Dr. Nils Rode | Private assets: three areas of focus in challenging times
In 2023, private asset investors face a complex mix of challenges and risks.
The likelihood of a prolonged recession is significant. Inflation is high. Interest rates are rising, while overall debt is elevated. The war in Ukraine continues, as does the resultant energy crisis. Even if these factors disappeared overnight, ongoing issues like social inequality and populism remain.
Nevertheless, private assets are long-term in nature. It's more appropriate that investors assess the medium-to long-term outlook before making any decisions. Over this longer timeframe, numerous durable, long-term trends mean we remain optimistic.
In particular, five long-term megatrends should provide tailwinds:
- Climate change and decarbonisation
- Technological revolution
- Sustainable lifestyles
- Aging populations
- Growth of emerging and frontier markets
The short-term challenges investors face today don't affect the urgent need to tackle climate change and decarbonisation. No economic backdrop – no matter how turbulent - will stop the technological revolution, nor the shift towards more sustainable lifestyles.
The global population also continues to grow older and larger, changing supply and demand patterns as a result. We expect the combination of aging populations and low birth rates to put pressure on real interest rates over the longer-term as they reduce the available labour force in many countries. Emerging and frontier markets will also continue to grow, with the countries leading this growth likely to evolve over time.
Other forces shaping private markets are not thematic, but relate more to developing trends in investor demand and behaviour. For example, we expect the transition to what we refer to as "Private Assets 4.0", to continue, if not accelerate. Private markets have evolved rapidly from the mid-80s, and transitioned through several forms as they have done so. In this new phase, access is improving for a huge number of investors previously excluded, as "democratised" solutions continue to develop.
Even so, the near-term is undoubtedly going to be difficult. Here are three key things investors can focus on to ensure private asset allocations are as resilient as possible to short-term market challenges.
- Steady investment pace
Keeping up a steady investment pace may be difficult. Nevertheless, investors who can make new fund investments in 2023 are well advised to do so. Recession years tend to be particularly attractive vintage years, according to our analysis.
Structurally, funds can benefit from "time-diversification", where capital is deployed over several years. This allows funds raised in recession years to pick up assets at depressed values as the recession plays out. The assets can then pursue an exit later on, in the recovery phase, when valuations are rising.
For example, the average internal rate of return of private equity funds raised in a recession year has been over 14% a year, based on data since 1980. This is higher than for funds raised in the years in the run-up to a recession – which, at the time, probably felt like much happier times. For private debt and real estate, there are similar effects. For infrastructure, the effects should be similar, but there is not enough data.
- Less correlated strategies
Even though private assets' valuations tend to correct to a lesser degree than listed markets, they are not immune to an increase in nominal and real interest rates. However, the private asset market has grown hugely and become very diverse. There are specialised strategies in each asset class that should be resilient to even a prolonged and deep recession.
Most of these investments can be found along the "long tail" of private assets. This is the 95% of transactions - smaller and mid-sized - that typically present 50% of the investment volume in each asset class.
The below table includes examples of less correlated strategies that can be found in the long tail of each asset class.
Additionally, we believe that investments with strong sustainability and impact characteristics provide better upside potential and more downside protection.
We believe that there will likely be interesting opportunities on the secondaries side in 2023, both for GP-led transactions as well as for traditional LP secondaries. GP-led transactions can benefit from the fact that other exit routes - like IPO and M&A exits - are growing more challenging. We expect attractive opportunities to acquire LP stakes from distressed sellers will arise during 2023.
- Avoid major dry powder overhangs
In our outlook last year we highlighted that exuberant fund-raising posed a risk to vintage year performance. During the Covid-induced boom-bust cycle, fund-raising for private assets has boomed. However, the build-up of dry powder has been unequal. Some strategies have seen fund-raising skyrocket, while for others it has remained more stable.
For many years, we've studied the deviation of fund-raising from its long-term trend as an early indicator for vintage year performance. There is a negative correlation between the two.
When fund-raising has been above trend, vintage year performance has been negatively affected, as dry powder can inflate entry valuations. This is known as a "dry powder overhang".
For late stage/pre-IPO venture and growth capital, fund-raising has been significantly above trend in recent years, which has contributed to the strong correction which started at the end of 2021. Large buyouts have exhibited similar behaviour, just not to the same extent.
Fund-raising dynamics in small buyouts, conversely, have been much more stable. This has led to a valuation gap between large and small buyouts that has led to increased absolute debt levels for large buyouts.
We would advise investors to avoid strategies with these dry powder overhangs, until they fall to more normal levels. However, getting dry powder back to more normal levels can take quarters, or even a few years.
Plot a course, and stick to it, especially in stormy weather
Investments in private assets are not immune to recession environments, and we do believe the US, continental Europe and the UK face a protracted economic slowdown as we approach 2023. Combined with issues such as dry powder overhangs, there is reason to be cautious.
Overall though, there is a great deal of data to suggest that investors can expect comparative resilience from private asset valuations. We believe that by targeting a steady investment pace and focusing on long-term trends, investors have numerous ways to position their private asset portfolios well.