What will be the next financial crisis?

What will be the next financial crisis?

After a crisis, we often ask ourselves what the shape of the next one might be. It is a delicate question to ask. However, we have some interesting avenues to consider, and we should consider them to avoid being too surprised if it happens. Some will point to rampant inflation, coupled with a shortage of raw materials and other logistical problems, leading to a deglobalization of the economy. However, there is one thing we should consider. The next crisis could be centered on private investments. Let's ask ourselves about a scenario that could happen, because in finance, as in everything, "excess is bad for everything". Perhaps we have become too dependent on this anthropophagous industry.

What will be the next one?

No one could contest a real booming of private markets and how successful they are and were. Nevertheless, the next financial crisis could be centered around private markets, just like in 2008, when the GFC was initiated by the sub-primes. Many people are predicting a strong economic crisis to come. What form it might take is the question we all want to answer. Alas, crises are not as predictable as hurricanes or tornadoes. So, we have to do a bit of what I would call "economic fiction" and ask ourselves what could cause it. Let's not lose sight of the fact that sometimes it is a combination of elements that combine to cause a deep crisis. Today, we can fear stratospheric inflation, the volatility of commodity markets, the strength of the dollar, the war in Ukraine and its consequences on energy, the high indebtedness of sub-investment grade companies, the under-capitalization of certain market players affected by the rise in energy prices and the weakness of demand, the climate shock (which demonstrated its devastating force this summer), etc. In any case, it remains very difficult to predict the economic future, even for a seasoned guru. Let's try to evoke an interesting and particular track: the "private investments".

The roots of a crisis

During the financial crisis of 2008, sub-primes were clearly attributed as the root cause. The next financial crisis could focus on private investments. These funds have indeed experienced a real "boom" and today private equity funds are the main buyers of industrial assets; no one can dispute this. Moreover, their voracious appetite and bulimia are having an impact on multiples, which have soared. Who can compete with a PE? No one can. Multinational companies are refocusing on their core businesses and when they want to purchase an asset, they are afraid to overpay it. Indeed, if you overpay for an asset, you risk, sooner or later, a "goodwill impairment" that will significantly affect your results. So, the competition has become unfair and unjust. It is in this context that we have seen PE's flourish and buy up everything they can get their hands on. Excess always harms those who do not know how to moderate themselves.

Latest formula for success

These alternative funds believe they have found the latest formula for success. They have invested 10 trillion of USD into unlisted equities, private credits, and early-stage new venture funding. There are major issues beyond the classic problems of over-valuations (above mentioned), optimistic assumptions, aggressive accounting methods, high indebtedness levels, firm conviction they have found the recipe for doing better and blindness strategies. Let’s address these additional concerns we must keep in mind. These investments remain inherently illiquid. Investors cannot cauterize losses easily. As monetization is largely relying on initial public offerings and trade sales, when markets are going down, it may become more complicate and may extend holding periods, more than usually. There are risks of mismatching between the redemption rights granted to ultimate investors and the ability to realize underlying assets. We have noticed a lot of continuation funds. It may be a sign that timing has maybe changed, and that patience could be required from investor side. In such scenario’s, investors could be forced to make distressed sales or be trapped in withdrawals resulting in opportunity costs. Then, the lack of market prices implies opacity on valuations. Of course, it misstates investment values. The unlisted equity valuation models rely on comparable traded companies and private financing rounds. Often differences in valuations and real market values can be significant. We saw many disappointing IPO’s (in terms of valuations, e.g., WeWork, Uber, Klarna, …). Recently, RE’s also faced a decrease in appetite for warehouses, after intense activities since COVID. In such industry, everything depends on subjective approaches (whatever you believe) and can result in large variations in private investment valuations. Infrequent valuations may mean prices lag when market conditions are affected and rapidly change. When market competition for interesting assets is fierce, actors can be encouraged to take unquantifiable and poorly understood hazards and risks.

Simple recipe

Usually, the recipe was simple: long holding periods, with substantial borrowings, in industries offering undervalued shares, strong cash-flows, low operating risks and potential for business improvements. That is the theory. The reality may be different. Many elements other than leverage are absent. And even the leverage may be too high in a fast-increasing interest rate environment. Service of debt may become difficult when markets are changing, and business are suffering. Assets exposed to economic cycles may face difficulties if wind is blowing. These assets bought may not have solid real estate assets, know-how, intellectual properties, plants, or equipment’s to secure such tough periods and stress cases. We must also consider that for some industries, non-profitable, cash-flow negative, low rated, it may become difficult to find funding. There is a clear refinancing risk. When (intrinsic/implied) ratings are going down, pricing grids may change cost of funding and make the service of debt suddenly complicate. The all-in leverage level may suddenly become too high if interest rates keep increasing at fast speed. Investments are often held through tiers of funds, via shadow banking structures or private providers. The opacity around financing is high and as always, the leverage may have been exacerbated and extended to its maximum. In such cases, any single sand seed may alter the whole construction.

What if…

Now, we know that any instability in such a construction may have impacts elsewhere within the financial system. That’s the real risk if this industry is straight away severely hit. When interest rates were low and even negative, momentum skyrocketing and companies performing well, everything was perfect. However, if one or several elements are disappearing, the whole structure may be impacted immediately and severely. The “gold” rush into private assets was predicated on the continuous availability of cheap capital and low interest rates and perceived as a sustainable investment strategy. The investors may have forgotten the basic correlation between risk and return, blinded by the performances of PE’s. A successful recipe can suddenly become less good and show some flaws. To say that the next crisis will come from this dynamic industry is a delicate question. I can't answer it. However, I think the situation deserves to be considered and the risks inherent in the model given the current economic circumstances and the combination of elements and factors, which, combined, could weaken the whole edifice. Something to think about...

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Fran?ois Masquelier, CEO of Simply Treasury – Luxembourg, September 2022

Disclaimer: This article was prepared by Fran?ois Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).