Private market assets not immune from interest rate and inflation challenges

THE macro environment is rife with uncertainty. On the geopolitical front, the war in Ukraine looks set to be long-drawn. Add to that the simmering tensions between the US and China over Taiwan. Markets are on tenterhooks, parsing the US Federal Reserve’s every move. Inflation remains stubbornly high, which suggests that the Fed is on track for yet another big rate increase this week. The BofA Global Fund Manager Survey for September records “super bearish” sentiment with cash levels at 6.1 per cent, and global growth expectations near all-time lows.

Amid such storm clouds, it is not surprising that the wealthy are gravitating towards private market assets, which promise the potential to generate not just higher returns than public markets but also uncorrelated returns. Lombard Odier in its 2022 high-net-worth study finds that the wealthy in Asia-Pacific have been repositioning their portfolios away from traditional assets towards alternative and private assets over the past couple of years. Among Singapore investors, as many as 60 per cent aim to raise their allocations.

Interest in private assets has been building through the years. According to Preqin, assets under management (AUM) in private equity (PE) grew from US$1.72 trillion at end-2010 to US$4.56 trillion in 2020; its compound annual growth rate accelerated from 6 per cent from 2010-2015, to 14.9 per cent between 2015 and 2020. Preqin itself forecasts robust growth of 15.9 per cent over the next 5 years, which would take the AUM to US$11.6 trillion by end-2026.

But what prospective investors should note is that just as record-low interest rates and central bank-fuelled liquidity fired up public markets in the past decade, they also lit a fire under private markets. Now that rosy backdrop has turned, and challenges loom on a number of fronts: 1) persistent inflation and slower growth will hit PE portfolio companies’ profitability; 2) higher interest rates will raise financing costs, particularly for leveraged deals. Beyond financing, however, higher rates and the spike in risk aversion are also set to make capital raising more difficult, particularly now that assets such bonds and US Treasuries have become more attractive.

But the biggest crunch may lie in valuations. Private assets are not spared the valuation reckoning posed by higher interest rates, especially for assets purchased in the past year or two, when it seemed as if the Goldilocks environment could last longer. With the upheaval in equity markets and investors casting a sceptical eye on issues, PE managers will also have to get realistic on exit avenues and valuations. On the flip side, those sitting on ample dry powder could pick up assets more cheaply.

Investors in private market assets will have to be far more discerning than they have been in the past decade, when the expansion in valuation multiples lifted all boats. Persistently high inflation, for instance, is a fresh factor that portfolio companies may not be prepared for, coming on top of supply chain snarls. While PE has historically proved rewarding – Preqin found that median net IRRs (internal rate of return) have exceeded 15 per cent every year since 2001 – the big question is whether they can be replicated should inflation and higher rates become the norm. While PE will still help to diversify portfolios, investors will likely need to tamp down their expectations of returns.