Perhaps the most devastating political legacy of the 2008 financial crisis was the sense among a large swath of the American population that the system was rigged. Homeowners and taxpayers took the fall, while big banks got bailed out and “nobody went to jail”, as financial reform activists still frequently point out.
The US Federal Reserve’s well-intentioned but necessarily inadequate (when not combined with smart fiscal policy) programme of quantitative easing raised wages a bit, but boosted asset prices significantly. The rich got richer, and inequality grew. And while the formal banking system was mostly brought to heel, money — like risk — moved into the shadows.
Those less regulated areas of finance, like private equity, hedge funds and venture capital, have exploded to a value of $18tn, with more capital being raised in private markets over the past decade than in public ones.
So, last week’s announcement by the Securities and Exchange Commission of more regulation for private markets — including audits of private funds, more transparency around fees and performance metrics, prohibitions on preferential terms for different investors, and so forth — was welcome and much needed. It is a sign that progress has been made. Regulators such as SEC chair Gary Gensler, who deserves praise for the energy with which he’s pursuing not only private market regulation but cryptocurrencies and cyber security risk, too, are trying to get ahead of the next crisis before it happens.
Yet the rise of these markets, which now represent a significant chunk of the investments of retirement plans, state pensions and non-profit and university endowments in the US, also illustrates the ways in which policymakers and politicians have failed since the crisis to put finance back in the service of the real economy. Wall Street is not primarily a helpmeet to Main Street, as it once was. It’s the tail that wags the dog.
No sector illustrates this more than private equity, which has got rich over the past several years, in part, by exploiting devastation left behind by the subprime crisis. Large companies were able to scoop up properties at rock-bottom prices, outbidding not only individuals but even other large and more heavily regulated institutional players in the housing market, including big banks.
The story of private equity making eye-watering profits buying foreclosed properties is now well known. But it continues to generate outrage, as evidenced by last week’s Senate Committee on Banking, Housing and Urban Affairs session, which examined how large institutional landlords have changed the housing market. “Investors are raising rents 50 per cent, issuing eviction notices and leaving toxic mould and pest infestations to grow worse, all in the name of their own bottom lines,” said committee chair Sherrod Brown.
I’ve seen many such properties with my own eyes, and, to be fair, I’ve seen some well cared for PE-owned rental homes, too (though they tend to be in richer areas where tenants can pay more). But the fact that a multinational PE firm can become the country’s biggest landlord is something that simply doesn’t sit well with a lot of Americans. It illustrates all too starkly how the financial markets seem to exist in a closed loop of service to themselves.
As Eileen Appelbaum, co-director of the Center for Economic and Policy Research, put it in her influential book with Rosemary Batt, Private Equity at Work, the rise of private equity represents “a fundamental shift in the concept of the American corporation — from a view of it as a productive enterprise and stable institution serving the needs of a broad spectrum of stakeholders, to a view of it as a bundle of assets to be bought and sold with an exclusive goal of maximising shareholder value.”
Why would public pension funds (which now represent 35 per cent of PE capital) invest in a way that could cause harm to their own retirees by pushing up rents? In part because they are desperate to keep returns as high as they’ve promised in an era in which that will become harder.
This may or may not be a smart move. Despite some recent strong performance, academic research shows historic returns often don’t outperform the wider market or even match it after huge carry fees are taken. Either way, principal-agent issues make it unlikely that a pension fund manager in charge of picking investments is going to raise a hand to say what most of us intuitively know, which is that we’re best off sticking our money in an index fund and forgetting about it.
I suspect that there will be an increasing political focus on how, almost 15 years on from the start of the subprime crisis, the relationship between finance and the real economy has yet to be rebalanced. Over the past few years, private funds have moved from housing into education and healthcare (it’s worth noting that aside from recent Covid-related economic disruptions, those areas are two of the most significant drivers of long-term inflation). Already, there are stories of how private investors looking for higher returns have raised costs and reduced the quality of care.
I’m not optimistic about how those stories will end. The light the SEC has shone on financial darkness is a bright spot in an otherwise troubling tale.
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Letter in response to this column:
Here’s why more disclosure in private markets may fail / From Andrea Gentilini, Head, SEI Novus, Zurich, Switzerland