Higher for longer: Private markets may be due a reckoning after a decade of stellar growth

In the first instalment of Investment Week’s ‘Higher for longer’ series, we examine the impact higher interest rates have already had on several corners of the market and how this environment could continue to affect different asset classes.

The number of private funds had tripled within the private market sector over the past decade to over 100,000 vehicles, and assets have swelled to nearly $30trn of invested and committed capital.

The investor base for these types of portfolios has also evolved as assets such as private equity, private debt, infrastructure and real estate are no longer just an option for financial institutions. Through a variety of vehicles, retail investors are starting to gain exposure to this market.

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However, this democratisation wave has come at a difficult time for the sector, which is grappling with steeper borrowing costs as central banks hike rates to levels not seen since the Global Financial Crisis. 

As markets speculate about whether or not the hiking cycle is over, attention has turned to how long central banks will keep rates elevated. Last month, Federal Reserve officials embraced a higher for longer approach to setting rates and slashed the expected magnitude of cuts for the next two years.

The impact of sharply rising interest rates has already been felt across the entire investment landscape, but for private markets, and private equity in particular, experts have said that the prolonged higher cost of funding would act as a headwind, given the heavy use of leverage of the asset class.

Headwinds 

In an environment of higher interest rates and heightened economic and geopolitical uncertainty, private equity was poised for slower growth and lower expected returns than the industry has been accustomed to in the last decade. 

A recent report by Preqin found that global private equity assets under management are expected to grow at a 10% compound rate between 2022 to 2028, a decline compared to the 16.2% increase seen between 2016 and 2022.

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Performance was also forecast to slow to 12.6% over that six-year period, compared to 16% from 2016 to 2022, with the internal rate of return in Europe expected to drop to 10% by 2028 from 16.1% in the preceding six-year period. 

According to Gauld, the risk of rising rates meant that it increased interest costs and reduces free cash flow in underlying portfolio companies, potentially reducing scope for further investment in the company. 

Higher financing costs could also slow down the process of de-levering an investment and can, in turn, increase the risk of covenant breaches and default, he said, while also moderating the valuations of all assets, including private companies.

Earlier this month, the Financial Conduct Authority said it would be launching a review into private markets valuations, as concerns mount over the impact of higher interest rates on the industry.

“The macro economy has moved from a period of low interest rates for a very lengthy period of time, and markets are now expecting higher interest rates for longer,” said FCA CEO Nikhil Rathi.

“At some point, you might expect that risk will crystallise in valuations of assets. Those valuations of assets could be assets like commercial real estate, and we know what’s happening in China.”

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The move came as regulators have expressed anguish that higher debt financing costs and easy money being withdrawn could lead to a crisis in the private markets, as the valuations in the sector lag the public market.  

Gauld noted that although “high-quality” buyout managers have been conservative in valuing their portfolios in the last decade, there is a “valid question” around whether valuations remain as conservative today following the declines in public markets during 2022.

“It might be the case that the uplift upon exit in private equity could moderate somewhat in the future, although we have not seen any evidence of that so far,” he added. 

Richard Moore, co-head of investments at Calculus Capital, said it was usual for there to be a lag between an increase in the cost of capital and the expectations of investors on the one hand, and the ambitions of companies raising funds on the other.  

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“This was particularly the case during the first half of 2023, although in recent months companies coming to market to raise fresh capital have become more realistic,” he said. 

“After a show of resilience to the pandemic and a particularly strong 2021, private markets have seen falls in value in the tech and life science sectors, although it should be remembered that this was after a period of significant gains.”

According to Barry Fricke, head of EMEA alternatives distribution for wealth at Goldman Asset Management, asset classes who’s cash flows are further into the future, such as venture capital, have had bigger valuation declines, while valuations in buyout strategies tend to drop to “a more modest degree”. 

Private credit valuations, however, were more insulated from the impact of fluctuating interest rates, he added, as the coupons were floating rate  and higher rates have “translated into higher coupons”.

Opportunities 

Rising interest rates have stifled private equity investment activity in the last year, resulting in a ten-year low in global dealmaking, according to data by the London Stock Exchange Group.

While new investment activity is relatively low right now in private equity, Gauld argued that differing buyer and seller expectations are likely to start converging with greater stability in rates. 

“A higher interest rate environment will eventually bring opportunities on the new deal front,” he said. “There will be forced sellers and more differentiated dealflow, and new deals should be at a more modest entry pricing, relative to long-term averages.”

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“Private equity has delivered strong returns as an asset class over several decades, even prior to the Global Financial Crisis when interest rates were not as low as they have been recently.”

Goldman Sachs AM’s Fricke also said lower valuations could potentially present an “interesting” entry point, while valuations and deal flow for sectors with secular, long-term growth prospects, such as renewable energy or digitalisation, remain robust. 

With some of the highest borrowing costs seen since 2008, he noted that being a lender – such as to corporates or against hard assets such as real estate – is “well compensated”, with the ongoing growth of the private credit industry accelerating further in the last year.