Should the FCA be regulating Private Capital Markets?

Blain’s Morning Porridge Feb 6th 2024: Should the FCA be regulating Private Capital Markets?

“The success of markets is a function of how free they are, not how constrained they become through regulation….”

The UK’s FCA is considering “valuations” in the Private Capital sector. That triggers alarm bells. Bi-lateral private markets are an important part of the professional financial system, but fall outside traditional regulation. Is it time to bring them onside?

The UK’s Financial Conduct Authority, the FCA, is looking into “valuations” in the Private Capital sector – private equity, debt and hybrids including capital and securitisations – which I usually group together under the “Alternatives” banner. My Spidey-senses are all a tingle at the news..

Full disclosure: My “day job”, which I am now incorporating into my new Bowline Capital Advisors business (website will be up and running shortly) is the Alternatives markets. (I remain a partner and strategist at Shard Capital also.) My expertise is available to advise buy and sell side clients on the private markets. I spent the first half of my financial career in the public capital markets, running DCM Financial Institutions at two leading investment banks, before switching to private markets in the wake of the 2008 crisis.

Let me assure the FCA I embrace Rule 3 of the Market Conduct rules, promising to “be open and cooperative with the FCA and other regulators”. However, whenever the authorities start looking at a market, my reaction is to ponder how might they damage and limit the market by imposing rules? So here I am, being open and cooperative, cautioning the regulators to be aware of the consequences of tinkering in imperfect markets, and to understand what they seek to regulate.

At its broadest level, the FCA is absolutely right to be concerned about Private Capital Markets. Direct alternative investments lack transparency, and are not suitable for retail investors, but equally retail should have a route to access the stronger returns available in the Alternatives sectors. These returns are a factor of the higher risk involved.

Any return entails an appetite for risk. The FCA is acutely aware it will be blamed in crisis: conscious of how the once £10 bln Woodford PE fund was suspended after its illiquid asset investments tumbled, leaving investors nursing hefty losses – while the eponymous investor still has his big house in Salcombe. In all things – there must be balance, but also caveat emptor!

There is also some confusion as to what is and what is not a private investment. This morning Bloomberg is reporting a $2 bn private bond sale for Ardonagh Group, arranged by Morgan Stanley and Goldman. The buyers are the typical list of big private credit funders: Antares, Blue Owl, ICG, Oaktree, HPS, CDPQ and GIC – exactly the kind of names I take my deals to. The three tranche deal looks exactly like any other high-yield public debt deal – so how is it private debt? (Hint to prospective Bowline clients: I can get your deal to same kind of investors, and I am much, much cheaper than Goldman.)

Last month we saw a deluge of corporate debt hit the January market. Much of that was hi-yield, privately owned corporates issuing debt into the hungry market. However, much of the proceeds were to pay dividends to these firms’ private equity owners, in order that they could pay their equally yield hungry investors. In many ways that’s a market distortion – private equity investors are effectively leveraging returns via public debt because the cheap price of debt means its more competitive than the returns generated by their investments…. (It’s a basic arbitrage – the trick is finding someone to fund it (which is easier if you jump between asset classes; using debt investors to fund equity-like risks.))

Does debt-addled Private Equity make sense? Is it better to raise debt to build plant to produce profits, or to pay dividends? Think it through a bit – if you are invested in private equity where the returns are provided by leverage, you are essentially creating short-term returns by encumbering the company’s long-term future with debt. Can that be a good thing – discuss. (Yes: high inflation will whittle away the debt. No: the company’s choices are fatally limited by liquidity constraints.)

Lines are blurred.

The FCA’s concerns about the value of private investments held by professional investors is laudable. Let’s understand why they hold these risks.

Since global regulators weighed in with punitive new capital requirements and trading rules on banks post the 2008 Global Financial Crisis, banks’ risk-taking appetites have been significantly repressed. The Alternative Sector sprung into being post-crisis to fill the market niche that opened as the banks retreated. Very quickly credit funds and some more imaginative hedge funds spotted the opportunity to lend direct to borrowers. Pension and insurance funds were looking for long-term annuity returns, and also saw how private market deals could provide these.

The key issue for regulators is that the inherent risks in lending cannot be transformed (except via complexity) – but they can be transferred. Much of the risk banks once absorbed and managed has been transferred into the asset management sector… where it now lurks on the asset side of the balance sheet. Does that now represent a systemic risk to the global financial system?

What kills banks is liquidity events. It kills them at speed. Hint that a bank has lost significant money and may take a capital hit, and there will be a run, draining liquidity from the institution. Liquidity killed Silicon Valley Bank and Credit Suisse last year. The fear is bank runs become an infectious epidemic.

What kills asset managers? They lose money and they die slow as confidence evaporates, funds under management are withdrawn, causing them to “gate” withdrawals – so goes the conventional wisdom. (If only it were so simple.)

A series of losses within the diversified Asset Management sector may look a better option for regulators than a systemic crisis in the very concentrated bank sector. If asset managers take a bath, regulators reckon they have more time to solve a crisis – unless of course we discover these assets have been multiply leveraged, as became pitifully clear when Lis Truss broke the UK Gilts market in 2022, triggering the Liability Driven Investment crash, which required swift intervention for the Bank of England to mop up fire-sale gilts, the only assets liquid enough to cover margin losses on leveraged gilt plays…

Some asset-management firms run the risks of private equity, private debt and direct lending with admirable skill. Others… not so much – as we are seeing with the investors sucked into to lending to Austrian property firm, Signa. Much of the news flow in recent months relating to the Alternatives asset market has been about rising illiquidity in volatile markets, the increased interest-rate sensitivity of private markets in rising rate markets, and apparently misunderstood and mispriced deals. (It does feel like the FCA’s decision to consider market-regulation is headline driven.)

The key issue is how to establish “fair-value” in the private markets. That can be done – but its complex. (If you want to value private assets, let’s chat – I have a concept that works.)

In a perfect world.. private assets would be perfectly valued. But we live on this very imperfect planet:

In public markets, the large number of participants voting to buy/sell establishes transparency on prices.
Private assets are priced by negotiation between buyer and seller – there is no price discovery via a market, but more a game of poker between the parties.
Any privately negotiated transaction is inherently knowledge driven, and knowledge is only valuable in a negotiation when it can be withheld.
The value of any private asset in the secondary private markets is only what the next buyer is prepared to pay for it.

The upside rationale for private assets is to generate above market returns. Do you want assets where everything is Beta and known, or do you want to own assets when your knowledge adds Alpha? Private markets are more risky because of the knowledge premium, but can add significant Alpha.

Fair enough. The FCA is there to ensure everyone is treated fairly. There are times when a regulator should step in and say these markets are not for unsophisticated investors – such as banning retail investors from bank additional tier 1 securities (CoCos), but should it be the role of the regulator to constrain professional investors from risk markets? No!

If the FCA does regulate Private Capital Markets, the costs will be significant, and probably seriously impact the market and the number of participants. Reporting requirements, regulatory filings, valuation methodologies and risk assessments to quantify, measure and mitigate private asset risks will scare off many. At a time when many London asset managers are struggling to remain competitive.. further regulation will shutter many players.

The ability to make mistakes is perhaps the most important discipline imposed on markets. Private markets require Eyes Widen Open. Introduce an element of regulation and a) you may create a false sense of security that a regulator has your investment interests at heart, and b) concentrate the returns from private deals by doing deals outside the regulators reach.

Back in the early 1960s the Eurodollar markets which led to the Eurobond market took off in London as effectively an offshore market. It was Eurobonds, not Big Bang, that made London the centre of global finance for the 40 years between 1985-2025. If the authorities want to create an offshore alternatives market – anything is possible. Such a move could hasten the growing contraction of global markets out of London.

Generally, many asset managers have proved themselves good managers of the risks they now manage. If I want advice on aircraft risks, for example, I am far more likely to ask some hedge fund managers for their perceptions than ask any of the banks in the market. However, the gist of risk in alternatives is that they are unknown except to the parties in a deal.

There is no substitute for deep dive due diligence – again, come talk to Bowline about how!

Out of time, and off to make sure Bowline Capital Advisors’ website is up.. (We found out recently there is an old firm called Bowline Capital Partners – but they appear inactive.)

Bill Blain

Strategist – Shard Capital

Alternatives – Bowline Capital Advisors

Author – The Morning Porridge