Private markets in 2023 – new ideas for a new regime
CHARACTERISED by challenges and opportunities, 2023 marks the next evolution for private markets. Higher interest rates and a shrinking Federal Reserve balance sheet are lowering liquidity in capital markets, creating financial headwinds across all major asset classes.
Furthermore, the rapid pace of rate increases has started to expose hidden vulnerabilities in certain sectors of the economy, increasing the frequency of sudden shocks or short-term crises.
The structural drivers of the ongoing evolution of private markets remain intact, but 2022 signalled a reset in the investment environment and an end of the easy money era. As a more challenging landscape emerges, investors need to consider new ideas for a new regime in private market investing.
As a diversified manager with specialised capabilities across the broad spectrum of private market investments, we believe there are opportunities in private markets that look more attractive today than in the last decade.
Private equity – paused, awaiting a reset
The private equity (PE) market reached an inflection point in 2022 as the idyllic era of declining interest rates and ever-growing valuations came to an end.
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PE exit activity dropped sharply in 2022, hindered by macroeconomic headwinds which are likely to persist in 2023. Furthermore, the sudden collapse of Silicon Valley Bank (SVB) was a shock to the system that will likely have further ramifications for the banking sector as a whole.
While we do not see the failure of SVB as an enduring risk for private companies, we do think it is a catalyst that will accelerate the shakeout in valuations that was already underway in the private equity and venture capital space.
Meanwhile, venture is in a period of deep revaluation that will require time for both buyers and sellers to agree on an appropriate multiple. Furthermore, increasingly negative sentiment around cryptocurrencies and exchanges has hit many startups even distantly associated with blockchain technology.
Looking through a longer-term lens, blockchain is an important technology with far greater applications than cryptocurrencies. Blockchain technology is the key to ushering in what we consider to be the next phase of commercial technologies – the period of decentralisation.
We think exits will remain low in 2023, potentially leading to a real reset in valuations. Lower-tier companies in their industries are likely to see the largest reductions, while top-tier industry leaders that are well-managed and well-capitalised should weather the storm better.
Private equity secondaries – no longer niche
It appears that 2023 will be a pivotal year for private equity allocators to take advantage of the growing secondaries market. Secondaries markets have evolved and deepened substantially, with more than US$100 billion in volume in 2022 alone.
This emerging marketplace provides an alternative to investing purely in primary fundraises. 2023 presents a significant shift in the supply-demand dynamics of secondaries markets. We expect secondaries supply to significantly outpace demand in 2023.
For asset allocators, secondaries allocations can help build more diversified private market portfolios by providing access to mature companies from many different managers, vintages, asset classes, industries, and geographies.
We are seeing a lopsided secondaries market that will likely heavily favor investors on the buying side of the negotiating table. From a risk/reward perspective, we believe 2023 will be a year to remember for secondary market opportunities.
Private credit – hardwired for hard times
The dramatic change in the macroeconomic backdrop has created headwinds for borrowers but has provided unique tailwinds for private debt managers.
Today, the private debt asset class presents a far different picture and shows how this segment is essentially “hardwired” for a rising rate, risk-off market environment where traditional modes of financing have been shut off for corporate borrowers.
In the current environment, lenders have much greater influence to secure stronger covenants versus years past. What has materially changed in private credit investing is the need for skilled and experienced workout teams in case the macroeconomic landscape worsens and defaults arise.
A large portion of private debt market investments were made during a sanguine market environment, without serious recessionary pressure or risk of defaults. Direct lending funds with experienced workout personnel and demonstrated high recovery rates may be better able to weather the shifting credit cycle.
In other parts of private debt, there is now a much larger opportunity set in distressed debt than during the previous decade. In less than two quarters, the stressed opportunity set quadrupled from US$75 billion to US$300 billion.
A phrase that many had forgotten is beginning to resurface, “good company, bad balance sheet”. Today, higher costs of capital and tighter financial conditions have limited corporate flexibility. As a result, good businesses that have made mistakes can become stressed, providing very attractive opportunities for special situations investors.
We believe the best risk/reward today lies within a portfolio of uncorrelated and bespoke process-oriented investments, event-driven themes, and names that stand to perform during a recessionary and inflationary environment.
Next generation of growth – the long(er)-term lens
Looking through a multi-decade lens, we see several emerging megatrends that will propel private investments for the next decade or more. In particular, we see growing momentum in three areas – energy transition, food innovation, and decentralisation.
We are in the midst of a remarkable transformation of the energy systems underpinning our economies. To reach global net-zero targets, annual clean energy investments must increase by more than three-fold by 2030. More than US$3 trillion is needed to fund innovative solutions for both adaptation and mitigation, including renewable energy, battery storage, and green industrials as well as carbon removal and capture.
As we pivot to a more electrical, low-carbon world, demand for electric vehicle technology is exploding, requiring exponential investment across a range of sectors, including the entire battery value chain as well as technologies related to materials and components, energy storage, recycling, and resource recovery.
By 2030, food demand is forecasted to rise by 50 per cent, while production of staples such as corn and wheat will decline by up to 30 per cent, due to climate change. Global agricultural production must rise 70 per cent by 2050 to feed more than 9.3 billion people, the World Bank indicated.
Solutions to improve the food system are wide-ranging – but innovation in the food industry must be financed. It is estimated this transition will generate US$10 trillion in additional business revenue and cost savings and more than 395 million jobs by 2030 – of which US$3.6 trillion and 191 million jobs are directly related to changing the food system. There are investment opportunities across asset classes, with private markets playing a growing and significant role.
Societies have already undergone massive technological transformations, however, the upcoming cycle of change may be the most disruptive yet.
We believe the decentralisation cycle will have profound impacts on the way that businesses function and on the relationships between a commercial enterprise and the individuals that make up its employee and customer base. These seismic shifts will fuel the next generation of growth in private investing.
Stephen Dover is Franklin Templeton’s chief market strategist and head of Franklin Templeton Institute. John Ivanac is SVP and consultant advisor at Franklin Templeton with a focus on alternative investment capabilities in the US.
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