Private assets views Q3 2023 - Investing during the slowdown

The latest update from our private assets business includes detailed thoughts on the risks and opportunities that are emerging in each private asset class, as a broader slowdown takes hold.

14/07/2023
Shanghai from the air

Authors

Nils Rode
Chief Investment Officer, Schroders Capital

Private assets were in a slowdown in the first half of 2023 in terms fund raising, investment activity and valuations. This slowdown could deepen during the second half of the year in the case of recession, which remains a risk.

Fund raising numbers are a useful early indicator of investment activity and, to some extent, valuation developments in private markets. In Q1 2023, infrastructure fund raising experienced a significant correction of almost 90% from the previous year, according to Preqin. However, other asset classes - such as private debt - only declined by 10% over the same period. Private equity buyout fund raising remained unchanged, indicating more stability.

We have highlighted in prior quarters that, while a general slowdown and the risk of a recession may be concerning, over time they can also create opportunities for new private asset investments. Historically, attractive vintage years have emerged during times of recessions.

In the current slowdown, we recommend that investors direct their new investments towards assets that align with long-term trends and exhibit low correlation with traditional investment strategies. Additionally, investors can seize cyclical investment opportunities by maintaining a steady investment pace. Investors should be particularly selective regarding investment opportunities that continue to face headwinds, or that have not yet fully repriced, given the current market environment.

Below are some guiding principals to stick to when investing through a slowdown.

Seek tailwind from long-term trends

We see promising investment opportunities in areas such as sustainability- and impact-aligned investments, renewable energy, generative artificial intelligence (AI) and investments in India. We expect these long-term trends to continue in the coming years, presenting investors with potential for attractive returns.

Focus on less correlated investments

We see attractive opportunities in small and mid-buyouts in certain industry sectors (notably healthcare), seed and early stage venture capital investments, direct lending, insurance linked securities and microfinance. These investments offer the potential for attractive returns while also contributing to portfolio diversification.

Seize cyclical opportunities

We view private debt and credit alternatives across various strategies as an attractive source of opportunities due to the tightening of credit conditions. Additionally, we see emerging attractive opportunities in infrastructure and real estate due to ongoing repricing. As timing can be challenging in private assets, we recommend that investors seize cyclical opportunities by maintaining a steady investment pace.

Be particularly selective for strategies with continuing headwinds

We see a heightened risk of valuation corrections for late-stage venture and growth capital investments, the larger end of buyout markets, and commercial real estate investments that have not yet sufficiently repriced. We recommend that investors are particularly selective when considering new investment opportunities in these areas.

Our assessment of opportunities by private asset class has remained largely unchanged over recent quarters.

We provide a more detailed examination of these opportunities below.

Private Equity

Buyout fund raising remained unchanged in Q1 2023 versus the same quarter in the prior year, according to Preqin. Venture capital fund raising was down nearly 70% over the same period. The correction in venture capital fund raising follows the exuberance that late-stage / pre-IPO venture investments experienced in 2020 and 2021.

We believe that being highly selective in private equity investments is a critical success factor. Specifically, we recommend focusing on investments that align with long-term trends. We also seek opportunities with the potential to capture a complexity premium; those requiring the deployment of unique skills to drive both organic and inorganic growth in portfolio companies.

In the coming quarters, we anticipate that small and mid-sized buyouts will outperform large buyouts, driven in part by a more favourable dry powder environment for smaller transactions. Similarly, we expect seed and early-stage disruptive investments to be more resilient than later-stage or growth investments, owing to the same dynamics.

By sector, we are particularly drawn to opportunities focusing on healthcare. Regionally, we continue to see the North America, Western Europe, China and especially India as attractive.

GP-led transactions are likely to rise further in prominence. GP-leds allow favoured portfolio companies to be retained and developed further by the same management team. With IPO markets closed, we anticipate a reduction in M&A exits, so GP-leds should increase.

Private Debt and Credit Alternatives

In the first quarter of 2023, private debt fundraising experienced only a slight declined – around 10% - compared to the same period in the previous year, according to Preqin.

This stability is a reflection of the attractive market conditions for private debt and credit alternatives.

The lending conditions for creditors remain favourable, offering attractive risk-adjusted yields due to spread widening, higher base rates, and more conservative deal structures with lower leverage, larger equity contributions, and tighter loan documentation.

Investments that offer variable interest rates and tangible asset backing, such as infrastructure and real estate debt, are especially attractive in our view. These asset classes provide explicit asset backing and robust downside protection, with many opportunities offering contractual or ‘pass-through’ links to inflation.

Floating-rate securities are also prevalent in the mortgage-backed, asset-backed, and collateralised loan obligation (CLO) sectors. These securities are backed by housing, real estate, and consumer debt as well as leveraged loans and direct lending and can provide diversification within a floating rate allocation.

The leveraged loan market has significantly repriced due to a changing economic landscape with higher rates and reduced credit availability, leading to more conservative structuring for new deals and refinancing activity.

Insurance linked securities offer valuable diversification in any fixed income portfolio due to their lack of correlation with traditional assets. Beyond this, yields are reaching historic levels due to natural catastrophes and insurance market dynamics.

Microfinance is another strategy that provides diversification and lowly correlated returns, with floating-rate portfolios delivering stable returns, making it an attractive option for investors seeking alternative sources of income.

Infrastructure

In Q1 2023, infrastructure fundraising declined sharply - by nearly 90% - compared to the same quarter in the previous year, according to Preqin. Investment activity has also slowed down due to the repricing of markets at different speeds in a higher interest rate environment. Additionally, a material increase in capex costs has led to a slowdown in new projects. The ongoing repricing is creating attractive investment opportunities, and we expect this trend to continue throughout 2023.

We see renewables as a particularly attractive investment opportunity due to their strong link to inflation and secure income characteristics, which can help investors navigate the challenges of high inflation and tightening interest rates. The ongoing war in Ukraine has heightened concerns about energy security and spurred efforts to reduce reliance on fossil fuels. Developing the necessary infrastructure is essential for a successful transition to renewable energy, with wind and solar investments playing a vital role. Adjacent technologies such as hydrogen coupled with renewable energy sources will also play a role allowing decarbonisation of heavy industries.

We also see attractive opportunities in other infrastructure areas related to digitalisation and other essential infrastructure.

While many of the most attractive infrastructure investment opportunities can be found in Europe and in North America in our view, we also see opportunities to make sustainable infrastructure investments in emerging markets on a highly selective basis.

Real Estate

Real estate fund raising saw a significant correction of nearly 60% in Q1 compared to the same quarter last year (Preqin). Similar to infrastructure, the higher interest rate environment has also slowed transaction activity significantly. Transaction pricing has declined by approximately 20% in Europe and the US since the third quarter of 2022. We anticipate further pricing adjustments for the remainder of 2023, especially in fringe markets and for secondary, non-sustainable, assets.

The repricing of markets is creating attractive investment opportunities, and we suggest a patient approach using a "sequential playbook" to prioritise opportunities across capital structures, sectors, and geographies. The most immediate opportunities can be found in markets that have experienced the fastest repricing, such as the UK and Nordic region, followed by regions where repricing tends to take a bit more time like the US and even more so in other Continental European markets.

The Asia Pacific region's market dynamics differ from the Western world due to varying developments during the pandemic. We see cyclical real estate opportunities in this region in markets that are reliant on China's post-pandemic recovery.

Logistics and urban industrial assets, convenience retail formats, mid-market multi-family housing, budget and luxury hotel formats, and self-storage are some of the sectors offering absolute and relative value. Occupational markets outside of the challenged US office sector remain well supported by tight supply conditions that we expect to persist given elevated construction and finance costs, thereby providing a conducive base for further inflation adjustment and rental growth once economies recover.

The transition to a higher interest rate regime has made financial engineering less feasible going forward, with performance centred on the delivery of efficient operational management across sectors, and on providing contractual or indirect inflation protection.

Sustainability and impact considerations should be prioritised to future proof portfolios against rapidly shifting occupier preferences and evolving regulatory requirements.

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Authors

Nils Rode
Chief Investment Officer, Schroders Capital

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