Growing risks in one corner of the $14 trillion financial markets pose a threat to economic stability, a research firm says.

• Private market funds are finding quick, creative but lightly regulated solutions to avoid defaults under tighter monetary policy.

• These strategies make it difficult to assess the underlying quality of assets, says Rosenberg Research.

• The firm warns that without greater scrutiny from regulators, private markets present systemic risk.

Private markets have grown in size in recent years and are rife with hidden risks, Rosenberg Research said this week.

The risks arise on private markets, coupled with a growing stock market bubblethreaten the financial system as a whole, the company’s vice president and senior economist, Dylan Smith, wrote in a note..

“The combination of the current public equity bubble (to which private valuations are compared) and the incredibly complex and interdependent levels of leverage in the opaque private market system merits attention as a source potential for serious financial and economic risk,” Smith said.

Private markets encompass the world of investments in non-public companies as well as startups, real estate, infrastructure and direct lending.

These markets quickly became big beneficiaries of the era of near-zero interest rates that followed the 2008 global financial crisis, Smith said. Cheap borrowing costs have led to a surge in buyouts from private equity firms and boosted valuations, helping funds lock in returns once those investments exit.

A new wave of deals during the COVID-19 pandemic has added fuel to the industry, quickly transforming private markets from a niche investment arm into a financial giant that will reach $14 trillion this year, he said.

But rising interest rates over the past two years have led to a drought in trading as high valuations have become harder to justify and higher leverage costs have made deals more expensive.

The result is $4 trillion in “dry powder,” that is, financing committed by investors but not yet deployed by the funds. This funding puts enormous pressure on the sector to find deals in difficult market conditions, Smith says.

The industry has therefore had to be creative, adding debt to existing debt, in increasingly opaque forms. That’s where the risk likely lies, Smith said.

“Private asset management is fundamentally a game of leverage. And that leverage is increasing,” Smith wrote, adding that fund managers are “resorting to an ever more creative array of temporary solutions, all of which have the effect of d ‘increase the total leverage of the company’. the system, increasing interdependence and circular credit lines between parts of the system.

These solutions range from adding additional capital to problematic portfolio companies rather than making losses on bad trades in the hope that conditions will eventually improve, to more astute approaches such as in-kind loans, where holding companies struggling to pay interest simply add the outstanding amount to their balance instead of repaying in cash.

These increasingly complex and overlapping lending channels create enormous risk, as it becomes increasingly difficult to assess the underlying quality of assets, Smith says.

Now that the Fed has started its easing cycle, that could provide some relief, Smith said, provided it cuts interest rates quickly enough and low enough that overall system debt is tolerable and that the underlying assets under stress can avoid defaults.

But if it maintains restrictive interest rates, a likely scenario given President-elect Donald Trump’s proposed tariffs, that could increase pressure on funds to generate returns.

“Eventually, the system could collapse due to a wave of portco defaults, especially if the economy as a whole slows down,” Smith says, adding that it would likely be a gradual realization by banks from the underlying poor quality of their assets, rather than from a sudden collapse.

Smith says the Fed and other government agencies are responsible and should take a closer look at the sector.

“The Fed’s ‘flying blind’ is a major problem with the impact of its policies on this integral part of the financial system. It’s not the financial market or the bursting of asset bubbles that trigger recessions, but the onset of a recession creates the conditions for a depreciation of cash flows, which generates a negative feedback loop and an eventual crisis,” he wrote.

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