Written by: Ash Lawrence | AGF
The past 18 months have been challenging for most sectors in the private markets after more than a decade of positive performance, according to Preqin data. Like most asset classes, private alternatives are not immune to a macro climate of persistently high inflation and rising interest rates. This environment has a knock-on effect that slows asset realizations, which reduce distributions and subsequently reduces net new fundraising. Coupled with negative impacts on performance of this environment and predictions of a slower economy, this has led to a slower pace of growth than was the average in the back half of the last decade. For the first time in a long time private assets are facing an uphill climb as we look to 2024.
However, despite the tougher backdrop, private markets have maintained positive momentum. Assets under management are still expected to grow by an annualized rate of 11.9% over the next four years, adding to an already impressive trajectory that has seen the size of the alternative investment class almost double since 2018.
And while the current environment has resulted in some decidedly mixed returns to date, an expected end to the rate-hiking cycle could be the catalyst for an increase in positive outcomes as capital sitting on the sidelines is re-deployed across a broader swath of strategies, including those that invest in privately held equities and credit.
Source: Preqin, Future of Alternatives 2027 report, October 5, 2022.
Private Credit: More of the same solid returns?
Of all the various flavours of private market investments, private credit has been one of the biggest beneficiaries of the recent rate-hiking cycle. While certainly some of this growth is a result of climbing yields in the sector, there has been a expansion of the opportunity set for private lenders as tighter lending conditions from traditional counterparts has created an attractive pool of under-served borrowers. Multiple factors have played a role in setting this dynamic, but it has been particularly noticeable since the collapse of Silicon Valley Bank in April, which resulted in many mid-sized U.S. regional banks curbing their loan activity to avoid a similar fate. In fact, recent data from the U.S. Federal Reserve shows that growth in traditional bank lending has been cut in half across almost all types of loans this year. We have seen a similar trend in Canada as banks have looked to reduce exposure, focus on higher margin clients and respond to regulatory changes in their capital requirements.
In turn, that has created the potential of more opportunities for private lenders who may be the only option for corporate borrowers needing to raise capital right now. Moreover, that trend could be expected to continue if economic growth weakens in 2024 and overall lending conditions tighten further.
Still, the near-term outlook for private credit isn’t without risks. For one, the threat of a severe economic downturn sometime next year will undoubtably increase the strain on In fact, we have seen signs of this already, yet this strain has remained relatively benign despite higher debt servicing costs from rate hikes that have taken place to date. Of particular concern should be strategies that invest in private loans with weak collateral and covenants, and/or rank low in the capital structure of the companies they lend to.
Perhaps more importantly, investors may need to spend the time understanding the lending approach taken by the managers they select to invest their capital. When there is a level of stress in the environment, private lenders need to have the skills necessary to properly underwrite and stress test a borrower’s credit and to structure loans that provide the right protections and risk mitigation to avoid negative outcomes.
Either way, 2024 should continue to buoy private credit as it doesn’t appear traditional lenders will be in growth mode until much later in the year. We believe the potential for solid returns remains mostly intact from still-attractive yields and a growing demand for the asset class among institutional and retail investors wanting greater diversification in their portfolios.
Private Equity: Cue the comeback?
If private credit has been a beneficiary of the current rate-hiking environment, private equity has been just the opposite and may gain more from a pivot in monetary policy next year.
Indeed, 2023 may end up being the bottom to one of the worst stretches for selling portfolio companies in a decade, according to PitchBook, a private market data provider. Higher rates have stunted the transaction market given the leverage used in most asset acquisitions. This has created a wide gap between buyers and sellers’ price expectations.
That said, we are seeing some thaw in the market for transactions as buyers and sellers adjust to the new cost of capital realities and this could continue into 2024. Should we continue to see a pause in hikes from central banks and start to see rates move downward toward the second half of 2024, we may see a a boost to activity in the private equity sector.
Moreover, while the prospect of an economic slowdown in the new year could result in more downward pressure being exerted on existing portfolio valuations, it could also be the catalyst for a new buying cycle later in the year. Downturns more often than not tend to produce opportunities for those who have dry powder (i.e. cash) to deploy and are ready to get it wet.
Ultimately, there is the potential that 2024 could end up being a turn for the better in private markets versus 2023, one that sees further gains for private credit and the performance of private equity staging a comeback, all while assets under management continue to grow globally and reach new heights.