The CEO of the world’s largest asset manager released a 9,000 word missive to investors on Wednesday that brought to the fore a nuance of the current macro environment that ought to be of considerable concern to private capital market participants – venture capital, private equity and asset managers in particular. In his letter to investors, Blackrock’s Larry Fink laid out a case that financial markets are now poised to suffer a reckoning for the prior thirteen-year period of “free money”, and he tactically deployed the trope of falling dominoes to make his point.
The first domino to fall in Fink’s analogy is stubbornly high inflation, of which he predicts we’ll all continue to suffer from for a much longer duration than the Fed has suggested. Estimating a long-term rate range between 3-5%, Fink sees this a direct consequence of the preceding decade’s historically loose monetary policy and free-handed fiscal stimuli, in addition to the Fed’s new program to backstop all depositors for their full account balances, above and beyond the FDIC $250,000 maximum.
Interest Rate Induced Asset-Liability Mismatches
The second domino to fall is the Fed’s breathtakingly rapid hiking of the Fed funds rate – over 500 bps in less than 18 months – and the corresponding systemic consequences of that rapid rise in rates throughout the global banking system. Much of the fallout from domino number two has been front and center in the past 10 days with the collapse of Signature, Silvergate, and Silicon Valley Bank (SVB). Though the failure of the last was proximally caused by incompetence and inadequate risk management, it was distally caused by an imbalance between assets and liabilities. SVB’s assets, a very large loan portfolio priced at below market interest rates and a securities portfolio overweight in long-term, off-the-run Treasuries that had been significantly devalued by the Fed’s aggressive rate increases, were completely inadequate to match the liabilities of SVB’s depositor obligations. Many of these depositor obligations were the large balances of VC funds, VC portfolio companies, and lendees who were forced to bank with SVB as a condition of their loans.
And it still remains to be seen just how many other financial institutions will suffer from the same fate as SVB because of the universally destabilizing effect of this type of asset-liability mismatch.
But it’s Fink’s third domino that’s the most disturbing to me, as it directly affects many of our fintech and software startup clients and the financial sponsors who comprise the capital base we connect them to. This third domino, a.k.a. a “liquidity-mismatch”, would disproportionately affect private market participants.
The concept behind a liquidity mismatch is based on the particular behavior that investors exhibit when money is everywhere, and it’s cheap. It’s precipitated by a two-part recipe that first sees investors driven into higher risk, illiquid assets in an effort to capture above market returns – Alpha – in a low interest rate environment. The second ingredient is an expression of the Peltzman Effect, which provides that when safety measures are put in place to backstop risky behaviors, people’s perception of risk changes, typically inclining them to take even more risk because loss aversion is attenuated by the safety precautions put in place. The classic example of this, and where this behavior was first observed and confirmed, was when states began mandating seatbelt use in motor vehicles. When seatbelt mandates were put into effect, fatalities went down, but overall accidents went up due to drivers feeling safer – less risk averse to catastrophic potentialities – than before.
As the Peltzman Effect relates to investors, they recalibrate their risk tolerance due to the abundance and all but unfettered access to cheap money which militates against downside risk and losses. Thus, they participate in riskier investing, where riskier investing means investment into riskier asset classes. One of which, and the class that Fink specifically references, is the asset class of private market securities, which are definitionally illiquid securities on a relative basis when compared to their publicly traded debt and equity cousins.
The potential fallout from years upon years of institutional and accredited investor allocations to illiquid, private securities, whether via direct investment, or indirect investment to managed funds, are two-fold. One, it’s not often clear what these securities are worth at any given time because fund managers, whether venture, PE, or asset managers, aren’t required to mark-to-market. And without this price discovery, it’s difficult to assess true asset values on the balance sheet.
Secondly, and more importantly, in the event where illiquid assets do need to be liquidated to cover other financial obligations – this would be depositors in the case of Silicon Valley Bank, or LP redemptions in the case of private funds – it’s very challenging to do so at full value. More often than not, they’re liquidated at pennies on the dollar, thus putting the financial health and long-term viability of private funds in serious jeopardy, along with their investors’ returns.
The consequences of this are obvious – private market funds could be sitting on billions if not trillions of dollars of illiquid securities whose market value may be woefully insufficient to cover potential liquidity obligations they have to investors or lenders.
And that’s one hell of a domino.