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In 2023, private equity investors face a complex mix of challenges and risks.
The likelihood of a prolonged recession is significant. Inflation is high. Interest rates are rising, and total debt has increased. The war in Ukraine continues, as does the resulting energy crisis. Even if these factors disappeared overnight, current issues like social inequality and populism remain.
However, private property is long-term in nature. It is more appropriate for investors to assess the medium to long-term outlook before making any decisions. Over this long period of time, a number of persistent, long-term trends mean that we remain optimistic.
In particular, five long-term megatrends should provide a tailwind:
o Climate change and decarbonization
o Technological revolution
o Sustainable lifestyles
o Population aging
o Growth in emerging and frontier markets
The short-term challenges facing investors today do not detract from the urgent need to address climate change and decarbonization. No economic backdrop – no matter how turbulent – will stop the technological revolution, nor the shift towards more sustainable ways of life.
The global population also continues to age and grow, changing supply and demand patterns as a result. We expect the combination of population aging and low birth rates to affect real interest rates in the long run as they reduce the available labor force in many countries. Emerging and frontier markets will also continue to grow, and the countries leading this growth will likely evolve over time.
Other forces shaping private markets are not thematic, but more related to evolving trends in demand and investor behavior. For example, we expect the transition to what we call “Private Asset 4.0” to continue, if not accelerate. Private markets have evolved rapidly since the mid-80s and have gone through several forms as they have done so. In this new phase, access is improving for a huge number of investors who were previously excluded, as “democratized” solutions continue to be developed.
Even so, the short term will undoubtedly be difficult. Here are three key things investors can focus on to ensure their private asset allocation is as resilient as possible to short-term market challenges.
1. Steady pace of investment
Maintaining a steady pace of investment can be difficult. However, investors who can invest in the new funds in 2023 are encouraged to do so. According to our analysis, recession years are particularly attractive vintage years.
Structurally, funds can benefit from “time diversification”, where capital is spread over several years. This allows funds raised in recession years to pick up funds at reduced values as the recession unfolds. Assets can then seek an exit later, in the recovery phase, when valuations rise.
For example, the average internal rate of return of private equity funds raised in a recession year was over 14% per year, based on data since 1980. This is higher than for funds raised in the years preceding the recession. – which probably felt like much happier times back then. There are similar effects for private debt and real estate. For infrastructure, the effects should be similar, but there is not enough data.
2. Less correlated strategies
Although private asset valuations tend to correct to a lesser extent than in stock markets, they are not immune to increases in nominal and real interest rates. However, the private property market has grown and become very diverse. Within each asset class, there are specialized strategies that should be resilient even in a prolonged and deep recession.
Most of these investments can be found along the “long tail” of private property. This is 95% of transactions – small and medium – which typically represent 50% of investment volume in each asset class.
The table below includes examples of less correlated strategies that can be found in the long tail of each asset class.
In addition, we believe that investments with strong sustainability and impact characteristics provide better upside potential and greater downside protection.
Table: Example of strategies that are well positioned, even in a deep recession
|
Private property |
Private debt and credit alternatives |
Real estate |
Infrastructure |
|---|---|---|---|
|
Small/medium purchases in healthcare |
Direct lending |
Affordable housing and care |
Renewable energy (wind, solar, biomass) |
|
Acquisition and construction strategies |
Medium-sized infrastructure debt |
Student and senior life |
LNG transportation and storage |
|
Early stage biotechnology |
Mid-sized real estate debt |
Laboratories |
Hydrogen infrastructure |
|
India’s investment in growth |
ILS |
Self storage |
Digital infrastructure |
|
The “crown jewel” of GP-light |
Opportunistic securitized products |
Large retail parks, convenience |
Health infrastructure |
Not an investment recommendation
We believe there are likely to be interesting opportunities on the secondary services side in 2023, both for GP-led transactions and traditional LP secondary businesses. GP-led transactions may benefit from the fact that other exit routes – such as IPOs and M&A exits – are becoming increasingly challenging. We expect attractive opportunities to buy LP shares from distressed sellers to emerge during 2023.
3. Avoid large excesses of dry powder
In our last year’s outlook, we pointed out that abundant fundraising poses a risk to the performance of the old year. During the boom-bust cycle caused by Covid, private equity fundraising boomed. However, dry powder accumulation was uneven. In some strategies, fundraising increased sharply, while for others it remained more stable.
For many years, we have studied the deviation of fundraising from its long-term trend as an early indicator of senior year performance. There is a negative correlation between the two.
When fundraising is above trend, vintage year performance is negatively impacted, as dry powder can inflate entry values. This is known as “dry powder”.
For late-stage/pre-IPO VC and growth capital, fundraising has been significantly above trend in recent years, contributing to a strong correction that began in late 2021. Large buyouts have shown similar behavior, just not to the same extent.
In contrast, the dynamics of fundraising in small buyouts was much more stable. This has led to a valuation gap between large and small buyouts, leading to an increase in 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, returning dry powder to more normal levels can take quarters or even several years.
Plot a course and stick to it, especially in stormy weather
Private property investment is not immune to the recessionary environment, and we believe the US, continental Europe and the UK face a prolonged economic slowdown as we approach 2023. Combined with issues such as dry powder, there is reason to be cautious.
Overall, there is a large body of evidence to suggest that investors can expect comparative resilience from private equity valuations. We believe that by targeting a steady pace of investment and focusing on long-term trends, investors have numerous ways to position their private property portfolios well.
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