Asset Allocation: Private Markets See Less Activity, More Scrutiny

Summary

• Private market activity has fallen in H1, with total vehicles closed down over 50%.
• Investment trusts exposed to the private market are currently trading at wide discounts to their NAV as low liquidity and fears over asset valuations hurt investor sentiment.
• Overall, private market companies remain in robust shape. Large discounts to NAV could offer patient investors an attractive entry point to gain exposure to interest assets while management teams are engaging in share buy-backs to narrow the discount.
• Private credit currently looks attractive versus high yield given the floating rate exposure, especially in the US where balance sheets remain strong and recession fears have calmed. Meanwhile, high-yield spreads have narrowed materially.

Update on Private Markets

We have been bearish on private markets this year. Rising interest rates challenge the business models of private equity firms, which tend to use leverage in the buyout (LBO) and value realisation phases.

We see exits becoming harder as public market valuations compress after the rapid interest rate rises over the last 12 months. Strategies that involve taking on floating rate debt as part of the LBO also face difficulty as higher interest costs pressure cash flows.

Venture capital also faces challenges. A significant influx of capital into the industry had boosted valuations, but the last 12 months saw an unwind – and challenges remain. Without the influx of capital, businesses that have failed to achieve product-market fit have seen revenues slow as they pull back on SG&A spend to focus on profitability.

We think valuation differentials (along with the use of leverage) drive private market outperformance. Shrinking valuation discounts can be seen as investors applying a lower liquidity discount, reducing expected returns. AQR has shown some investors are willing to pay a premium in some cases for this illiquidity as it also comes with smoother returns.

This year’s public market rally will help private market performance by lessening the pressure to reduce valuations.

How Have Private Markets Assets Performed This Year?

Private market data is generally difficult to obtain. Industry-wide data tends to be lagged, and there is little transparency around the valuations of investment companies.

To surmount these challenges, we look at 12 listed investment trusts in the UK that invest predominantly in private markets via a closed-ended fund structure. This is valuable to us for three reasons.

1. Portfolio company valuations tend to be more frequent.
2. It indicates how the public market is thinking about the private markets based on the discounts the market ascribes to the net asset value (NAV) of the fund.
3. There is greater transparency around what is driving the changes in NAV, particularly at year end.

The private market funds chosen span mid-market buyout, growth equity, private credit, and venture capital.

When assessing the performance of the investment trusts, we find the following:

1. Last year, we saw the market value of the investment trusts fall sharply even as the NAVs were marked higher (Chart 1).
2. Despite performance being more mixed this year, all but three private market funds marked down the value of their NAVs (Chart 2).
3. The market value discount to NAV has widened year-to-date for all but three private market funds (Chart 3).

On the last point, many of these assets typically trade at a discount to NAV due to factors such as low liquidity and caution over asset valuations. However, the current discounts ascribed by the market are far wider than the historic average of c. 20% (currently 40%).  

What Is Driving Private Market Valuations This Year?

1. Deal-making has slowed

The biggest takeaway is that private markets are still recovering from the sharp drawdowns in public markets last year, driven by the rapid increase in interest rates. This has resulted in a sharp slowdown in deal-making. Private Equity International finds that fundraising dollars raised by private equity funds globally reached $315bn this year versus almost $400bn this time last year. Further, just 508 vehicles were closed during the first six months, 466 fewer than last year (Chart 4).

The decline in activity was broad-based and impacted realisations among existing funds. Slowing activity mean exits become harder to realise. The impact on investors is that distributions fall, and cash management and liquidity become more important. Capital calls could also increase as GPs have less cash to fund new investments and there is an increased likelihood of extension requests for funds in their asset realisation phase. 

2. Realisations are still occurring at a premium to the holding value

Despite a slowdown in activity, realisations that proceed are still doing so at a premium to the carrying value. For the companies we monitor, the premiums realised vary around the 10-30% mark, which is slightly lower than the historic norm.

We think the resiliency is due to only the ‘trophy assets’ coming to market. This matches what we see from the private market funds. Given the slowdown in deal-making, we think the uplifts would be far smaller and potentially on a par with the previously held valuations if we saw a greater volume of assets being realised.

3. Portfolio companies (portcos) are more resilient to interest rate hikes

As discussed previously, households and corporates used the Covid period to lock in loans at low interest rates. This is also true in the private markets, particularly in mid-market buyout.

Princess Private Equity (PEY), for example, locked in low rates for their portcos that mature well into 2024 and 2025. The general equity-debt level within the companies is also lower than in the past, at 60%.

Pantheon International (PIN) ensured their portcos took on fixed rate debt rather than the floating rate exposure more typical within private markets. Companies that had floating rate exposure began hedging their risk using interest rate swaps towards the end of 2021 and early 2022, meaning there is an increased resiliency to higher rates.

4. Investors remain concerned about private market valuations

Given the drawdown in public equity valuations, investors are scrutinizing the legitimacy of existing marks. We think this is an important reason for the increase in private market funds’ discounts to NAVs this year as inventor appetite continues to sour.

Here we have three takeaways:

1. Auditors and LPs alike are reluctant to keep valuations at their last funding round. There is increased pressure placed especially during half and full-year end to ensure valuations reflect the current profile of the business in line with IPEV guidelines rather than keeping valuations fixed.
2. Valuations in public markets rose less in 2021 than those in public markets, which explains some of the resiliency seen in 2022. Valuations have also been calibrated to minimise the impact of multiple expansions and instead focus on improved business performance (75-25 ratio of business performance to multiple expansion).
3. Using a blend of market comparables is preferred to other methods such as DCF where the assumptions can be inflated. 

Investor and auditor focus on private market valuations is a positive development that should continue to increase the transparency investors receive.

What About Venture Capital?

The situation in venture capital (VC), while similar to growth equity and mid-market buyout, will vary based on the early-stage nature of the businesses.

We highlight the following differences.

Investors are demanding greater terms when looking to participate in future rounds. Investor demand for anti-dilution provisions and pre-emption rights has increased. This allows investors to gain further protection from unforeseen funding requirements diluting their ownership and lets them purchase more shares before exits.

Higher big tech valuations have not translated over to VC. Despite big tech names driving higher public market valuations, the smaller cap tech companies have continued to see multiples remain steady or compress. VC is also the area that saw the largest decrease in valuations last year.

Finally, M&A is increasingly seen as a better exit route for businesses rather than the public markets. Given the difficulty smaller tech businesses have going public, a greater number are positioning themselves for takeover, either by another private vehicle or a larger technology business.

Private Credit Remains Resilient

Private credit is still the main area where activity remains comparable to recent years, particularly in Q2. Ares Capital (0HHP), one of the largest players in the space, said activity firmed relative to Q1. They also note that US banking issues have boosted demand for private credit as bank lending standards tightened.

The business is also able to demand attractive terms, while leverage levels relative to equity remain lower than in previous years. This speaks to the stronger balance sheet theme we discussed above. Meanwhile, most deals are still floating rate, which means the risk-adjusted returns calculated by Ares are said to be 15% higher than its 10-year average. For context, the weighted average yield earned by Ares was around 11.5% in Q2, while net debt to EBITDA remains low at around 4.5x.

What Does This Mean for Investors?

We remain underweight private markets. However, we recognise the value available, especially in the listed market space, for patient capital holders who are comfortable with owning less liquid vehicles. The large discounts to NAVs provide an attractive entry point to access high-quality assets and experienced management teams who are actively buying back shares to close these discounts. This should also help with liquidity concerns when buying.

Excluding the public market alternatives, we hold out for more attractive valuations to increase allocation to private markets more broadly. For us, private markets are best used selectively to gain exposure to assets not readily available in the public markets, such as infrastructure, and smaller mission-critical businesses that generate substantial cash flow.

A recession being pushed out, particularly in the US, opens the opportunity to gain exposure to private credit (versus high yield, for example), particularly while company balance sheets remain robust. However, we would be more selective, ensuring capital is invested with high-quality teams with strong track records.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Viresh Kanabar has worked in the UK financial services industry for over 8 years including in Consulting and Investment Risk. Most recently he launched The Macro Journal Substack where he puts out regular in-depth reports covering all areas of global macro.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)