Opportunities in the evolving private markets landscape

2017–2021 was a bonanza for private capital markets with fundraising topping $1 trillion each year.¹ Some estimates suggest that by the end of 2021, the global private market, including both funded and unfunded commitments, was nearing $10 trillion in size.² Valuations in the buyout space began to push towards pre-2008 highs with some sectors commanding EV/EBITDA ratios nearing 20x.³ The unique confluence of factors that drove this “zero gravity” period for investors—low cost of borrowing, anemic return assumptions for public versus private markets leading to large-scale asset allocation shifts, and record fiscal/monetary stimulus—has now made a dramatic U-turn.

However, some of the most attractive private market return opportunities have historically been in vintage years with challenging macroenvironments. As always, manager selection and asset class choice are key to successful outcomes. According to research by NEPC, both illiquidity premiums are higher and manager dispersion is 25% wider in vintage years during and directly after a recession.⁴

Now, the macro picture has become a bit clearer. Rates will likely be higher for longer and inflation may stick around. We may be already in a recession, or at least one may be coming, and we can expect more muted economic growth going forward. While not presenting investors with the most ebullient picture for 2023, we do think several opportunities within private markets can bring a bit of a rosier tint to the picture.

Asset class outlooks

So, what is the true state of the private markets asset class? And how should allocators manage their capital in this uncertain market environment?

Private equity (PE): Paused, awaiting a reset

The PE market reached an inflection point in 2022 as the era of low interest rates and ever-growing company valuations came to an end. With exits also at a 15-year low, today’s macro environment has brought a bit more realism to the market. Under the previous regime, quality was sometimes overlooked while valuations reached record highs. Within some sectors, EV/EBITDA ratios were near 20x.³

However, this ongoing repricing won’t be felt evenly. Companies with capital reserves are less likely to see significant devaluations. General Partners (GPs) are also required to differentiate themselves especially when raising fresh capital. For venture capital, the current macro environment has been a major headwind, the effects of which will take some time to play out. Furthermore, negative sentiment around cryptocurrencies and exchanges – including recent legal actions against a big industry player by the U.S. SEC – continues to affect startups and companies, including those distantly associated with blockchain technology.

Private equity secondaries: No longer niche

In 2023, allocators are taking advantage of the growing secondaries market. This sub-asset class, which can help investors build more diversified PE portfolios, recorded US$100 billion in deal volume in 2022 alone.⁵ Secondaries supply is expected to significantly outpace demand this year. This will be driven by three key factors:

• GP-led secondary sales are likely to rise as GPs look to extend funds to hold high-quality companies for longer.

• With less than a year’s worth of dry powder available, sellers are outnumbering buyers, which should continue to drive greater discounts in the market.

• Asset allocators are likely to continue seeking liquidity to manage the denominator effect created by public market drawdowns.

From a risk/reward perspective, secondaries allocations can help build more diversified private market portfolios by providing access to mature companies from many different managers, vintages, asset classes, industries, and geographies.

Private credit: Hardwired for hard times

In contrast to previous years, private credit lenders have much greater sway in the market today. Higher costs of capital and tighter financial conditions have limited corporate flexibility, shifting the balance of power in lenders’ favour. In Europe, spreads per unit of leverage have increased, reflecting a more dynamic pricing environment.

Looking at the direct lending space, one key material change has been the need for skilled and experienced workout teams to manage a potentially worsening macroeconomic landscape and rising defaults. Tough economic environments may lead to greater dispersion in manager returns in both European and US markets, challenging the idea that the direct lending space has become commoditized. In this environment, a focus on restructuring expertise will come to the fore.

One area of the market set to expand is distressed credit. As an example, the size of the European stressed and distressed credit market has grown from €70 billion pre-COVID to above €120 billion currently, based on the share of corporate leveraged loans and high yield bonds trading above 12% yield to maturity.⁶ We expect the opportunity to continue expanding in both Europe and the U.S. as eroding corporate earnings trigger downgrades and borrowers struggle to refinance at significantly higher interest rates.

Unlike in many past cycles such as the global financial crisis, there is a significant diversity of opportunity across sectors today, some of which have historically been defensive such as food producers, telecommunications, grocery retail and healthcare. In practical terms, an expanded investment universe and the ability to buy good businesses at a discount may provide the opportunity for attractive return potential and limited downside risks.

Private real estate: Remodelling for rising rates

2023 will be a challenging year for private real estate. The combination of higher inflation and rising interest rates is having a material impact on the asset class. Understanding how to invest in the face of high inflation and asset repricing has led many investors to slow or pause their allocation decisions.

Consequently, transaction activity has slowed. As an example, transaction volumes in many European markets are at their lowest since the global financial crisis. As the macro environment remains uncertain, we expect further bifurcation. Well-located, sustainable, long-term rental or reversionary assets will continue to attract significant investor interest, while assets in unfavourable sectors could suffer disproportionately. For instance, some segments of the market, like industrial, residential apartments, life sciences, and self-storage, are expected to see sizeable ongoing rental growth. In addition, post-pandemic trends like remote working, e-commerce growth, and the migration of people to nontraditional urban business centres are reshuffling segments of the market.

In Europe, social infrastructure is one area of the market where there is a significant supply shortage. Typically, social infrastructure tenants provide healthcare, education, affordable housing, civil services, and public safety. Unlike other segments of the real estate market, their indispensability persists regardless of the stage of the economic cycle, making them historically less volatile and more resilient.

Looking ahead, opportunistic investors may be able to acquire high-quality assets at a discount – and at scale – in segments of the market that enjoy secular tailwinds.

Next generation of growth: The longer(er)-term lens

Key megatrends that will drive private investments over the next 10+ years are starting to emerge. These seismic shifts represent monumental evolutions in behaviour, technology, and lifestyle. Essential areas such as energy transition, food innovation, and decentralisation will require large amounts of capital.

Blockchain is key to ushering in the next phase of commercial technologies. Like the “virtualisation” periods of the 2000s and 2010s in which cloud computing became the norm, the “decentralisation” period will change the way consumers, industries, and global economies operate.

Conclusion

The era of easy money is over. The wave of private market activity that marked the past several years appears to be ebbing, perhaps, for the better. As with public market portfolios, private market allocations will need to shift to weather the new market environment. In our view, secondaries, private credit, and select venture capital (for those with a longterm view) appear more attractive today than they have in a decade. Even in the wake of 2022’s market challenges, allocators have at least one new advantage on their side in 2023: the ability to be more active in private markets.