Exploring the Impact of Higher Yields on Private Markets
The macroeconomic landscape has shifted dramatically in the past year. After a prolonged period of near-zero levels, interest rates in the US and the eurozone have risen sharply and are expected to remain at higher levels than we have become accustomed to. As we forecast at the beginning of 2023, while inflation is expected to ebb later this year, it might well remain at relatively high levels for some time – and clearly that means the monetary environment will prove much tighter than has been the case over the past 15 years or so. This shift in monetary policy calls for a different set of investments than those that have performed well in recent years.
The prospects for the global economy have seldom been as clouded with uncertainty as they are at present. Consequently, unexpected moves to the upside or downside in economic data can send markets either soaring or into a tailspin. There can be little doubt that the stickiness of inflation has taken central banks by surprise, with the Federal Reserve admitting it was too slow to start raising interest rates after inflation took off in 2021[i]. It is also looking increasingly likely that interest rates will remain at relatively elevated levels for longer than most people expected just a few months ago.
The accompanying hike in yields over the past 18 months or so might suggest that private markets will fall out of fashion as investors switch back to their public counterparts. However, there are various reasons why private debt and other sectors will remain attractive. These include the likelihood that interest rates may be close to their peak and are likely to begin to decline later this year or early next year as economic growth deteriorates. That should mean yields also fall back, lowering the returns from investing in public markets and hence boosting the appeal of private debt once again.
Private debt in demand
Increased demand for debt financing as banks retrench their lending is also increasing opportunities for private-debt managers, who may deploy capital for their current vintage of funds at a faster pace. About 46% of the banks surveyed by the Federal Reserve reported tightening lending standards during the second quarter of 2023, compared with 39% in the previous three-month period[ii]. Meanwhile, direct lending grew to US$224 billion in 2022, from US$219 billion in the previous year[iii]. Moreover, Preqin says the private debt market is holding up well in 2023[iv].
Calpers, the biggest US public pension plan, certainly believes there are increased opportunities to be found in private debt. It was recently quoted as saying it is “seeing more deal flow opportunities” in private debt following the collapse of Silicon Valley Bank and other lenders, and that it is ready to take more risk to profit from such positions.
Private equity overcoming challenges
Deal flow in private equity also remains strong, according to Pitchbook data. That’s despite a challenging background that included regional bank failures, a slowly reopening leveraged loan market and an unfavorable fundraising environment.
Figure 1: US Private equity deal flow remained strong in Q1 2023 in the US,
Source: Pitchbook, as at end March 2023
Moreover, fresh opportunities are likely to emerge in private markets this year as volatility continues on the back of a likely continuation of data surprises and as valuations become more attractive. In addition, as the cost of capital remains at relatively high levels, companies are likely to be increasingly open to managers who can supply much-needed capital.
Caution is required in some sectors. Valuations in the private market for real estate, for instance, have yet to correct to the same degree as REITs. However, there are opportunities even here. Banks, for example, are not refinancing the maturing debt fully and a large proportion of existing debt will reach maturity. This is giving rise to preferential equity or real-estate debt where lenders can enjoy attractive rates with downside protection.
Private real-estate investments continue to offer the ability to generate more attractive returns than REITs. That reflects the ability to invest in off-market properties, focus on high-growth markets and implement value-added strategies to generate higher internal rates of return.
Private markets also remain an important diversifier for a portfolio. This is particularly important at a time when many analysts argue that valuations in public markets remain excessive. The S&P 500 is trading at close to historic highs, according to some metrics such as the Shiller PE[v], despite the continuing possibility of recession, considerable geopolitical uncertainty, and the risk that inflation may take some time to ebb. The ratio of total market capitalisation to GDP, or the so-called “Warren Buffett indicator”, stands at 154%, for example – higher than the levels seen during the dot-com bubble a little over two decades ago, despite the sell-off in 2022[vi].
Figure 2: The S&P 500 has bounced back from the lows of 2022 despite an uncertain economic outlook
Key takeaways
Interest rates may be close to their peak and are likely to begin to decline later this year or early next year as economic growth weakens, an outlook that should favour private markets.
Increased demand for debt financing as banks retrench their lending is also increasing opportunities for private-debt managers.
Private markets remain an important diversifier for a portfolio, particularly given possibly excessive valuations in public markets.
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