Dr Nils Rode, Chief Investment Officer at Schroders

 

A normalisation in fundraising and valuation adjustments create promising investment opportunities. The artificial intelligence (AI) revolution and other long-term trends make certain private market strategies especially appealing. Furthermore, a potential easing of inflation and anticipated interest rate cuts could provide short- to mid-term tailwinds. However, due to ongoing political tensions within and between countries, and escalation risks for ongoing conflicts, diversification within private market allocations is crucial.

 

At the beginning of Q3 2024, private markets have largely reverted to pre-pandemic levels in terms of fundraising, investment activity, and valuations, creating a favourable environment for new investments. Some areas have even corrected beyond 2019 levels. In 2023, fundraising was concentrated on large funds, making small and mid-sized private market strategies particularly attractive. This is evident in private equity, where buyout fundraising for large funds reached record levels, while the rest of the market remained healthy.

 

Historically, fundraising has been a valuable contrarian indicator. In many private market strategies, fundraising levels and dry powder directly influence entry valuations and impact vintage year return expectations.

 

We find private market investments aligned with the AI revolution and the 3D Reset (decarbonisation, deglobalisation, demographics) particularly attractive. AI is driving investment activity across private market strategies, notably in venture and growth capital for innovation, as well as in data centres and renewable energy, addressing increasing energy needs in a sustainable way.

 

Income has become particularly appealing across most markets, with private debt and credit standing out. We favour investments that benefit from market inefficiencies, focusing on fundamentals over distressed assets.

 

Although interest rates are likely to remain higher for longer, we anticipate that easing inflation and potential interest rate cuts will provide a tailwind for private market investments in the short to mid-term. This is especially true for real estate, where significant valuation corrections have occurred, and our proprietary valuation frameworks suggest that 2024 and 2025 will be attractive years for new investments.

 

While our private market investment outlook is generally positive and has not changed materially from prior quarters, we believe that given ongoing geopolitical risks and domestic political tensions as well as escalation risks from ongoing conflicts, it’s essential to maintain high selectivity and robust diversification within private market allocations. In the following, we highlight the most attractive opportunities within each private asset class.

 

Private equity

 

Private equity has broadly normalised with fundraising and deal volumes back to pre-Covid levels. Larger exits, however, remain especially slow relative to 2019, while smaller exits have been more stable.

 

We advocate for a highly selective approach to private equity investments, focusing on opportunities that resonate with global trends and can capture a complexity premium.

 

We prefer small to mid-sized buyouts over larger ones due to a more favourable dry powder environment and a valuation discount of around 6x EV/EBITDA. Furthermore, there are attractive exit opportunities for small buyouts as around 60% of dry powder currently sits with large buyout funds.

 

Co-investments are attractive as banks have withdrawn from the lending market and credit funds have been more cautious. The equity requirement in deals has increased, resulting in a capital gap that active co-investors can step into.

 

GP-led transactions are compelling due to the lack of traditional private equity exit routes and demand for distributions. We find both single-asset and multi-asset GP-led investments attractive. Single-assets can provide runway for star assets while multi-assets provide an efficient end of fund-life solution.

 

We believe the innovation in AI, disruptive energy technology, and biotechnology will be driven by seed and early-stage ventures. Early-stage investments benefit from a disciplined fundraising environment, leading to more conservative entry valuations. Conversely, late-stage or growth investments face higher refinancing and valuation risks due to decreased venture capital fundraising and a still-closed IPO window. In terms of sectors, generative AI investments have surged across private assets, with venture funding for generative AI projected to reach nearly 15% of total venture investments in 2024, up from just 2% in 2022.

 

From a geographic perspective, we find North America, Western Europe, China and India attractive. China remains the second-largest private equity market globally, with the RMB market playing a pivotal role in driving growth. India’s private equity market is promising due to its robust long-term economic growth prospects, a rapidly growing private equity industry, and a broad spectrum of high-growth private companies.

 

 

Private Debt and Credit Alternatives

 

Income remains highly attractive across most markets. Despite peaking interest rates in developed markets, we anticipate they’ll remain higher than levels seen in the past two decades, suggesting an opportunity to reallocate to income.

 

Banks in the US and Europe continue to reduce their lending volumes as they attend to increasing regulatory pressure as well as distress in their commercial real estate loan portfolios. The result is a significant risk premium available beyond rates for alternative, non-bank lenders. As risk premiums in the liquid debt market have collapsed, private debt and credit appear very attractive.

 

We favour investments offering high income and benefiting from capital provision inefficiencies. These include:

• Defensive income from infrastructure debt with stable, low-volatility cash flows.
• Opportunistic income from sectors with distress that causes emotional bias, like real estate debt.
• Uncorrelated income from sectors such as insurance-linked securities.
• Diversifying income capitalising on changes in bank regulation, like asset-based finance, or sectors with limited capital access, like microfinance.

 

Our focus is on fundamentals rather than distressed assets. We target areas with emotional bias due to distress but avoid those with unresolved fundamental issues. For example, while commercial real estate debt faces fundamental distress in the office sector, this has unfairly impacted investor sentiment towards healthy sectors like apartments. Local apartment markets with recent inventory spikes will see rent growth recovery due to reduced future supply from higher financing costs. Unlike offices with excess space, the US still faces a housing shortage.

 

Today, most liquid markets have historically tight risk premiums. Value remains in agency mortgage-backed securities (MBS), non-syndicated MBS/asset-backed securities (ABS), and specialised sectors such as insurance-linked securities.

 

Insurance-linked securities provide valuable portfolio diversification due to their lack of correlation with macroeconomic conditions and offer attractive returns due to higher yields driven by reinsurance limitations.

 

The growing interest in income allocations and maturity of private debt allocations have created a need for diversification. Asset-based finance is a key area of inquiry due to its diversity and the benefits of Basel III impacts in the US. Opportunities within this sector span equipment, consumer, and housing, and can be accessed directly, via financing, or through risk transfer mechanisms such as bank capital relief.

 

As investors face extensions in their traditional private debt book’s maturity, strategies generating cash flow, particularly with near-term income or capital return – as is the norm in asset-based finance – are in greater demand.

 

 

Infrastructure

 

The energy transition segment in infrastructure is particularly compelling due to its strong inflation correlation and secure income traits. It also diversifies portfolios through exposure to distinct risk premiums like energy prices.

 

The push for decarbonisation, coupled with energy security concerns, which are amplified by the conflict in Ukraine, continues to benefit renewable energy. The cost-of-living crisis has also spotlighted the issue of energy affordability. In many regions globally, renewables have become the most cost-effective option for new electricity production.

 

Currently, renewable energy in Europe has a €600 billion base, representing 45% of infrastructure transactions. By the early 2030s, this is forecast to more than double to €1.3 trillion, potentially making renewables and energy transition infrastructure the majority of investable assets in the sector.

 

Renewable-related technologies, such as hydrogen, heat pumps, batteries, and electric vehicle charging, will play a crucial role in facilitating the decarbonisation of sectors like transport, heating, and heavy industries.

 

The market has shifted to a buyer’s market, recalibrating expected equity returns due to rising interest rates and reduced dry powder, creating a gap between renewable projects and limited capital investment. This makes the current environment attractive for core/core+ strategies, with equity returns rising over 200bps in the last 18 months. We favour core/core+ strategies that benefit from strong asset performance and enhanced cash generation via active management. Selectively, there are higher return opportunities in infrastructure projects like hydrogen, although we remain cautious on early-stage developments due to capex volatility.

 

We see a return dislocation between listed and private markets, with listed assets trading at a discount, leading to significant take-private transactions.

 

AI advances are boosting renewable sector demand, notably increasing electricity consumption for data centres (e.g. Ireland’s electricity consumption is expected to increase by 32% in the next 10 years, driven by an expansion of data centre capacity). This demand shift supports long-term green electricity pricing, underpinned by corporates’ net-zero ambitions.

 

In terms of geography, Europe and North America benefit from these dynamics, where energy security concerns mitigate short-term political impacts.

Real Estate

 

The real estate market has been experiencing value corrections across the globe, albeit with varying degrees of progress made across regions, sectors, and investment structures. This presents a live sequential opportunity to access the asset class on an attractive basis. Indeed, our proprietary valuation framework suggests that 2024 and 2025 will be opportune years for real estate investments, with some market segments likely to have already fully rebased.

 

Occupational markets remain robust, with expected growth in most real estate sectors, particularly those driven by favourable structural trends. Tight supply conditions due to increased construction and debt finance costs, continue to support rental income levels. The lack of high-quality ESG-compliant spaces will also help stimulate rental growth post-economic recovery.

 

Opportunities are emerging from ongoing constraints in the debt capital markets. Refinancing waves, including platforms seeking capital solutions to shore up balance sheets, are anticipated to accelerate these opportunities amid further price discovery in 2024.

 

Despite more volatile geopolitical conditions, we believe that interesting investment opportunities are starting to arise in selected parts of the markets where strong fundamentals prevail. Immediate opportunities are present in markets where rapid repricing has occurred, such as the UK and Nordic region.

 

In Asia-Pacific, opportunities that align with China’s delayed recovery or support nearshoring/friend shoring of supply chains are favoured. Industrial and logistics assets have rebased to attractive price points in most submarkets. We prefer operational properties with strong demand-side tailwinds and direct or indirect inflation-linked income potential.

 

The current environment reinforces our focus on operational excellence to ensure long-term, sustainable income and investment outperformance. We believe all real estate has become operational, aligning the financial outcome of investments with the success of tenants’ businesses within these assets.

 

 

ENDS