investment insights

    Private assets return to fundamentals

    Private assets return to fundamentals
    Thierry Celestin - Head of Private Assets<br>Private Bank

    Thierry Celestin

    Head of Private Assets
    Private Bank

    Key takeaways

    • Private markets are back to basics, with a renewed focus on value generation, following years of search for growth “at any cost” in a low-to-zero interest rate environment
    • With much economic value and innovation created in the private sector, integrating private assets into a multi-asset portfolio offers a different and potentially complementary set of opportunities
    • Research shows that the best private asset fund managers consistently outperform, especially through economic crises. This makes manager selection key to successful private asset allocations
    • For investors who can place capital for the long run and tolerate illiquidity, diversified exposure to a range of private assets, together with a consistent multi-year strategy, can improve a portfolio’s overall returns.

    The higher cost of capital is driving a return to fundamentals in private markets, with fund managers focussing once again on generating profits by improving and transforming their investee companies. For investors, economic crises and dislocated markets historically deliver outperformance, on condition that they can access a broad range of top managers and maintain a consistent, long-term horizon.

    The pandemic years, from 2020 through 2022, saw private assets attract a total of USD 4 trillion across all sub-asset classes, according to management consultancy Bain & Company. The last two years, 2021 and 2022, were respectively the highest and second-highest totals ever raised. By contrast, in the first three months of 2023, the mergers and acquisitions market recorded its slowest first quarter of any year in a decade, according to data by Refinitiv and reported by the Financial Times. The combination of higher borrowing costs, uncertainty about slowing economies, and the disruptions in regional US banks have all played a part.

    Attention has switched back to opportunities to generate value through operational improvements and positive cash-flow generation

    This new economic cycle is opening up new avenues for value creation. After years of low-to-zero borrowing costs that saw investors search for growth “at any cost”, attention has switched back to opportunities to generate value through operational improvements and positive cash-flow generation. We expect the higher-for-longer interest rate environment to favour the strongest fund managers who actively work to transform their assets – private equity managers with strong industry or sectorial expertise, scalable operational capabilities, and access to a deep bench of advisors and experts, for example. Instead of relying on potential multiple expansion or access to leverage, successful investments now require strategic and operational improvements, as well as tangible profit growth. While this trend reinforces the importance of careful fund manager selection –  the difference between top performers and the rest is wider than other asset classes (see chart) – it can also provide good entry points for new capital.

    Still a good time to invest?

    Much of the economic value created by companies remains inaccessible to an investor whose portfolio contains only publicly-listed assets. An estimated 87% share of US gross domestic product is created by privately-held firms that moreover employ three-quarters of all workers, according to the US Department of Labor. Much of this value, and especially at the early stages of a company’s innovations, can be captured only before a business is listed. An additional factor is that private companies are staying private for longer and there has been a declining number of listed firms over the past decade, according to US census and World Bank data.

    Performance dispersion increases in crisis vintages

    Do this new economic environment and shift in investment style mean that an investor without exposure to private assets has missed their window of opportunity? We don’t believe so. First, liquidity is slowly returning for deals, and market volatility generates investment opportunities. At an industry conference in Berlin last week, Carlyle Group Inc.’s co-head of private equity said that there are signs that deal flow is picking up as banks start lending again after valuations declined over recent months. Second, crises have historically produced strong private equity vintages, but fund manager selection is, as mentioned above, central to success. In economic slowdowns and times of dislocation, capital will gravitate to top-of-their-class managers, with proven ability to generate returns in crises. For instance, during the Great Financial Crisis of 2008-2009, the best managers not only kept investing, but in performance terms, tended to deliver returns that were stronger than through more stable economic phases – one reason being because they were able to buy assets more cheaply. Nevertheless, it is worth noting that performance dispersion also increases in crisis vintages.

    Diversification benefits

    Private assets have a very important role in diversifying an investment portfolio from more volatile publicly-listed assets, across the full economic cycle. While private equity accounts for two-thirds of all private assets, the varying dynamics of private debt, infrastructure, and real estate offer different opportunities.

    Private assets can be an important element in a well-balanced portfolio

    Demand for private credit – or loans extended to non-listed companies – has risen sharply as recent banking sector turmoil has seen banks pull back from lending. Accounting for around 11% of the total private asset market, according to a study this year by Prequin and McKinsey, private credit offers diversification from traditional, liquid bond markets. While bankruptcies and defaults may rise as growth slows, returns from the asset class have traditionally been relatively stable. Loans are typically short term, and at floating rates, where current spreads are some percentage points above market rates, providing investors with the opportunity to increase their portfolio’s yield. With higher interest rates and wider spreads, we see compelling opportunities to achieve strong risk-adjusted returns in direct lending funds. The current economic slowdown and rising rate environment may also prove fruitful for distressed debt opportunities.

    Commercial property rents and infrastructure investments are often index-linked, acting as a hedge against high inflation. Opportunistic and value-add real estate strategies should benefit from the current reset in real estate valuations in both Europe and North America. While challenges facing the office and retail sectors have fuelled some risk aversion, they have also created attractive entry valuations for the best performing real estate fund managers, as they also invest for the long term across secular trends like changing demographics, healthcare and ageing populations, new environmental building norms, and continued technological innovations that are reshaping real markets, such as e-commerce, logistics, life sciences, and new ways of working, among others.

    Finally, the transition to more renewable resources offers opportunities to invest in innovative infrastructure solutions and technologies.

    Private assets are not appropriate for every investor due to the long-term and illiquid nature of investments. However, for those with the ability to stay invested and follow a multi-year investment strategy, they can be an important element in a well-balanced portfolio. A disciplined, selective, and gradual approach is paramount, as is adequate diversification across all sub-asset classes, to benefit from their different characteristics throughout the economic cycle. Finally, the ability to choose and access the investment vehicles from the top managers remains a critical ingredient of successful investing in private markets.

    Important information

    This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
    It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
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