Several asset managers and investors are raising concerns about liquidity in the public markets in 2016. One hedge fund manager says the market “massively misprices” liquidity risk in public markets. A pension fund manager says it is foolish to assume public assets will provide the liquidity they once did, while they also pay no illiquidity premium.

The solution? Investing in the private markets.

Institutional investors are already increasing their participation in these markets, particularly private debt, where the potential risk-adjusted returns are higher. 

We are witnessing an important change in the global economy, whereby an increasing share of long-term assets will be in the hands of long-term investors rather than short-termist, share-price-focused bank CEOs. Will the model work? Probably, but only if managers are able to discern the quality assets from the bad ones. This is all the more difficult in an unstable economic environment. 

No one would deny that part of the reason the pre-crisis banking model failed was because it was poorly constructed. It was dominated by highly leveraged maturity transformation and opaque securitisation – in other words, truly ‘shadow’ banking practices. But it worked until some time in 2007 when it appeared that some of the assets that backed loans were rapidly falling in value. Clearly, the high level of systemic risk exacerbated the catastrophic destruction of value that followed. That systemic risk was particularly high because of the poorly constructed lending model. 

Today, that level of systemic risk may be lower because of regulation as well as self-regulation. But what is stopping asset managers and institutional investors from investing in bad assets, especially in a global economy with interest rates at historical lows and a huge amount of debt?

There will be high competition for private debt assets, and there are winners and losers in any competition. Let us hope there are more winners than losers; game theory proposes that co-operation might benefit all the actors involved. 

In short, the trend of asset managers and pension funds to become increasingly involved in lending should be closely observed. It could be a welcome development. Some argue that certain types of private debt are a more natural space for long-term investors. But it is a challenge to individual investors’ decision-making, to regulators and the market as a whole. The goal is finding sustainable ways to grow the global economy.

What we loosely term ‘hedge funds’