But the second half looks set to be more uncertain. Survey and hard data suggest slower growth ahead. Core inflation lingers above many central banks’ targets, suggesting scope for both higher rates and stickier inflation.
Investors may find an allocation to private markets helps to navigate this challenging outlook. We believe private assets can generate attractive returns throughout the business cycle, while enhancing portfolio diversification. Recent developments in some corners of the private market space offer potential for investors to enhance wealth accumulation and/or generate income.
Private credit – compelling income with robust fundamentals
In an environment of higher rates, we see favorable risk-adjusted income opportunities in private credit. Private credit can benefit from stronger covenant protection amid slowing economic growth. As banks retreat further, direct lenders are filling the void. Their improved negotiation position has helped secure higher yields with JP Morgan data showing new loans yielding a coupon of close to 12.5% p.a. Newer deals are also comprising less leverage and more equity.
But with increasing cost of debt and deepening economic worries, we do anticipate some credit deterioration going forward. Default rates have started to pick up, and we expect them to rise to historical averages in 2023. While triggering some losses, total returns should remain positive in the mid-single digit range, driven by high income generation.
Private equity – dispersion suggests opportunities
We think today’s market dynamics, especially bigger performance differences between strong and weak companies, offer good entry points in private equity.
Widening valuation dispersion should offer opportunities for managers to acquire assets at compelling valuations. And while elevated rates pose a risk for PE managers as they impact cost and availability of debt financing, some negative impact has been offset so far by active fund management and positive company EBITDA and revenue growth.
As companies streamline costs and focus on raising liquidity, we observe increased activity in add-on deals, carve outs, and divestitures. We note that these deals also require less leverage and are generally better priced. To take advantage of these opportunities, we prefer exposure to value-oriented buyout strategies. We also think secondaries offer good value, with average pricing declining to 81% in 2022, compared to 92% at the end of 2021. Lastly, investors should not lose sight of long-term growth opportunities—notably in themes such as the transition to the green economy, growing healthcare needs, and digitalization.
Real assets – time for selectivity
In an environment of stickier inflation, allocations to infrastructure and select core real estate could help with long term inflation mitigation while providing additional portfolio diversification and income.
We are selective in real estate and recommend remaining invested in line with benchmark allocations. In the current environment, we maintain a focus on quality and resilience and favor properties with strong market fundamentals with brighter prospective returns in robust sectors, like logistics. However, we would refrain from investing in suburban offices and shopping centers given near-term challenges.
Infrastructure assets have shown resilience to the current macroeconomic pressures while benefiting from policy and structural tailwinds. In the current environment, we recommend investing in core assets that benefit from robust, predictable, and inflation-linked cash flows that are less exposed to cyclical pressures and have manageable levels of debt.
Risks in private markets
Investors should however understand risks inherent to private markets. These include illiquidity, longer lockup periods, leverage, concentration risks and limited control and transparency of underlying holdings. While risks cannot be fully eliminated, it is possible to mitigate them through strong due diligence and strict manager selection, and by diversifying across vintage years, strategies and geographies.
Main contributors - Antoinette Zuidweg, Matthew Carter
Original report - Private markets in the second quarter and beyond, 7 July 2023.