Keeping an eye on private markets’ not so private vulnerabilities | articles

4. Valuation risks

In contrast to the public market, supervisory oversight surrounding asset valuation and pricing is not as overarching for private markets. This adds to the inherent opacity of the sector and complicates the assessment of potential losses for external investors.

A report from the French Market Supervision Organisation points out that in addition to being infrequent, private market valuations suffer from three other vulnerabilities. Firstly, due to the nature of the projects funded, assessments often lack comparison potential. Secondly, the assets linked to the valuation are frequently intangible or linked to innovation making it difficult to estimate the liquidity premium. Finally, the sector’s development also increased its complexity which makes valuation more difficult. Consequently, models used to derive private assets’ valuation inherently contain a large part of subjective assumptions.

The difficulty of deriving a realistic assessment of private funds’ underlying assets and the large place for assumptions in the models used adds to the infrequent reassessment of those valuations. All these variables make the sector prone to hiding potential losses and underlying volatility. The IMF estimates that in a downside scenario, the lack of transparency and adequate data could result in a deferred loss realisation for the sector. This could lead to a spike in defaults and a confidence loss in the assets.

5. Procyclicality

Private markets also suffer from procyclical features. While the sector’s exponential growth stems from the low interest rate period and investors’ search for yields, the extended period of higher interest rates may expose the sector to higher risks.

The higher for longer interest rate environment, in addition to inflation, exposes the private sector’s vulnerability on two sides. On the one hand, financed companies might suffer from inflation with higher costs and lower revenues. On the other hand, private finance funds might see their financing costs increase and, in some cases, struggle to refinance debt issued, even if we see this as a lower risk.

Next year’s economic forecast points to sluggish growth despite some additional interest rate cuts. Higher interest rates for an extended period accompanied by slow economic growth could hit the sector and result in higher default rates. This circles us back to the importance of accurate valuations.