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Facing the prospect of poor returns in traditional markets as interest rates rise, and with a natural desire for minimalist oversight, hedge funds and family offices are sharpening their focus on private markets and alternative investments.

The appetite among thousands of attendees at a trifecta of hedge fund and alternative asset conferences in Miami at the end of January to find new avenues for ‘generating alpha’ was palpable.

But as these sophisticated investors plow more cash into the shadowier parts of the investment universe, regulators are sharpening their antennae to the potential threat this poses to financial stability and even systemic risk.

The U.S. private equity and debt markets were worth a record $4.1 trillion at the end of June 2021, according to industry data provider Preqin, comprising $3.25 trillion of equity and $826 billion of debt. That’s up 44% from pre-Covid levels in December 2019.

The global total exceeds $6 trillion, and a broader measure of worldwide private market investments is nudging $10 trillion, Preqin data shows.

According to one Securities and Exchange Commission official, the total U.S. private investment universe including hedge funds, venture capital and other markets has more than doubled to $11 trillion since 2013.

The S&P 500 may have returned a juicy 28% last year, but that anomaly will not be repeated this year with interest rates about to rise. The BofA U.S. Treasuries index fell 1.9% in January, its worst start to a year since 2009, and will also remain fragile as borrowing costs rise.

Private markets offer a potential escape.

Data from Cambridge Associates shows that in the 10 years to 2021, private equity and venture capital strategies outperformed Wall Street. They enjoyed an annualized return of 16.67%, marking a 1.92% premium over equities, and also outperformed hedge funds by more than two to one.

There is money to be put to work too. Blackstone, the world’s largest alternative asset manager, last week said it expects to reach its goal of managing $1 trillion in assets this year, much earlier than a previous target of 2026, and has over $135 billion of unspent capital.

TIGHTER REGULATION AHEAD

Eric Noll, chief executive of Context Capital Partners, notes that the sense of skepticism and cynicism toward traditional financial markets that exploded in the retail investor world last year has spread to the fund community.

“What we are seeing now is an appetite for the new. They’re looking for opportunities to put money to work anywhere they think that they can maybe have an advantage,” Noll told Reuters at the Context-hosted conference.

For the big players, private debt may offer more potential than equity because tighter Fed policy should make capital more scarce and more expensive. That means private lenders can command higher rates of interest, perhaps 10-15%.

“Because capital is moving out, there is going to be a need for people like us. We’re happy to take these risks, Marc Lasry, chief executive officer at Avenue Capital Group, told a panel at the iConnections conference in Miami.

“Where there’s volatility, there’s huge opportunity, especially on the credit side,” he said.

But as the schmoozing and deal-making was heating up in Miami, the SEC in Washington was putting forward proposals to improve private market oversight and strengthen “financial stability and investor protection.”

SEC Chair Gary Gensler said the government’s transparency into private funds was “scant at best,” and the SEC will propose further rules around funds’ reporting of positions and flows later this month.

This follows minutes of the Fed’s November policy meeting which showed “a few participants” expressed concern over potential risks to the financial system, including “the growing exposure of banks to nonbank financial firms.”

These are the less-regulated, privately-owned entities comprising hedge, private equity and debt, and venture capital funds. Once liftoff on rates is out of the way and quantitative tightening begins, these issues will likely on the Fed’s radar.

The political and regulatory wheels in Washington, however, grind slowly, so concrete measures to make private markets less opaque may not be put in place until next year at the earliest.

It remains to be seen if regulators’ bite is as effective as their bark. As the partner of one California-based private equity fund puts it: “What is initially proposed is always over-reaching. The proposals won’t even get close to passing.”

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