Every crisis has a response. Policymakers put in safeguards and provide incentives for the next bull market, in their attempt to prevent it from happening again.
In these policies, we should, usually, seek the seeds of the next crisis. From the biggest potential risks, the private equity space is where we would focus.
In the 1970s, the world experienced a decade of slow growth and high inflation. In their effort to put a stop to it, central banks launched interest rates at very high levels. Desperate homeowners were, anecdotally, sending their house keys to Paul Volcker, the chair of the Federal Reserve in the mid-1980s.
To balance the equation and foster growth again, governments defanged laws preventing banks from leveraging their deposits to give out more loans. It enabled banks to essentially create money. However, risks for depositors rose, without compensation or their knowledge.
The 2008 global financial crisis was about 25years of banks taking increased risks with their clients’ deposits. It got so bad that banks were happy to give out loans to people who could never hope to repay them, and then try to pass on the risks to others.
Governments knew that it was their own deregulatory efforts that led to this result. “Too big to fail”, bad as it sounded, was probably more politically palatable than, “we had to do something 25 years ago”.
Banks re-shackled
The response to that crisis was as expected. Regulators relaxed oversight and made sure private investors had enough tax incentives to pick up the investment baton. The central banks would print enough money to keep risks and interest rates low enough to foster investments, and then deliberately kept the banks off the party’s guest list.
Banks were re-shackled, becoming the boring institutions they were five decades before. No more proprietary trading desks or super-leveraging deposits. A decade of ultra-low-cost capital signalled the rise of private equity investing.
Many companies even opted to remain private, rather than raise money through an initial public offering. Over the past 25 years, the number of US public companies declined by a third, and the remaining pool is dominated by a handful of tech companies.
Private equity companies currently have a valuation problem. The valuation of a company depends on the amount the last investors put in.
Let us use a company called TechX as an example. TechX produces equipment with haptic feedback for game consoles and the metaverse. During the time of cheap money, a venture capitalist invested $20mn (£15.7mn) from its $1bn pool to acquire 2 per cent of the company.
The stake was purposefully low. With a small amount of money, an influx of just $20m, the company is now suddenly a $1bn “unicorn”, although it has never seen that amount of money. That status is set to attract even more investors.
Private equities — a step up in terms of capital and scrutiny from venture capitalists — would now put TechX on the radar. They might offer less generous valuations terms, but still big enough for the company to grow exponentially.
