Emerging Risks in Private Finance - IOSCO publishes a Thematic Review

On 14 September 2023, IOSCO published a Thematic Analysis, "Emerging Risks in Private Finance" (the Report).

The Report highlights that private finance markets are inherently opaque and present challenges for both regulators and market participants to understand the scale of risk in their activities. In the words of the press release, "IOSCO is concerned that the sector may be tested going forward and respond in ways that uncover hidden risks, such as excess corporate leverage".

What's the background?

With private credit and private equity funds taking an increasingly significant share of overall financial markets - as at June 2022, private market AuM stood at US$12.8 trillion - it is clear that they play an ever more important role in financing the real economy.

The Report accepts that the activities of private finance can, of course, be economically beneficial - especially in financing key growth areas where banks are unwilling to provide credit or in providing key sources of developmental finance. But that with this increasingly important role comes potential risks.

The Report (which focuses on private equity and private credit), looks at the potential vulnerabilities that might arise from private financing activities, including how risks in this sphere could impact public capital markets and IOSCO's objectives of minimising financial instability and systemic risk.

What does Report contain?

The Report draws its conclusions from a combination of an "extensive review" of literature, market research, and roundtable discussions with stakeholders. These conclusions include:

• the inherent opacity in private finance can insulate investors from transparency costs faced in public markets but can also jeopardize the availability of information that regulators and investors need to be able to assess risks effectively (including risks that could arise as a result of how private finance firms conduct their activities and of how macro-financial developments could impact the sector)

• the rapid growth in private finance markets since the global financial crisis has been due to accommodative monetary policy and cost advantages as against other sources of finance. However, global macro-financial conditions have significantly changed in the near-term and higher interest rates, in particular, could expose vulnerabilities in private markets

• the inherent opaque nature of private finance gives rise to a lack of clear understanding of the level of risk in private finance activities. Even so, that private and public markets are clearly so intertwined that any one market event could have implications across both markets (as well as, potentially, the financial system more broadly)

• the relative lack of transparency in private compared with publicly listed markets gives rise to greater asymmetries of information. Transparency in public markets may come at a cost to issuers and shareholders but helps support efficient price formation and reduces search costs for investors. The Report concludes that "any attempts to increase transparency (either for regulators or market participants) in a market built with opacity as a key functional feature would need to carefully balance the increased costs to market participants, with the benefits to the financial system more broadly"

• dramatic changes seen in the investment landscape, with the return of inflation and the rapid shift to interest rate normalisation, have created challenges to funding models within certain sectors, in terms of continuing access to cheap, secure sources of debt funding. This leads to questions about the ability of these sectors to navigate the transition to the "new normal"

• interest rates staying at current levels for longer than expected will most likely lead to a reduction in the availability of funding to support private finance activities and the extent to which private finance firms can mitigate this through the 'dry powder' they have accumulated

• portfolio companies are likely to face higher rates on existing borrowing as well as on new and refinanced borrowing, particularly over the medium to long-term. Overall, sectors such as technology and healthcare, which have become reliant on a constant flow of affordable financing could suffer significant impacts

• it is difficult to determine whether the impact of higher defaults would be worse in the private finance sector compared with public markets. Nevertheless, the impact could be significant whilst being less actively monitored by regulators and investors

• conflicts of interest exist in different investment products as well as in some aspects of valuations, transaction negotiation practices and GP-led secondary markets. The scale of these risks, the frequency in which these issues arise and the extent to which they are managed effectively are, though, hard to assess

• the relative lack of transparency in private finance markets "is especially relevant when considering any increased participation by retail investors". A push toward new sources of capital would naturally come at a cost - investment products would be subject to increased regulation, governance and oversight than those sold to institutional investors, while aspects of the market may need to change (such as offering greater liquidity, more information, and ensuring investors receive suitable advice)

• however, private finance activities can offer benefits to the financial system and the real economy. In the eyes of some, the increased use of private markets by private companies and their private equity sponsors to meet their funding needs has considerable benefits, as private credit providers may be able to provide more bespoke, flexible covenants, higher risk tolerance, and a longer investment horizon than banks are willing to support.