here, this could trigger a cascade. This is because the investments are partly debt-financed. It is possible to guess how much. According to data from last year, the current value of the properties is offset by 37 percent of the invested capital. This indicates a debt financing of a good 60 percent. This would be normal for the industry across all private equity classes and could even be described as conservative for real estate. However, if the tenants can no longer afford their instalments and the refinancing becomes more expensive for the private equity investor, the portfolios will come under pressure, especially since the investors could withdraw at least some of their money.
And this is already happening: one investment company has just restricted the redemption of fund units after quarterly redemption limits were exceeded. So, is pressure building up here because such developments are also likely to be registered by the lenders of the properties?
Through corresponding (leveraged) loans, they may be in the same boat. This shows the problem that a lot of business has been transferred from the banks to the shadow banks. In the realm of shadow banks, no investment company is "too big to fail", but this time there may be "too many to fail".
So, the US housing market could once again be a catalyst for a crisis. Private capital from wealthy individual investors could absorb losses but leveraged loans could once again become systemic.
The collapse of the so-called family office Archegos Capital Management shows how quickly even individual cases can cause problems worldwide. In spring 2021, losses on leveraged equity positions triggered double-digit billion dollar losses and the collapse of Archegos, which involved hedge funds and well-known banks, among others. The banking sector alone had to bear write-downs of over ten billion dollars - yet Archegos was a comparatively small fish.
The FSB's concerns raised about the lack of regulation in the shadow banking sector seem plausible, especially in light of the examples given. Due to the sheer size of the market, the risk would have to be mapped. However, the examples further support the need. We opt for a classification in the uncertain category, as the historical comparison is difficult due to the novelty of the development.
Conclusion
Our map of risks outlines the "known unknowns" ("known unknowns"). We have tried to identify higher and lower risks in this category. But the uncertainty remains - in the words of US economist Frank Knight - "radical". The reason for this is the so-called "unknown unknowns", which only become "knowns" ex-post.
Overall, a picture emerges that should make all players think. The proverbial "turn of the times", also in terms of interest rates, is likely to expose many weak points in the financial sector with more or less major consequences. Investors should therefore keep financial buffers in reserve for unforeseen impacts. Unfortunately, politics follows a different logic of action. Since it is incapable of financial precaution, one must expect that it will plug unexpectedly occurring financial gaps with new money creation. Although one cannot rule out a deflationary effect, we consider a further kindling of inflation more likely in the event of new financial crises.
1https://www.esma.europa.eu/sites/default/files/library/2015/11/2012-482.pdf
2https://www.ft.com/content/b53f2254-9409-432a-9755-62c621e3f552
3https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.pr220721~973e6e7273.en.html
4https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3823293
5https://www.ecb.europa.eu/mopo/implement/app/lending/html/index.en.html
6https://www.ft.com/content/9f4dadb1-c538-4c50-802b-55c5a22e098e
7https://www.ft.com/content/fe34de37-9389-4672-81a3-738cc044d4a6
8https://www.flossbachvonstorch-researchinstitute.com/de/fvs-vermoegenspreisindex-deutschland/
9https://www.fhfa.gov/DataTools/Downloads/Pages/House-Price-Index-Datasets.aspx
10https://www.nytimes.com/2022/09/28/opinion/housing-prices-pandemic.html
11https://fred.stlouisfed.org/release/tables?rid=52&eid=1192326&od=2007-01-01
13https://hypo.org/app/uploads/sites/2/2022/09/HYPOSTAT-2022-FOR-DISTRIBUTION.pdf
17https://www.imf.org/en/Blogs/Articles/2018/11/15/sounding-the-alarm-on-leveraged-lending
19https://www.abp.nl/english/financial-situation/annual-report
20https://www.abp.nl/images/top-100-investments.pdf
21https://www.ons.gov.uk/peoplepopulationandcommunity/personalandhouseholdfinances/incomeandwealth/bulletins/pensionwealthingreatbritain/april2018tomarch2020 and https://www.pfzw.nl/content/dam/pfzw/web/about-us/Annual%20report%20PFZW%202021.pdf
22www.abp.nl/english/financial-situation/annual-report, page 153