The Next Financial Crisis? The Imperative for Sustainable Practices in Private Markets

Article by Stacey Varsani

Founder & Principal Consultant, Hadouken Consulting

I recently read an article in the FT suggesting that the next financial crisis could emerge from private markets, where private credit funds pose a systemic risk to the broader financial system. This concern is rooted in the seismic shift occurring within the financial landscape, as private markets surge and expand into new asset classes, as well as attract more retail investors.  

According to McKinsey, private market assets under management reached $13.1 trillion in mid-2023. While this is still less than a tenth of public markets, private credit is rapidly expanding to encompass a diverse range of assets and borrowers. Non-bank lenders are increasingly financing infrastructure projects, asset-based loans (such as aircraft financing), jumbo residential mortgages, and higher-risk commercial real estate. 

The Risks of Opacity 

This trend, while offering opportunities, raises urgent questions about transparency and accountability, as well as the risk of capital misallocation. The International Monetary Fund (IMF) has warned that the rapid expansion of private credit, combined with increasing competition from banks on large deals, may lead to declining underwriting standards and heightened risks of credit losses.  

This underscores the urgent need for enhanced oversight and a more rigorous approach to managing these investments. In particular, the interconnectedness between private markets and regulated banks raises systemic concerns that could reverberate throughout the financial landscape. 

Regulatory Environment 

The U.S. has faced similar surges in opaque markets in the past and responded with increased regulation—first in the early 1930s with the introduction of federal securities laws, and again in the early 1960s with the introduction of Section 12(g) of the Exchange Act in response to the growth of over-the-counter (OTC) markets. 

Following the 2008 global financial crisis, governments increased their scrutiny of financial activities, including private markets. However, most new regulations were aimed at traditional banks and drove the growth of more lightly regulated non-bank financial institutions. Regulations on private markets currently remain relatively light and vary significantly across geographies.  

EU regulations are generally the most comprehensive, where measures such as the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive II (MiFID II) require firms to meet certain reporting, transparency, and investor-protection standards. The EU has also been leading efforts to promote ESG regulations, such as the Corporate Sustainability Reporting Directive, that increase disclosure requirements for firms operating in the EU or dealing with EU-based investors.  

In the US, the regulatory landscape is more fragmented but there are several important regulations that govern private equity, private credit, and other alternative investments, including Dodd-Frank. However, many US firms ultimately operate with little oversight compared to their EU counterparts.  

Enhancing the Health of the Financial Ecosystem 

As private markets evolve, investors must embrace a long-term perspective that transcends immediate returns and current regulations. It's essential to not only implement best practices but also sustain them over time. This approach is fundamental to strengthening a firm's resilience, enhancing its reputation, and maximizing the value of investments.  

Investors and private credit firms can take the following actions to enhance transparency, accountability, and sustainability: 

1. International Standards: Implement standards, such as ISO 9001 for quality management and ISO 31000 for risk management.  

2. ESG Frameworks: Implement frameworks such as the Global Reporting Initiative (GRI) or Sustainability Accounting Standards Board (SASB) standards to guide environmental, social, and governance (ESG) disclosures. Incorporate ESG criteria into investment decision-making processes to evaluate potential investments comprehensively. 

3. Transparent Reporting Practices: Establish a schedule for transparent reporting to stakeholders, including updates on financial performance, risk management, and ESG initiatives. Use standardized metrics (e.g., IRR, MOIC) to facilitate comparability across different investments and funds.  

4. Risk Management Frameworks: Utilize risk assessment tools to identify, measure, and mitigate risks associated with private market investments, including market, credit, and operational risks. Engage in scenario planning and stress testing to prepare for potential market downturns or crises. 

5. Regulatory Standards: Develop comprehensive compliance programs that ensure adherence to relevant regulations. Provide regular training sessions for employees and stakeholders on compliance requirements and best practices. 

6. Collaboration with Industry Groups: Join industry groups or initiatives focused on improving standards and practices in private markets (e.g. the Principles for Responsible Investment). Participate in forums and conferences to share knowledge and best practices with peers in the industry. 

In conclusion, the rapid expansion of private markets presents both significant opportunities and alarming risks. As these markets continue to grow and participation increases from retail investors, the potential for systemic crises looms larger, echoing the lessons of past financial upheavals. To navigate this complex landscape, investors and stakeholders must commit to a long-term perspective that prioritizes transparency, accountability, and sustainable practices.

By adhering to established regulations and embracing best practices, industry players can mitigate risks, maximize investment value and ultimately foster a more resilient financial ecosystem.