The Dividend Cafe - Private Markets Trick or Treat?

Episode Date: October 31, 2025

Today's Post - https://bahnsen.co/4qxLxMp Demystifying Private Markets: Risks, Rewards, and Systemic Implications In this episode of Dividend Cafe, host David Bahnsen, Chief Investment Officer at The Bahnsen Group, delves into the complexities of private markets, focusing on private credit and private equity. Bahnsen addresses the widespread discussions around the potential opportunities and risks in these markets, arguing that both extreme optimism and pessimism are misguided. He explains the inherent risks associated with higher returns and emphasizes the importance of understanding these investments' systemic implications, even for those not directly invested. Bahnsen also explores the historical growth of private markets, the exit bottleneck in private equity, and the potential for systemic risk. Emphasizing the necessity of prudence in investment and manager selection, he advocates for awareness of liquidity issues and proper diversification. This episode aims to provide a nuanced perspective on private markets, debunking myths and highlighting the real stakes involved. 00:00 Introduction to This Week's Dividend Cafe 00:40 Understanding Private Markets: Credit and Equity 03:07 The Risks and Realities of Private Credit 07:18 Private Credit vs. Traditional Banking 12:13 The Growth of Private Equity 18:53 Current Challenges in Private Markets 29:18 Conclusion and Final Thoughts Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividing Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to this week's Dividend Cafe. I am your host, David Bonson. I'm the chief investment officer here at the Bonson Group, and I have been excited for a few weeks to do a special Dividendon Cafe dedicated to the subject of private markets. where there is an awful lot of conversation right now. There is various either hand-wringing of people panicking about the next big shoe to drop. And then on the other side, there are people that are just absolutely euphoric about never-before seen opportunity. And it is my position that we are in need of a discussion about the reality of the lay of the land in private credit and private equity. And if you are right now listening saying, okay, I can tune out because I don't own investments in private credit. I don't own investments in private equity.

I'm not going to so this doesn't affect me. I just want to say that isn't actually true. That my major intent today is beyond just those that might either be invested in or want to be invested in private markets. But my intention is to explore the potential systemic ramifications. of where things stand in private markets. In other words, how it may impact those who don't actually specifically own it. There are plenty of investments in the world that you could say this can go badly and the person who owns it will suffer consequences. There are other things that you can say this could go badly and people with direct ownership exposure might suffer,

but also others may suffer if it leads to a contagion effect. that spreads and does damage throughout other elements of financial markets and the broader economy. I want to explore that today as it pertains to private markets. There's no question that the entire universe has exploded both in size and relevance and prominence, but it also has exploded in conversation. There's more financial media coverage and more things to be said, about these respective universes. And I would argue to kind of put this on the table at the very get-go that what you often have in this conversation are two different extremes that are the opposite of one another and both equally wrong. One extreme, that this is the greatest opportunity

and most risk-free, wonderful environment for returns devoid of any risk, and then others arguing that this is the biggest risk we've seen in a biggest setup for systemic risk since before the great financial crisis. And I'm going to argue that both of those extremes are wrong and that nuance and some sort of prudent wrestling with the issues is in order. I think that we need to start with a couple philosophical tenets. And I don't think this is very deep, but it sure isn't stuff that people hold on do very easily, it seems. When you talk about any investment that has an expected rate of return significantly higher than the risk-free rate, you are inherently talking about an investment that has more risk than the investment that offers a risk-free

rate of return. This is what we refer to in the English language as a tautology as something that is inherently true, but to just quickly apply it to, let's say, private credit, if someone says, I have a debt fund and it's yielding 9%, and treasuries are yielding 4%, so this is much better because nine is a higher number than 4. The only thing that they said accurately is that 9 is a higher number than four. And I'm at least grateful that these ignoramuses know that. But that the idea of that kind of premium return does not involve a premium risk is insane. This is true no matter what the investment is we're talking about. Now, why does this need to be said? Are people saying that that 9% yields are available without any difference in the risk of a 4% yield on a fixed income

type product. Are they saying that because they are dishonest or because they are ignorant? And the answer is that it could be either. And if it is a financial intermediary, I will leave it to you to decide what's worse, if they're a fraudster or a moron. But I do not recommend getting advice from either category. Now, as a general principle, and let's apply it right now to private markets, if we are looking at higher yields or we're looking at higher expected rates of return, there are higher risks associated with it that may very well be attractive. That risk-reward trade-off may be something you are comfortable with or that fits into a properly constructed portfolio. But the idea that there is not an illiquidity risk,

a default risk, a leverage risk, any number of things that could go wrong, that represent a risk premium that represents the higher compensation. To not understand that basic concept of math, but of just investment logic is going to lead to all sorts of things. Now, why do I have to say this. For the financial intermediaries that may be dumb or may be dishonest, that's a separate category from human nature, whereby the people that want to believe it, where they'll say, oh, I got this thing going on, and it might be a real estate investment or a second trust deed or a first trust deed or this or that. And they may have a great return, and they may have a great relationship between the return and the risk that is itself attractive.

but the notion that these premium returns and yields do not come with a commiserate increase in the volatility or one of the different risk categories is something that people believe because they want to believe it. It's something some people believe because they need to believe it because they have to make something pencil for their own financial situation that doesn't pencil without it. So it is my job. It is our job at the Bonson Group to counter that, shall we say, unhealthy human tendency to believe what you want to believe. Now, with the fundamental principles laid out, let's apply some things. Let's get a little vocabulary down when I talk about today's Dividy Cafe being about private markets. Private credit essentially

non-bank lenders loaning money to borrowers, and they are generally corporate borrowers. There's smaller scale or more middle markets, and then there's larger with companies that are much bigger-sized, higher EBITDA, higher enterprise value businesses. But essentially, the loans are made outside the highly regulated bank system. So banks are funded by depositors. They then are able to leverage the deposits within regulatory constraints. They formulate a balance sheet. These are what banks do. Formulate a balance sheet out of the capital that they have. And then they have regulatory limits around the risk-weighted assets that they can lend out. And it is essentially lending banks, excuse me, mortgages, home borrowers money for 30 years, 10 years, lending companies

money for one year, five years, commercial real estate projects for five, seven, ten years. There's all these different durations or maturities, the asset, the money they've lent out, but then the problem is their liability could be callable at any day because what is the liability of a bank? It is their depositor's capital. So one person's asset, the money they put in their checking account, is another person's liability. The money the bank owes them. and that person might leave the money in their checking account for 20 years, which matches up perfectly with a loan the bank gave out, but they might pull it out the next day. And so you have a unknowability and a mismatch between assets and liabilities in the banking system that is

largely regulated and mitigated. This mismatch of duration between assets and liabilities is largely mitigated through regulation. There's capital, requirements, and then there is a regulatory apparatus from the FDIC and the Fed that is there to try to keep banks from becoming insolvent. And it mostly works, and every now and then doesn't work, and that's what we're dealing with. And then when it gets bad, not for one bank here or one bank there, but systemically, that contagion effect that we had in mass in 2008 is what we're trying to avoid. So now private credit comes along, and there always been private lender. but now you have an ability to better match the duration of the assets and the liabilities.

How do you do that? One company borrows money for five years. The way you're not using depositor money to bank to fund it, but investor money. And the investor doesn't need their money back for five years, doesn't expect it back for five years. So there is a matchup of the asset and the liability. Well, this has exploded since 2000. and eight, because of the increased capital requirements and regulatory environment and risk appetite changes at the banking system, it became much more advantageous for a lot of borrowers to pursue non-bank lending, and the private credit system is able to do this with

much less systemic risk. And so for that reason, I'm largely a pretty big fan of the idea. Now, I would suggest that whenever something explodes this big, there's going to be risks that we want to understand, and we're going to get to that in a moment. But I want to also be clear that private credit does not just exist as an alternative to the bank deposit system that has funded so much lending in society, and it's still by far, by the way, the largest source of borrowing money is through banks. but it's a competitor to the bond market where these are generally registered securities. They trade. They have more liquid of a market where private credit is more illiquid and unregistered. And so there are both advantages and disadvantages. The borrower is probably

going to pay more money in private credit than they are in a bond market, but they're going to be able to go quicker. And they're not going to have to show everything about their business. to the world because bond markets exist in a public forum, and so there's more disclosures and sharing of strategy and sharing of financials where private credit, your lender needs to know what's under the hood, but it doesn't have to be disclosed to the whole world. So private credit is a competitor to the bond market and to the banking system. Private equity, of course, is merely ownership, stakes in companies that are not publicly traded. And in the 1990s, as it was really starting to take off, there was about $100 billion invested

across the country and private equity. And that number is $7.6 trillion today. So you've had a really, really big increase. Let me give you actually some timelines. 100 billion in 1990s, 500 billion in 2000 and then 2.8 trillion in 2010 and then 7.6 trillion now. So it went 5x in the 90s from 100 to 500, but then it went another 5x and then some from 500 to almost 3 trillion in the 2000, 2010 decade. And then it is actually the rate of growth is slowed, but it's something about two and a half time since is it's gone from 2.8 to 7.6 trillion since 2010. And now, of course, that's 15 years. What are we talking about? Almost $5 trillion of increase the last 15 years. But the percentage growth was massive early on and just kept going. And that's the sort of law of exponential math here.

But then what I would argue is that this is in concert with another thing that's very important to understand for those who are invested, not in private equity, but in public. public equity, those are invested in the stock market, those invested in the S&P 500, is there were about 7,500 public companies when I entered the business 26 years ago, professionally managing money, and there's less than 4,000 now. So you have a big decrease in public-contraded companies. A lot of times companies get bought, they get merged, some companies fail, but then they're being replaced with new companies all the time. So that number is growing. And now what we've seen is clearly there's just a lot of companies that don't want to be

public, higher disclosure, higher regulatory burden, quarterly reporting requirements, more liability. Sarbanes-Oxley, if some of your numbers are wrong and what you report, you can go to jail. The whole world is going to see your strategy, your finances, you have to go disclose things because you're publicly owned. And so there's reasons people don't like that, but they needed capital. to monetize for the owners. They needed to take money off the table. They needed liquidity or they needed growth capital. They were a big growing company. They needed more money. Public markets gave way to do that. But this big growth in private equity has meant there's less of a need for public markets. And this is a very important thing for public equity investors to understand.

Some of our best companies with the best growth, with the best prospects, are going to stay private either forever or for much, much longer than they were before. And then when they do go public, a certain part of their growth curve and trajectory has already happened, and then you're buying it in public markets with a different growth profile in front of it. because what would have been previously a growth experience that happened as a public company, now happened as a private company. And this happens in mass, and it's very easy for me to go through and identify this stuff retroactively. But all I can do right now is identify it on a forward basis theoretically, is to say that we know a bunch of the great next 10 years' worth of companies. investors will not have access to them at the same level that they would have in past decades

in public markets. If someone wants what these unnamed companies are, they have to buy them in private markets because of the massive, indisputable, undeniable trend that companies are waiting longer to go public, if at all, and that a lot of that is afforded to them by access to massive amounts of capital, growth capital and monetization in private markets. All right, we're about to get to the important stuff, but I do want to quickly make a philosophical point. You hear me talk a lot in Dividend & Cafe that I believe we invest to capture the value added, the value creation, the wealth creation that is a byproduct of human productivity. that that is the ultimate risk premiums, the way in which humans who have been created by God

to be productive, creative, and innovative are able to build wealth. And we capture that in various investment forms in capital markets. Ownership of businesses, sometimes lending money to businesses, but where the value comes from is just these wonderful things that the human spirit and human talent and productive engines can do. I believe that that human, proponent exist in private markets as much as I believe it exists in public markets. In fact, I could argue that a bunch of the best ingenuity and innovation exist more in private markets. Now, it's a totally different dispersion of returns. There's going to be many more failures. There's less mature businesses. There's a total different liquidity profile. I'm not making a

comment about the suitability for investors, which is highly relevant when it comes to allocating capital, what one's own income goals are, cash flow needs, liquidity profile, risk profile, all of those things. There are going to be more mature businesses with more transparency and understanding of sustainability of cash flows, particularly for us as dividend investors. That universe is going to be better and more fertile in public markets. But to the extent we're just simply trying to talk about where value is created in the world of investments, there's a ton of opportunity in private markets too. So when I say, I want to be an equity investor, I want to own good businesses. You look, I happen to own a business that is a far

more important part of my balance sheet and cash flow productivity than anything I own in my investment portfolio and my business is totally private. So you get the idea. Well, once we establish that private markets do have a place for some given the liquidity realities and risk realities. And we understand that the world of private credit, private equity has changed a lot. Then now we get to the current state of affairs, which is, are we dealing with something that is fundamentally changed in private credit and private equity? And I'm going to divide this up into three categories that we're going to quickly cover. One is, is private credit now a case of way too much money chasing way too few deals that so much more money has come in that there's just

less loans to be done that are good, more loans to be done that are bad, and so you risk lower returns or greater risk because the supply and demand balances have changed. That's a fair issue we're going to address. Number two right now is that there's an exit bottleneck in private equity that so many deals were done in 2019, 20, 21, early 22 when interest rates were lower, that there is a very difficult time right now for a lot of private equity sponsors, private equity managers to get certain businesses that may have performed well and may have grown in their value, but to exit them right now is more difficult. Interest rates went. higher and the volume is such that there's just a limitation to how many strategic buyers, financial

sponsors, public market appetite. What we refer to is sort of the indigestion problem. You may not have the ability to take this much in in financial markets. And so it leads to a problem of getting money back in certain private equity investments. And the number three is what I said everyone ought to be listening to, which is concern of systemic risk. Do we have a problem right now where even though we think just investors have the risk, not bank depositors, but the widespread connectivity in the financial system and sheer volume increase in private credit, private equity has led to a different risk profile with more contagion risk than we previously thought possible? What I want to say about the concern number

one regarding private credit is it is absolutely incontestable that there will be defaults, that there will be certain loans that go bad. Now, right now, there was a company that kind of seems to have blown itself up and its debt is trading very near zero. And it looks like there may end up being fraud. There's investigations of a company called First Brands. And so some will say, look, there's more of these things under the hood. What are we going to do if there's, you know, these other big loans that go bad. But others could say, and I'm more in this camp, that this might be the example that proves my point, that with the right diversification and the right underwriting and the right quality control and the right ability to generate recovery out of defaults, that,

you know, look, you did have a major loan go bad, a major borrower, and a bunch of the really good private credit companies didn't own it. That's why underwriting matters. That's why covenants matter. That's why quality control matters. That's why the experience and skill of managers matters. I do believe that there are a lot of what people are saying right now, private credit space is true. I think there's some bad loans out there and there's some bad lenders and I think there's definitely some bad borrowers.

I also believe you mitigate but don't eliminate risk with diversification. You mitigate but don't eliminate risk with managers that know how to do workthroughs, meaning when there is a default, they can do a workout where they're going to end up recovering a lot of value. There's risk mitigation by being the senior secured lender, not a subordinated lender who is going to get paid back second, third, or fourth, being at the top of the cap stack is far better than being in a lower mezzanine-type position. Now, none of these things are foolproof, and that's what the yield is for. But my point is that with the right sponsors, you should be in a much better position, even though there is a top-down factually correct assessment

that there is just a lot of money out there chasing loans that can't all be as good as the last one. This is marginal economics 101. So I would not try to chase a higher yield. If you have a mid-quality sponsor offering 12%, and a high-quality sponsor offering 10, then don't chase the extra 2%. I mean, I'm making up the definition of mid and high quality and the numbers attached to make the kind of relative point. I also believe that when we talk about private equity in this exit bottleneck issue, there's an opportunity to really see it as a feature, not a bug. There's two things that determine your percentage return with private equity. First of all, it's the dollar return.

You bought a company at X and you're going to sell it for something more than X. So what that more than X amount is is the return. But then to know the percentage return, you need to attach that dollar return to a period of time. So if in exactly 365 days you bought something for 100,000 and sold it for 110,000, then you made exactly 10%. And if in exactly one year, you bought something for 100 and sold it for 200, you made exactly 100%. But then if it is over four years or six years, you have to take the dollar amount and then there's math to determine what. we call the internal rate of return that is essentially a time-weighted return around the period of time you owned it. So there's two things that can hurt return. One is more time going by and two is a

lower dollar amount of the profit. There's inversely two things that can help return, higher dollar and less time. And these things are in tension with one another. So if right now someone said we could solve for the exit bottleneck by people selling more quickly, you say, okay, well, less time that theoretically means a higher return, but not if it comes to the cost of a lower dollar amount. Would you rather sell something for a 10% return in three years or a 50% return in four years? Now, I'm making up the numbers to be obvious about it, but you get the idea. To the extent that high quality private equity managers are not impatiently selling something, and they do believe this is totally hypothetical, that there is a path to greater value creation

and value realization with a little more time. It's entirely possible, albeit the bogey gets harder, okay? The burden is higher, the more time that goes by. And I think that will put downward pressure on IRRs, but if the trade-off is protect IRR by selling more quickly and you do not realize the same level of value creation, then it may very well be a bad deal for investors. My point is this is not a situation you want a bad manager having to navigate. You want higher quality private equity managers that have a lot of experience, that have a lot of sector expertise that have virtually limitless rolodexes for strategic, financial, and even public market possibilities. And at the end of the day, the fact of this tension I'm describing

is already there. It isn't like a case to now be figured out. There is a burden of exit bottleneck. That's on the table. And my suggestion is that that illiquidity can be a good thing, but that presupposes that people bought the private equity they bought with the understanding of the liquidity to begin with. The systemic issue is what I want to spend the most time with. Because while I made a point earlier accurately of saying that private credit is where you have non-bank lenders, non-depository institutions, basically investors who are risk takers, putting skin in the game to lend money at really nice, attractive yields to corporate borrowers, the fact of the matter is that we do have about $300 billion of bank lending that has gone to non-bank depositors,

excuse me, non-bank and non-depositor institutions. The non-bank lending group does have bank capital in it, but not on a deal-by-deal, loan by loan, at a high level. So they have now essentially become a senior lender over an enterprise providing warehouse capability, perhaps putting some of the leverage on. An individual loan could go to zero and the equity could go to zero of the sponsor before the banks lose money. First of all, I point out that $300 billion is barely over 1% of total bank assets. I do not believe it represents some form of systemic risk. and secondly, that we're not talking about them being risk takers with the private credit loans,

but rather in a very senior position in capital structure to the underlying sponsors. But third, that there is still something in the weeds there that probably will go wrong because it just always does. But I don't consider that necessarily at this time systemic, but rather very issue specific. some bank that is in over their skis or is lent to the wrong sponsor or didn't have the right covenants. Will there be isolated banks that this thing goes wrong for? I think that's entirely possible. I lack the creativity to know the way some of these financial institutions start playing FOMO, fear of missing out, and screw things up for themselves. But there is no evidence to me

that we are remotely approaching a place of banks through lending to non-banks have generated a systemic risk, and it's something I've looked at a great specificity. What we basically have are private markets as a very legitimate, very valuable diversifier in certain investors' portfolio, where those investors can handle illiquidity. when someone tries to game the system by saying, I want to buy illiquid loans but get monthly liquidity, this creates a problem. And when people say folks don't know this illiquidity problem, the greatest solution to that is to know the illiquidity problem, because it's not a problem if you know it. We don't want our clients buying things on the basis of a sort of magic wand liquidity, where, It isn't really liquid, but somehow they're going to make it liquid.

As long as everything stays above the net asset value, you get made whole, you make your money. So you're going to get your premium return that comes with an illiquidity risk, and you're going to have full liquidity. And as long as you buy and sell at the right time, everything works out great. That's all fine. And in fact, that's predominantly what has happened for most people. But our view is that the illiquidity should be treated for what it is. And if the structure of an investment allows you to try to lie to yourself, we say, ignore the structure, pursue the truth. These are underlying ill-liquid investments and should be treated as such.

But where that appetite and knowledge and awareness and understanding exist, I think there's all kinds of great investment opportunities there. I think that the return profile is far more narrow, that it is far more particular around manager talent, deal flow, process, infrastructure, institutional credibility. This has no time to be investing in a private debt fund your Uber driver runs. And I know that's an extreme example and it sounds like I'm just trying to do a reductio ad absurdum. But I mean it on purpose that there are people that say, oh, yeah, I mean, you're in a private credit fund with XYZ high-profile, well-known, Park Avenue, asset manager. There's his other private credit fund. It pays 3% more than yours does. And it's run by a few guys that, let's say, don't have the

track record or whatnot. And it can all go well. But I don't think it's any time for these things that don't have the institutional credibility. Institutional credibility is not an assurance of no risk. The way I know that I can be assured there is risk is. the yield. These things only have the return profile they have because there is greater risk, but that mitigation of risk in the macro environment we're in, I believe with higher quality control, underwriting, and workout savvy, they've been through defaults before and they know how to capture value on the exit. That's a big, big deal when you're talking about private markets. I do not believe that we face a big systemic contagion risk, but I do believe that we face a big systemic contagion risk,

but I do believe that there will be noise around it. But we manage the illiquidity reality by living in the illiquidity awareness. What we never, ever, ever do is believe that risk and reward are getting divorced. Thank you for listening, watching, and reading The Dividend Cafe. Look forward to being with you next week on Friday for a full discussion of where we are with the U.S. and China in light of the big meetings between President Trump and Xi this week. Have a wonderful weekend. Look forward to joining you into November. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC,

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