The "known unknowns" of financial risks (2024)

Despite problems, however, it is unlikely that pressure on the markets could come from this side. Swap transactions for bonds similar to those in Great Britain are not known. In addition, in case of doubt, claims of beneficiaries can be reduced or the companies behind the funds can be called in. And at the end of the day, there is still the Pension Protection Association, which could at least absorb smaller funds.

14. Private Equity (classic): low solvency risk

Private equity investors seem to have been largely spared the slide in the prices of publicly traded companies in 2022. While the private market index of the investment consulting firm Lincoln gained 3.2 percent in the first three quarters, the S&P 500 EV, i.e., as an index measured in corporate values excluding financial companies, lost a good 22 percent.²⁴Should non-publicly traded companies have withstood inflation, rising interest rates and supply chain problems better? That may be true for individual companies, just as there were also crisis winners among publicly traded companies. But in the breadth of an index, it is first of all astonishing.

We suspect there is another reason behind this. While shares of companies from the S&P 500 are traded daily in large numbers and the share price thus reflects the expectations of market participants in a timely manner, the valuation of private equity is often based on individual models with their own assumptions on interest rates and projections of future cash flows.²⁵ We therefore suspect that the earnings in the private equity sector are artificially smoothed by the valuation methods applied and that hidden burdens exist. The extent of this seems limited, however, if one takes the devaluations of the S&P 500 as a benchmark and considers that more long-term (and wealthy) investors are invested in this investment category with a market volume of around five trillion dollars.²⁶

15. Market volume of shadow banks: uncertain liquidity risk

In a letter to the G20 heads of state, the chairman of the Financial Stability Board (FSB) points out possible risks from the area of so-called non-banking financial institutions, such as insurers or clearing houses. The term shadow banks is also used colloquially for this. In 2020, these held a total of 227 trillion dollars in financial assets (including derivatives and cash), which corresponds to 48 percent of all financial assets held worldwide. This means that they exceed the assets of banks and central banks combined.²⁷

The FSB 2023 would like to pay special attention to the detection of "hidden leverage", i.e., transactions with debt capital that are not shown on the balance sheets of market participants. In addition, the FSB is looking at potential liquidity squeezes of investment funds. It cites a mismatch between fund pay-out modalities and the short-term liquid ability of assets as a problem in times of high volatility.²⁸

A first example of such initially abstract distortions can currently be seen in American real estate funds. We will outline this in more detail in the next section:

In addition to the classic private equity market, which is characterised by purchases of unlisted and listed companies or parts of companies, there are other private investments: for example, in unlisted debt instruments (private debt), real estate and infrastructure. There is another 2.6 trillion dollars of investment capital in them. And unlike classic private equity funds, these instruments allow limited sales of shares.

The world's largest investor in commercial real estate by its own account, a well-known US private equity firm, manages a real estate portfolio of over 565 billion dollars for its investors alone. This includes a 70-billion-dollar real estate investment trust (REITs) for reasonably wealthy ordinary investors, which invests in student flats and casinos, among other things.

Should difficulties arise here, this could trigger a cascade. This is because the investments are partly debt-financed. It is possible to guess how much. According to data from last year, the current value of the properties is offset by 37 percent of the invested capital. This indicates a debt financing of a good 60 percent. This would be normal for the industry across all private equity classes and could even be described as conservative for real estate. However, if the tenants can no longer afford their instalments and the refinancing becomes more expensive for the private equity investor, the portfolios will come under pressure, especially since the investors could withdraw at least some of their money.

Conclusion

Our map of risks outlines the "known unknowns" ("known unknowns"). We have tried to identify higher and lower risks in this category. But the uncertainty remains - in the words of US economist Frank Knight - "radical". The reason for this is the so-called "unknown unknowns", which only become "knowns" ex-post.

Overall, a picture emerges that should make all players think. The proverbial "turn of the times", also in terms of interest rates, is likely to expose many weak points in the financial sector with more or less major consequences. Investors should therefore keep financial buffers in reserve for unforeseen impacts. Unfortunately, politics follows a different logic of action. Since it is incapable of financial precaution, one must expect that it will plug unexpectedly occurring financial gaps with new money creation. Although one cannot rule out a deflationary effect, we consider a further kindling of inflation more likely in the event of new financial crises.

¹https://www.esma.europa.eu/sites/default/files/library/2015/11/2012-482.pdf

²https://www.ft.com/content/b53f2254-9409-432a-9755-62c621e3f552

³https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.pr220721~973e6e7273.en.html

⁴https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3823293

⁵https://www.ecb.europa.eu/mopo/implement/app/lending/html/index.en.html