Private Markets Investment Outlook Q1 2024: New year, new opportunities
As developed market interest rates show signs of peaking and private market activity has been in a slowdown phase in recent quarters, we see attractive new investment opportunities across private markets. These are particularly appealing when they align with the global 3D Reset theme and the artificial intelligence (AI) revolution.
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Following a phase of very strong fundraising during the pandemic, 2023 marked a period of slower capital raising for many private asset classes. We now see private markets having largely reverted to pre-pandemic levels in terms of fundraising, investment activity, and valuations. However, noteworthy exceptions include large buyouts in private equity, where fundraising has remained vigorous - a concern as it results in higher dry powder and entry valuations. Moreover, fundraising for infrastructure and venture capital has seen a significant downturn, and real estate valuations have undergone strong corrections in some regions and market segments.
It is time for optimism
Developed markets have made remarkable strides in bringing inflation closer to policy goals, with a considerably lesser impact on growth, notably in the US, than markets had anticipated. While potential uncertainties arise from geopolitical risks and muted growth expectations for 2024, we believe it's time to be optimistic about the potential for private market investments, given that private market conditions have largely normalized (with a few exceptions).
Private markets offer the advantage of diversification across risk premia, access to investments with defensive characteristics, and exposure to the global 3D Reset themes, such as decarbonization, deglobalization, and demographics, as well as the AI revolution. Many of these trends will favour specific investment categories, including sustainability and impact-aligned investments, renewable energy, generative AI, and investments in India. Simultaneously, some of these themes are inflationary, contributing to higher interest rates. Coupled with funding gaps created by regulatory capital limitations on banks, we anticipate this will generate appealing lending opportunities.
Capital flows: A contrarian indicator
Many private market strategies operate as closed systems where fundraising determines the amount of available dry powder, which subsequently influences entry valuations and ultimately investment returns. Therefore, we favour strategies with stable fundraising dynamics, such as small/mid buyouts and see potential in strategies where fundraising has significantly deviated below its long-term trend, like infrastructure equity and venture capital. We're also drawn to strategies with higher capital needs due to the retreat of traditional capital providers, such as real estate debt, insurance-linked securities, specialty finance, microfinance, and private credit.
Selectivity remains key
Many current private investments involve "re-ups", or reinvestments with existing partners. The pandemic has amplified this trend as due diligence on new strategies and meeting new managers posed a challenge.
Considering the new market dynamics driven by the 3D Reset and the AI revolution, we believe it's crucial to question whether past successes can be replicated. Are existing partners and strategies well-positioned for today's trends (decarbonization, deglobalization, demographics, and the AI revolution)? Are the fundraising and dry powder dynamics within the sub-sector healthy? Given the changes in market dynamics, it's likely that opportunity sets should also evolve.
Now, more than ever, it's vital to expand investments into opportunities that benefit from these transformative trends and policy changes, diversify a private allocation as it matures, and concentrate on areas with healthy fundraising dynamics that provide access to less efficient markets and opportunities.
Subsequently, we summarize where we see the most attractive opportunities within each private asset class based on these criteria.
Private equity
In our view, a critical success factor in private equity investments is a highly selective approach, focusing on opportunities that align with previously mentioned trends and can capture a complexity premium. These opportunities require unique skills for driving both organic and inorganic growth in portfolio companies.
We expect that small and mid-buyouts will outperform large ones in the coming quarters, due to a favourable dry powder environment and an added exit strategy: selling their portfolio companies to large buyout funds, facilitated by strong fundraising activity among large buyout funds, which typically acquire most of their companies from other funds.
We also expect disruptive seed and early-stage investments to show more resilience than later-stage or growth investments, due to similar dynamics. Early-stage investments have the advantage of a new set of investment opportunities, particularly in artificial intelligence, while a tight fundraising environment enforces discipline regarding entry valuations. Meanwhile, late-stage or growth investments face increased refinancing and valuation risks due to a drop in venture capital fundraising and a yet-to-reopen IPO window.
We find the healthcare and technology sectors particularly promising. Regionally, North America, Western Europe, China, and especially India remain attractive. In China, we see the most attractive opportunities in the onshore, RMB-denominated market.
We foresee a further rise in GP-led transactions, allowing favoured portfolio companies to be further developed by the same manager.
Private Debt and Credit Alternatives
Income is now highly attractive across most markets. Interest rates in developed markets have likely peaked or are nearing their peak, offering higher income. Additionally, leverage is lower and terms are more favourable.
We like investments offering variable interest rates, robust security through tangible asset backing, and debt with contractual or ‘pass-through’ links to inflation. Some sectors, such as infrastructure debt, provide defensive opportunities, while others, like commercial real estate, offer selective opportunities driven by significant fundamental changes.
We exercise caution where significant change, like the work-from-home trend in the US, has occurred. In real estate debt, we focus on sectors with strong fundamentals, such as rental and student housing. Offices may become an opportunity once supply and demand changes are fully appreciated.
Asset-backed and mortgage-backed securities and collateralised loan obligations offer diversification from traditional corporate credit or loans. The retreat of key buyers such as the Federal Reserve, influenced by quantitative tightening, and US banks, guided by Basel III regulations, has opened up appealing opportunities in these high-grade securities.
The corporate loan markets, both syndicated and private, have seen significant capital inflow, which we approach with caution. While loans have shown resilience, and while yields benefit from higher base rates, and considerable yield spread, loan prices are high, there is no call protection in a par loan and there is considerable re-pricing of loans today. In our view, high selectivity is key.
Insurance-linked securities offer valuable portfolio diversification due to their lack of correlation with traditional assets. Additionally, high risk spreads yield attractive portfolio returns. Microfinance is also attractive due to diversification and less correlated returns.
Infrastructure
Within infrastructure, we see renewables as particularly attractive due to their strong link to inflation and secure income characteristics. They also contribute to diversification through their exposure to differentiated risk premia (such as energy prices and weather).
In addition to the decarbonisation trend, renewable energy is benefiting from heightened concerns about energy security and the need to reduce reliance on fossil fuels, which were reinforced by the ongoing war in Ukraine. Furthermore, the cost-of-living crisis has also brought focus to energy affordability, and in many areas around the world renewables are now the cheapest source of electricity production that can be built.
Technologies related to renewables, such as hydrogen, heat-pumps, batteries and electric vehicle charging will play an important role in enabling the decarbonisation of industries such as transport, heat and heavy industries.
There is currently a notable disparity between the high number of renewable projects and the limited capital investment, leading to higher returns and making now an enticing entry point, particularly for core/core+ strategies.
Additionally, we see potential in other infrastructure sectors connected to digitalisation and essential services, offering opportunities for inflation-linked and often stable returns.
Many of the most attractive sustainable infrastructure investment opportunities can be found in Europe and in North America in our view, but we also see opportunities in emerging markets on a highly selective basis.
Real Estate
Real estate markets have undergone significant repricing due to the new higher interest rate environment, inflation, geopolitical changes, and market fluctuations affecting investor allocations.
Despite a slight softening in demand, occupational markets remain resilient due to tight supply conditions caused by high construction and debt financing costs, and a shortage of sustainability-compliant spaces. This situation is likely to spur growth in the medium term. To meet evolving regulatory and tenant demands, it is crucial to prioritize sustainability and impact considerations, which will necessitate increased capital expenditure.
We believe the real estate sector is in the early stages of a broader cyclical buying opportunity due to the extent and uneven pattern of the repricing so far. We advise investors to be patient as opportunities emerge over time across capital structures, property types, and regions.
Immediate opportunities can be found in markets that have experienced the fastest repricing, such as the UK and Nordic region, followed by the US and other Continental European markets. In the Asia Pacific region, cyclical opportunities are focused on markets that align with China's recovery or offer alternatives in the nearshoring/friendshoring of supply chains.
Industrial and logistics assets have significantly repriced but remain supported by strong structural fundamentals. We favour operational property types that have strong demand-side tailwinds and can deliver direct or indirectly inflation-linked income. These include self-storage, hotels, senior housing, select residential segments, and healthcare-related real estate.
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