What’s in store for private markets?
What could be the impact of high interest rates in private markets over the year to come?
High interest rates are prompting LPs and GPs to take a long, hard look at their portfolios and at where they will invest over the coming cycle. So what could be the impact on private markets over the year to come?
The US economy may have defied economists’ predictions of a recession for 2023, but that doesn’t mean it can’t happen in 2024. Indeed, many in private markets are wary about the coming year. “It has been difficult to predict the direction of the economy over recent years, as Covid, supply chain disruption, labor shortages, inflation and interest rate rises have played out,” says Dave Tayeh, Head of Private Equity North America at Investcorp. “But history tells us that it takes some time for increased cost of capital to flow through to the economy. We are only in the early stages of that.”
Jim Neary, Managing Director and Co-Head of US Private Equity at Warburg Pincus, agrees. “Interest rate rises haven’t bitten yet,” he says. “That is to come. The fact is that capital still remains fairly ubiquitous as there is a lot in private credit and in private equity, while corporate balance sheets are strong. That said, we’ve already seen discrete pockets of ‘recession’ or difficulty, either because of staffing issues, or in areas like selling equipment to e-commerce providers in 2022, which had significant declines. The lower end of the consumer market is also in a difficult position right now. There is stress in the system and that will continue whether or not we have a technical recession.”
“We are starting to see some volatility in our portfolio,” adds a senior portfolio manager at a US public pension plan. “Interest rates are having an impact on some LBOs, especially those that are highly levered as debt interest has doubled from 6% to about 12%.”
Interest rate hikes may not have fed fully through to existing portfolio company valuations, but this will come, says Anjan Mukherjee, Managing Partner at BayPine. “We had a tailwind of lower rates,” he says. “Higher rates are now a headwind, although deal pricing has risen as opposed to fallen. Yet we will get to a point where deal multiples will have to come down and that will be a painful process. GPs want to hold on to yesterday’s marks, but that will have to change.”
Even with recent signals from the US Federal Reserve that it may reduce interest rates in 2024, they are still set to be higher than the past decade. Accordingly, private credit is looking increasingly attractive to many LPs. “In the last cycle, there was an inclination towards equity and credit was growing because it was substituting the banks,” says Francois Aguerre, Co-Head of Investment at Coller Capital. “Most likely, we will now see a short cycle where it’s better to rebalance towards credit.”
It’s a shift that Stephanie Lynch, Managing Partner of Global Endowment Management, says could be attractive. “Private credit has historically been frustrating for us,” she says. “The time horizons of our endowment model mean that it has to compete with private equity and, with the low interest rates and credit spreads seen from the late 2000 to today, it didn’t compare well. We did some work back in 2020 on private credit and we’re dusting this off now that interest rates have risen. The spreads on the real rates from private credit haven’t yet moved that much, but we are waiting patiently and there are some areas, such as real estate debt, that are starting to look interesting.”
Hazman Hilmi Sallahuddin, Chief Investment Officer at Kumpulan Wang Persaraan, agrees. “The spread is narrowing between private equity and private credit,” he says. “As a result, private credit is becoming more attractive.”
The spread is narrowing between private equity and private credit, as a result, private credit is becoming more attractive
“As I look around today, the most interesting investment area is direct lending,” adds Jim Pittman, Global Head of Private Equity, British Columbia Investment. “If you can get 11% with low volatility as a pension fund, where you are striving to achieve overall 7% returns, you’d take that all day long.”
Sentiment is also changing around public markets in private credit’s favor, according to Matt Cwiertnia, Partner and Co-Head of Private Equity at Ares Management. “We’re seeing a secular shift towards private credit and away from public markets,” he says. “It’s following the same trajectory as private equity. Private credit is still in its early innings and many LPs are still new to the asset class, but they are shifting more dollars here because of the relative value and alpha versus what they can get on public markets. As interest rates have risen and investors have become less enamoured with public markets, they are seeing that they can generate higher returns in private credit for roughly the same risk.”
“It’s an alpha world today,” says Cwiertnia. “If markets are flat and interest rates are higher for longer, managers need to generate alpha. The market is not the same as it was and multiple expansion has gone as a return driver. Managers have to use less leverage and make companies better.”
“We will have to support companies with intervention strategies to get the same returns we achieved when interest rates were acting as a tailwind,” says Mukherjee. “There needs to be more revenue growth and margin expansion – it will be imperative for private equity managers to have a reliable and systematic capability for generating alpha.”
And while large buyouts are always likely to form at least part of many LPs’ private markets allocations, there is a notable shift towards further down the market among many investors as they search for managers that can really move the needle in the companies they back through operational improvement and buy and build strategies.
The top three areas of interest for LPs in the 2024 Probitas Partners Private Equity Investor Trends Survey were US mid-market buyouts, US small buyouts and European mid-market buyouts, all of which have increased as target areas over the previous year’s results. “Over the past year, large buyout managers have often prevailed in a difficult fundraising environment as LPs have grappled with uncertainty,” says Dorothy Kelso, Global Head at SuperReturn. “Yet over the coming period we may well see some LPs look more to mid-market strategies to capture further value creation.”
And Lynch is one of these LPs. “We have learned not to time the markets and we are keeping our allocations stable,” she says. “Yet we are shifting some allocations under the hood. We’re leaning more towards smaller buyouts because we believe they offer good diversification and they tend to retract less and rebound more quickly in recessionary environments. The managers we invest with also tend to pay less than the prevailing market multiples, use less leverage and rely more heavily on operating efficiencies to grow earnings and exit at compelling multiples.”
It’s an alpha world today
