In the midst of higher debt financing costs, a reduction in liquidity and incoming recessions in the US and Europe, private equity — the largest asset class by assets under management within the private markets space — is facing a fresh set of challenges.
"Private markets have been very hot for a number of years, with private equity being all the rage. This led to a lot of money flowing into the sector and has likely resulted in some overvaluation," said James Yardley, senior research analyst at Chelsea Financial Services.
"With the easy money now being withdrawn and financing now much more difficult to obtain and more expensive, private equity is going through a difficult period."
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Private equity deal activity, along with the broader M&A market, has slowed in 2022.
The volume of controlling-stake M&A deals has fallen by 46% compared to the previous year, according to Bloomberg Law.
Rob Morgan, chief investment analyst at Charles Stanley, said: "Higher interest rates mean borrowing costs are ratcheting up and it is necessary to keep a keen eye on debt levels, as well as earnings, which may be under pressure from recessionary forces."
Falling equity markets have sparked concerns among investors about how this will impact the multiples used within private equity fund valuations, which lag the public market due to the delay in reporting of asset prices.
Public vs private real estate
Persistently high inflation, a dramatic shift in central bank monetary policy and a looming recession are also largely to blame for weak investor sentiment and disappointing returns for listed real estate.
This year, there has been a stark divergence in returns between listed and private real estate, with a gap of over 30% this year, according to Janus Henderson. This is despite owning similar assets, and due mostly to reporting delays.
Fears of potential drawdowns in private real estate have driven retail investors to run for the exits in recent weeks, pushing some of the largest non-traded REITs to limit redemptions, such as Blackstone's £69bn Real Estate Income trust.
This is despite the trust being up 9.3% and not having delivered a negative return through October this year.
Performance often far exceeds that of listed REITs, as seen by NAREIT's all-REIT index, which is down 20.9% through November this year.
Better valuations?
Looking into 2023, Karen Ward, JP Morgan Asset Management chief market strategist for EMEA, said private markets still offer compelling opportunities, but warned that investors should be very selective, especially on the back of patchy liquidity.
Meanwhile, Schroders Capital's CIO Nils Rode said that investors can expect comparative resilience from private assets valuations despite an incoming economic slowdown.
Given the "widespread scepticism" of private markets, those allocating new capital will benefit from better valuations, said Charles Stanley's Morgan.
"It is likely that the space will offer up opportunities in companies that stand to benefit from strong, structural trends such as the energy transition and healthcare advances, or which operate in attractive, profitable niches," he said.
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However, Morgan also noted it is important to be selective, take a long term view and appreciate the diversification benefits of private assets, given these are "esoteric opportunities" that are not available in the listed equity sphere.
Nils said investors who can make new fund investments in 2023 would be well advised to do so.
Recession years tend to be particularly attractive vintage years, he noted, citing analysis by Schroders.
"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," he said.
In real estate, Blackrock's alternatives team said that investors who can identify the regional and thematic sweet spots, in spaces such as logistics, will find a "compelling" opportunity set.
However, the firm warned of further asset repricing in 2023.
"Occupancy levels across sectors are still high - something that could change as we get deeper into the economic cycle. And valid questions persist about how profoundly the rise in interest rates will disrupt property prices, especially if occupancy rates drop," the firm said.
Private debt and infrastructure
Beyond private equity and real estate, Morgan noted that he is also seeing opportunities in private debt and infrastructure, which he said can help broaden more cautious and income-seeking portfolios.
"Infrastructure stands to benefit from continued investment in the energy transition, and could play a role as a non-correlated inflation hedge, while the flexibility of capital in private debt should see it continue to grow as an asset class," he noted.
Private debt has taken off since the global financial crisis, with over $1.2trn in assets as of December 2021, according to Preqin.
It is expected to continue to expand further as public financing retreats and more companies seek capital.
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However, there are concerns that investors in private debt funds would see higher default rates and, eventually, losses, if borrowers do not keep up with the increasing costs of servicing their debt in a higher interest rate environment.
"Generally, we are wary of private debt, which may still have a difficult default cycle to go through if we enter a recession," said Chelsea Financial Services' Yardley.
In an economic climate of higher inflation, JP Morgan's Ward also highlighted infrastructure as an asset class within private markets that act as an inflation hedge.
This was echoed by Blackrock global head of alternatives Edwin Conway, who said infrastructure should benefit from continued investment in sustainable energy and energy security, and provide investors with stable cash flows.
However, BlackRock analysts warned that infrastructure is not without risks.
"Regulators in Europe have shown a willingness to impose price caps on energy, which can inhibit returns. At the same time, a possible recession, coupled with higher labour, materials and financing costs, have the potential to stall projects around the globe."