Private assets return to fundamentals

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.

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.

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.