Private assets views Q2 2023 - Navigating the downturn
A regular update from our private assets business, that includes detailed thoughts on the risks and opportunities emerging in each private asset class.
Since October last year, our view has been that there is a high probability of a recession occurring in 2023. That remains the case.
Recent events, such as the failures of Silicon Valley Bank and Credit Suisse, have reinforced our outlook. We also note that after the significant bankruptcies during the recessions of 2001 and 2008, it took an additional year for equity markets to hit bottom. Therefore, we believe that the recent banking failures may not necessarily indicate the end of the current economic downturn.
We believe that recessions can create attractive investment opportunities for private assets. Historical data suggests that recession vintage years have often produced favourable results for private assets.
In the current economic climate, 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 could consider cyclical or contrarian investment opportunities for tactical adjustments to their asset allocation, while avoiding investments that may be exposed to cyclical headwinds.
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, 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, and microfinance. These investments offer the potential for attractive returns while also contributing to portfolio diversification.
Consider investment strategies with cyclical or contrarian opportunities
Given the recent tightening of credit conditions, we see cyclical opportunities in private debt and alternative credit across various strategies. Additionally, we view real estate secondaries as a contrarian opportunity. These potential investment opportunities can inform tactical adjustments to asset allocations.
Avoid investment strategies with cyclical headwinds
We caution against strategies where we see a heightened risk of valuation corrections. This includes late-stage venture and growth capital investments, the larger end of buyout markets, and commercial real estate investments. By avoiding these strategies, investors can mitigate risks and focus on more promising opportunities. 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.
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 and offer the potential to capture a complexity premium by deploying unique skills to drive both organic and inorganic growth of 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.
The failure of Silicon Valley Bank may result in a reduction in the availability of venture lending and subscription lines of credit. This could accelerate the ongoing valuation correction for later-stage and growth investments.
By sector, we are particularly drawn to opportunities focusing on healthcare. Regionally, we continue to see 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 alternative credit
We continue to see favourable lending conditions for creditors, offering attractive risk-adjusted yields. Recent market volatility has led traditional banks to pull back from lending, creating more opportunities and bargaining power for alternative lenders. In response, loan terms now feature stronger covenants and more conservative deal terms that favour lenders. Additionally, spread widening and higher base rates over the last 12 months have resulted in higher yields.
Of the different private debt strategies available, we especially like investments that offer variable interest rates and tangible asset backing. Infrastructure and real estate debt, in particular, provide explicit asset backing and many opportunities offer contractual or 'passthrough' links to inflation. Additionally, both asset classes have historically offered robust downside protection.
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 and can provide diversification within a floating rate allocation while also exposing investors to different types of corporate risk via leveraged loans or direct lending.
The leveraged loan market has significantly repriced due to a changing economic landscape with higher rates and reduced credit availability. Consequently, we expect new deals and refinancing activity to be structured more conservatively.
Insurance linked securities (ILS) can offer valuable diversification in any fixed income portfolio due to their lack of correlation with traditional assets. Additionally, yields for ILS have recently reached historic levels, primarily due to natural catastrophes and insurance market dynamics, resulting in a significant increase in risk premiums. We anticipate this trend will continue.
Another strategy that provides diversification and lowly correlated returns is microfinance. Floating-rate portfolios in microfinance can deliver stable returns, making it an attractive option for investors seeking alternative sources of income.
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. Renewables offer a particularly attractive option 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.
Globally, positive policy stimulus such as the Inflation Reduction Act in the US and the Green Deal Industrial Plan in Europe, combined with reduced funding availability from traditional sources, has led to increasing returns for renewables. This trend is evident in the US, the UK, and many parts of Europe.
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, we also see opportunities to make sustainable infrastructure investments in emerging markets on a highly selective basis.
In real estate markets, the higher interest rate environment has slowed transaction activity significantly. We have seen double digit valuation declines since the third quarter of 2022. We anticipate further pricing adjustments through 2023, especially in fringe markets and for secondary, non-sustainable, assets.
The repricing observed has already created attractively rebased investments in places and we anticipate a broader buying opportunity emerging through 2023. This will be amplified by distressed selling around refinancing and other liquidity needs, creating opportunities for well capitalised buyers.
This is set against occupational markets remaining well supported by tight supply conditions, that will 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 will make financial engineering less feasible going forward. Performance will instead be centred on the delivery of efficient operational management across sectors, providing contractual or indirect inflation protection. This encompasses operational sectors driven by structural versus cyclical trends and where long-term success of the tenants’ business is aligned with property owners.
Sustainability and impact considerations should be prioritised to ensure that portfolios are future proofed against rapidly shifting occupier preferences and evolving regulatory requirements, with additional expenditures in relation to these more likely to be reflected in valuations.
Shortages of well-located sustainable office space meeting future demand versus expected obsolescence of non-sustainable properties will drive significant bifurcation in performance between ‘winners and losers’. We currently see absolute and relative value in convenience retail formats; urban industrial and logistics assets; mid-market multi-family housing although being cognisant of pending changes in rent controls to protect consumers; and more operationally intensive sectors such as budget and luxury hotel formats and self-storage.
Schroders Capital views recessions as an opportunity for private asset investments and maintain a steady investment pace. During market conditions where the likelihood of a recession is high, it is especially advisable to focus on private asset investments that align with long-term trends and have low correlation with other private asset strategies. We urge caution regarding strategies that face cyclical headwinds. We believe that the long-tail of the private assets market, comprising more small to mid-sized transactions that constitute the majority of transaction volume, presents particularly promising investment opportunities.