Is the horizon clearing for private assets in 2024?

Author: Thierry Celestin, head of private assets at Lombard Odier IM

In 2023 private equity, which constitutes the predominant part of the private assets market, experienced significant difficulties. The increase in interest rates and geopolitical and macroeconomic uncertainty led to a drought of transactions, slowing the flow of profits for investors. Divestments and sales reached their lowest point in over a decade, also impacting the fundraising that, in 2023, fell to its lowest level in eight years. Private equity firms now accumulate a record figure of 2.8 trillion dollars in unsold investments and another 2.6 trillion in uninvested cash. It is unlikely that this burden on the sector will soon abate. With valuations down and scarce capital distributed, it is expected that some areas of private equity have achieved lower results than those of public markets last year.

Private assets: Will 2024 be different?

Private equity managers were forced to reduce the value of their portfolios in 2023. The slowdown in growth and still restrictive credit conditions will continue to weigh on business activity and, in particular, the appetite for large operations. We anticipate that fundraising will continue to be a challenge in 2024. But the surprising resilience of the US economy is containing credit risks. In the second half, interest rate cuts in developed markets and the decrease in the cost of capital should create a more favorable environment. Our baseline macroeconomic scenario maintains the expectation of a soft landing for the global economy and further declines in inflation.

There are already some signs of recovery in private equity. The value of operations worldwide increased by 58% in the fourth quarter of 2023 compared to the previous three months, according to data provider Preqin. Private equity managers report a more encouraging flow of operations and a relatively solid portfolio of opportunities. The executives of Nasdaq and the New York Stock Exchange report that in recent months there have been many more applications for listing. All this suggests a potential for greater liquidity and activity in 2024.

Given that the uninvested capital of private equity has continued to increase and that interest rates have stabilized, the expectations of sellers and buyers should converge more, which will result in an increase in the volume of operations in the future. The technology sector, driven by the innovation of small businesses in artificial intelligence, cloud computing and certain emerging markets, also offers new opportunities.

The sector has also found new ways to finance operations and distributions to investors. These include loans against the cash flows of portfolio companies, the sale of shares to secondary funds or the creation of "continuation" funds for the same purpose. The pressure for liquidity increases and continuation funds now represent approximately half of the secondary sales market, so it could be a strong year for investor allocations to these strategies.

The importance of choosing managers appropriately

The decline in valuations in the private equity sector, especially in venture capital and growth funds, is creating opportunities for those with capital and focusing on distressed assets. According to data from Cambridge Associates, private equity funds that have been launched in difficult markets have historically performed well. Both public and private equity markets have had an unusual concentration in 2023, with well-established large managers capturing most of the funds. We foresee this continuing, driving sector consolidation and underlining the importance of manager selection for investors. The difference between the best and worst performing managers in the funds from 2009 to 2019 was 18 percentage points, according to McKinsey estimates, highlighting the high dispersion of results within this asset class.

Will the remarkable growth of private credit persist?

A rebound in operations this year would also help private credit, or non-bank loans to companies that, for the most part, are not listed on the Stock Exchange. 2023 was an exceptional year for the sector, with a record number of funds in the market and the largest loan in history, of 5.3 billion dollars. According to Moody's, assets under management in the private credit segment are already approaching 1.3 trillion dollars, approximately the size of the global high-yield bond market. The withdrawal of banks from corporate lending partly explains this remarkable growth. Private credit markets have also been boosted by investors' desire to capitalize on rising interest rates, as private loan rates are usually variable and offer higher returns than coupons on comparable-rated public bonds.

In 2024 we anticipate that falling interest rates will pressure private credit returns. But the appetite of investors and asset managers to diversify and opt for this asset class remains high. Private credit returns are not correlated with market sentiment, so they can offer stability and diversification benefits.

Concern about the rapid rise of the sector and its fate if the economy slows down and default rates increase warrants close monitoring. However, we believe these risks seem manageable, as private loans are usually secured with the assets of the borrowers, while default rates remain contained for now

Issues in the commercial real estate sector

Since the start of the pandemic, various private real estate sectors have faced significant challenges. The availability of bank financing and capital for operations has been reduced due to investor caution and tensions in the commercial real estate sector. Valuations could continue their decline. Despite this, macroeconomic challenges could generate opportunities for those looking to acquire distressed assets, especially in areas experiencing structural growth, such as logistics, data centers, and student residences. Supply is decreasing, especially in office markets, which could drive a long-term recovery. At the same time, rents linked to inflation provide a hedge against rising prices.

Meanwhile, infrastructure funds are experiencing a marked long-term upward trend. Most developed economies need to significantly increase investments in their infrastructures, both existing and new. Since governments cannot bear this financial burden alone, the private sector will play a key role in this capital outlay. Infrastructures now lead the fundraising in the field of real assets, as projects related to sustainable energy and digital infrastructures have displaced the interest of the former leader, the oil and gas sector. The resilience of cash flows in infrastructures, which depend less on the economic cycle, positions them as an attractive addition to investment portfolios.

Long-term opportunities and our "total equity" approach

Of course, private asset investors must be aware of the risks involved and the limitations of immobilizing capital for several years. For investors with an appropriate risk horizon, our "total equity" approach combines public and private assets in a portfolio, with the aim of achieving diversification, higher returns, and lower volatility. Research suggests that the best private equity investments have historically outperformed public markets. This is reflected in our own 10-year return expectations.

Private assets are also benefiting from secular tailwinds, such as the withdrawal of banks from some forms of lending and the fact that companies remain private for longer. According to Preqin, more than half of US companies with over 1 billion USD in revenue are privately owned. It predicts that the private asset sector will grow by 10% annually over the next five years. Private equity still represents less than 5% of global financial markets, implying significant room for expansion. We see opportunities here and favor multi-year investments in a range of private assets, focusing on identifying the strongest managers and gaining access to them.