When one pictures America’s financial markets, the images that come to mind almost invariably involve trading on the major US stock exchanges: the ringing of the bell, the prices listed on the ticker tape, and Dan Aykroyd and Eddie Murphy shouting inscrutably about orange juice on the trading floor. Yet over the past decade, such public markets have been eclipsed by what are commonly known as “private” financial markets: funds organized by asset managers as limited partnerships, which include venture capital, private equity, and private credit funds, buying and selling non-financial assets in transactions that ordinary people cannot participate in.
Indeed, private financial markets have grown to the point where they now dominate financial activity. In the last decade, private funds have approximately tripled in size to $26 trillion in gross assets (compared to the $23 trillion in the U.S. commercial banking industry), and private markets now raise more in equity than public markets: in 2021, new stock issuances from publicly-traded companies resulted in $434.7 billion, while private markets raised nearly four times that amount ($1.73 trillion) in committed funds.
One reason this shift matters is that it undermines the protections afforded by existing securities laws. These laws are structured to require companies to disclose information publicly only when the public can buy and sell the securities issued by those same companies. By contrast, when transactions are open only to “sophisticated investors” (i.e., wealthy individuals and institutions), the law requires neither disclosure nor monitoring by regulators. The trouble with this arrangement is that in recent decades the financial assets of ordinary people have been bundled into retirement funds that are considered “sophisticated investors” under the law — so nearly everyone, wealthy or not, is now exposed to these less well-regulated private markets. In the words of legal scholar George Georgiev, there has been a “breakdown of the public-private divide in securities law.”
This development represents new systemic risks to the economy at large, as well as to the institutional shareholders participating in these markets. In this post, drawing on a recent working paper with Harrison Karlewicz, I sketch the institutional arrangements that characterize these private financial markets, and explain the distinctive set of potential risks posed by the specific growth of private credit funds, which have received far less attention than the more familiar rise of private equity.
Before proceeding, a note about how we talk about financial markets. As with so much of the language of finance, the way we use the words private and public in reference to financial markets is misleading. We tend to use the word “public” to refer to financial markets that are open to all with the disposable wealth to trade in them, and the word “private” to refer to the segment of the financial market that is closed to all but the wealthy and financial institutions. Neither side of the financial market is, of course, “public” in the sense of belonging to us all, or democratically determined; nor is either side “private,” in the sense of somehow being independent of the state, since the entire financial system depends on the state’s grant of its franchise. I prefer the terms “regulated” or “open” to refer to the more familiar segment of financial markets—index funds and stock market trading—and the terms “unregulated” or “less regulated” to refer to what we colloquially call “private” financial markets, as their distinguishing feature is that disclosure of their activities is not required. In what follows, however, I will adopt the conventional usage, applying the term “private” to refer to the less regulated side of financial markets, which are quickly becoming the center of financial market activity and whose opacity has largely shielded them from receiving the scrutiny they deserve.
The Institutional Framework of Private Financial Markets
The Securities Act of 1933 and the Securities Exchange Act 1934, the landmark legislation that established the Securities Exchange Commission’s regime of regulation over certain corporate and financial transactions, institutionalized the “public-private divide” in securities markets. The Acts established a “highly” regulated public realm, and a lightly regulated private realm, based on the premise that “public markets” were the domain of shareholders purchasing and selling corporate shares who lacked expertise and thus needed detailed disclosure of corporate activities. Private markets, on the other hand, were the domain of wealthy expert shareholders, who were able to engage in dealmaking without public disclosure.
This distinction initially limited institutional shareholders, such as public pension funds, from purchasing assets that were not sold on open securities markets. However, in 1979, the Department of Labor revised the standards for trustees of pension funds, enabling them to purchase illiquid assets for the first time under the new “prudent man rule.” This change enabled the growth of private markets by allowing, for the first time, the largest pools of institutional financial assets—pensions—to participate. Today, public pensions in the United States allocate 34% of their holdings to private markets, and account for $2.7 trillion in committed funds.
One argument made in favor of private markets, and one reason that some see institutional shareholders as a good fit for such markets, is that the illiquid nature of asset purchases enables a longer-term focus by asset managers and institutional shareholders. Leading investment scholars Victoria Ivashina and Josh Lerner claim, for instance, that “long-term investors who are actively involved in managing an investment may be able to contribute a lot of value,” and that the compensation structures in private markets give executives the incentive to work to make the production process successful. They warn, however, that many investors have a stop-start pattern to their private investment, so they do not end up with the rewards of such long-term investment.
In contrast with open financial markets, where constant trading is the norm, private markets are organized to enable fund managers (also referred to as asset managers) to utilize the financial assets of qualified institutions or wealthy individuals, pool them into funds, and use those funds to purchase non-financial assets. “Pooled investment vehicles,” or “private funds,” raise financial assets from “limited partners” and are managed by investment advisers, who decide how to allocate the funds. These funds—either because they have a limited number of beneficial owners (100, or in the case of venture capital, 250) or are limited to “qualified purchases”—are exempt under the Investment Company Act of 1940, which normally requires that investment companies “disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis.” What this means in practice is that private funds operate largely in the dark. And because private and public pensions are some of the main contributors to such investment vehicles—along with family offices, endowments, insurance companies, and sovereign wealth funds—everyday households are just as bound up in these private funds as they are in public markets, yet we have little insight into how these private fund managers are operating.
The final institutional aspect worth noting is that, legally, asset fund managers are distinct entities from the funds themselves. This legal distinction is critical to the business model in private markets, in which asset managers reap the benefits but avoid the risks incurred by the underlying companies or real assets held by the fund.
The Risks of Private Credit Funds
In recent decades, two forms of private financial markets have attracted significant public attention: venture capital and private equity. Legal scholars and economists have, for instance, detailed in great depth how private equity harms both workers and the companies that it purchases, many of which provide crucial social services like health care and childcare. By contrast, the “exponential” growth of private credit funds has been less visible to economic policymakers, even as public pensions have begun to allocate funds to them and even as these funds pose distinctive risks to our financial system. Only recently has this situation started to change, with both the IMF and the Federal Reserve sounding the alarm about the distinct risks of private credit funds.
Private credit funds became an attractive asset class because of their relatively higher returns during a period of low interest rates. Over the past five years, assets under management in such funds have grown at an average annual rate of 20 percent, totaling $1.6 trillion, about 30 percent of which are from public and private pension funds. As a result, private credit funds now provide “seven percent of the credit to non-financial corporations,” and though loan details are scarce, the average loan size exceeded $80 million in 2022, which is larger than the average loan size made by regulated banks.
Private credit funds pose a unique set of potential systemic risks to the broader financial system because of their interrelationship with the regulated banking sector, the opacity of the terms of their loans, the illiquid nature of the loans and potential maturity mismatches with the needs of limited partners to withdraw funds, and the fact that this growing market has never been through a downturn in the business cycle. According to the most recent IMF Global Financial Stability Report, “the rapid growth of private credit, coupled with increasing competition from banks on large deals and pressure to deploy capital, may lead to a deterioration in pricing and non-pricing terms, including lower underwriting standards and weakened covenants, raising the risk of credit losses in the future.” In other words, these are loans made to companies using financial assets that ultimately come from households, in which the loans are risky and opaque, and the terms bespoke, and in which risk is passed along through securitization so that it’s unclear where it lives. Replace “financial” with “mortgage” assets and we have the basic setup of the last financial crisis.
Consider, for instance, the fact that private credit funds often finance private equity buyouts of nonfinancial companies. While private equity firms have always used debt to buy operating companies, which they then either sell for capital gains or bankrupt after stripping them for parts, they used to have to obtain the debt from the regulated banking system. Now, with private credit funds making these loans, neither the deals nor the loans are ensured of due diligence, the interest rates are floating, and regulators do not monitor the deals or require a safety net in the form of reserve requirements. What could go wrong?
As a public sector employee, I am especially concerned that public pension funds are deeply embedded in private credit funds, and private financial markets more generally, creating risks for non-wealthy households. Public pension funds, as we detail in our working paper, are increasingly allocating portfolios to different segments of private markets; in one recent example of this shift, Calpers, the largest public pension fund in the United States, announced that it is raising its allocation to private markets to $30 billion. As I’ve written before, public pension funds need to be run in the actual, holistic interest of the underlying economic beneficiaries—public sector workers and their families—and to reduce the extractive activities of the current institutional setup of such funds. The growing allocation to private funds means that we have even less insight into what is happening with our retirement funds and potentially threatens the economic security for a large segment of the U.S. workforce. While many discrete policies are necessary, the framework within which we think about financial markets and their relationship to shareholders needs to change to accommodate the reality that private markets have continued to grow, and show no sign of stopping.
