Alts managers hope for rate cuts to spawn more deals in 2024, while battling for new money

Most investors plan to maintain or increase their private markets allocations in 2024, banking on private equity and credit returns continuing to outstrip those of stocks and bonds despite the pain they suffered in 2023.

Private equity and private credit industry executives anticipate that the Federal Reserve's signaled interest rate cuts could relieve some of the pain by kick-starting transactions. Without transactions, private credit managers can't spend the capital they've amassed to make or invest in loans and private equity managers can't exit portfolio companies that would be providing profits for general and limited partners to share.

During the first three quarters of 2023, the transaction value of global private equity exits was a combined $232.4 billion, 55% of the value of private equity exits in all of 2022, a Preqin private equity report noted.

This dearth of exits means less money through the door to LPs in the form of distributions, making investors hard pressed to commit to new funds. In the meantime, companies also have to contend with a higher cost of debt, which could cause issues not only for their private equity owners but also their private credit lenders, which might have to make concessions to prevent defaults.

"Although interest rates could come down 75 basis points in the new year, there's still pressure on companies which, when they were bought, did not forecast that senior debt" would be as high as it is, said Jim Pittman, executive vice president and global head, private equity, at British Columbia Investment Management, which had C$215 billion ($161 billion) in net assets under management as of March 31.

"It will put pressure on companies that are not doing as well as the rest," especially those that are smaller than $1 billion in enterprise value, do not have as robust management teams and were highly levered in anticipation of rapid growth that did not materialize, he said.

Pittman does not share concerns that there could be a private debt bubble.

"Company owners have to be good at generating value and cash flow" in a higher interest rate environment, he said. Additionally, "banks use much higher leverage than private debt," he said.

But if interest rates stay at 10% or more for two or more years, then there will be higher default rates in private credit portfolios, Pittman said. "If we believe Jay Powell (chair of the Federal Reserve), even if rates come down 1%, companies will use up less cash," he said.

BCI has had two or three companies in its $13 billion direct private equity portfolio that have had issues, but those companies have been having issues for more than two years now, Pittman said.

"We're not seeing companies get that much worse," he said. However, BCI's direct private equity portfolio is made up mostly of companies that have an enterprise value of at least $1 billion and so they are more stable, he said.

Even with the risks and uncertainties in the private markets, investors are indicating that these investments are still worth it.

According to secondary market manager Coller Capital's latest LP survey released Dec. 11, 90% of surveyed investors plan to maintain or increase their private markets allocations. Forty-four percent of investors indicated they are most likely to increase their target allocations to private credit.

For BCI, credit is a better bet right now among private market asset classes.

In September, BCI along with sovereign wealth fund Abu Dhabi Investment Authority jointly committed almost $2 billion in initial equity commitments to be anchor investors in a direct lending fund to be formed by Centerbridge Partners and Wells Fargo & Co.

"As an organization when we sit on the investment committee and can be paid 9% to 10% returns in credit where (no other lender) is ahead of you, why would you go invest on the equity side" with lower returns and added uncertainty, Pittman said.

Global private equity posted a -4.5% net internal rate of return for the 12 months ended March 31, a dramatic turn from gains of 29.3% net IRR in the year-earlier period, according to a Preqin private equity report released in December.

Preqin forecasts that global private equity IRR's will fall by a total of 3.4 percentage points by 2028 from 2022 due to challenging economic conditions and higher-than-expected interest rates.

These return prospects combined with high interest rates and embedded inflation will make the next few years challenging for both fundraising and assets under management until a strong pickup in 2028, Preqin predicted.

Fundraising for private equity funds will still be challenging in 2024 because it's hard for investors to make new commitments when their GPs are sitting on a big pile of assets that haven't been exited, said Chris Webber, director at placement agent Monument Group. Plus, volatile public markets is increasing private market asset classes' share of investors' portfolios, pushing them at or above their target allocations.

These factors caused a major pause in LP commitments in 2023 before investments started to pick up in August.

"There's a lot of capital tied up in these embedded gains that have not been realized ... that's what driving up (LP) overallocation to a degree," he said. "We're hoping (in 2024) to see more liquidity and deal volume pick up across the market and that will inherently drive the momentum in the fundraising market."

In 2023, global private equity firms raised $508.6 billion in the nine months ended Sept. 30, which is 46% of the capital raised in all of 2022, the Preqin report said.

While many investors are leaning in on private credit, they are doing so with the understanding that the sector is not without risks, industry insiders say.

One of private credit's largest sectors, direct lending, is expected to return 7.3% by 2028 from a net IRR of 7.7% in 2022, Preqin projects. Distressed debt is expected to double to 14% by 2028.

"Market participants are focused on interest coverage ratios," a formula that shows whether the borrower can pay off its debt," said Mary Bates, managing principal and private markets consultant at Meketa Investment Group. "The margin of safety for a lot of companies has declined."

While investors are of the view that there won't be a significant uptick in defaults, she said, "We will probably see some, but not a meaningful distressed opportunity."

"We expect an uptick in capital solutions" in which managers create customized solutions for borrowers, such as offering rescue financing, Bates said.

However, Bates added, "an opportunity-rich environment for special situations can be a challenging credit environment in which one would expect to see more impairments in portfolios."

Jeff Diehl, managing partner and head of investments at Adams Street Partners, expects a widening of manager dispersion, with investors favoring "managers that behaved well and didn't get over their skis on company level leverage" vs. those that did not.

It will be a good time for investors to dig into their manager due diligence "and not rely on top-line IRR (internal rate of return) numbers," he said. "I expect return dispersions on the private equity and the private credit sides, which have been quite benign for a while."

Still, private market asset classes' expected long-term outperformance against the public markets is hard for some investors to resist.

For example, in November, the $15.7 billion New Mexico Educational Retirement Board, Santa Fe, completed a review comparing private and public market performance as part of an overall review, said Bob Jacksha, the retirement plan's chief investment officer.

For the year ended March 31, private equity produced a -0.51% return compared to total public equity's -17.89% for the year ended Dec. 31, 2022, according to a report to the New Mexico retirement plan's board by NEPC, its general investment consultant. (Private equity performance generally lags by one quarter.) Opportunistic credit returned 0.89% for the year vs. -0.55% for fixed income.

Private equity and private credit also outperformed public equity and fixed income in the 10-year time frame: private equity produced 15.31% vs. total public equity at 7.99%. Opportunistic credit returned 6.42% vs. fixed income at 4.78%.

"The main point of the comparison is to evaluate whether or not the extra time and effort involved in private assets is worth it. We say, yes, given the outperformance," Jacksha said.

New Mexico Educational Retirement Board had $3.6 billion in private equity and $2.8 billion in opportunistic credit as of Sept. 30.

A dip in interest rates could make it easier for private market managers to again outperform the public markets in 2024, industry insiders say.

Higher rates mean private equity managers have less room to maneuver because they buy companies at a lower price when rates are high, BCI's Pittman said.

"There's been a lot of pressure on private equity GPs because many of their investors are overweight private equity and private assets, in general," he said.

According to Pensions & Investments' annual survey of the largest U.S. retirement plans, private credit assets among the 200 biggest plans grew 12.5% to $98 billion in the year ended Sept. 30, 2022, despite some asset owners' portfolios falling during the period. Private equity was up 2% to $692 billion in the year ended Sept. 30, 2022.

Another stumbling block for the industry is the continued uncertainty around valuations. Private market participants use public market comparisons as well as transaction prices in recent deals as metrics in valuing their portfolios.

When public markets are more liquid and transactions are more fluid, investors and managers have a better idea of valuations than when mergers and acquisitions are down about 60%, he said.

Jeremy S. Schein, a partner with alternative investments firm Corsair Capital, is also optimistic that transaction volumes will increase in 2024.

"Many companies seem to be 'getting ready to get ready' to sell," he said. "Despite the IPO market's slow recovery, if market levels remain steady and prospects of a soft landing with lower interest rates grow, we could see increased strategic bids, utilizing stock for transactions as early as Q1" of 2024.

But uncertainties, including the 2024 presidential election in the U.S., will prompt buyers to remain cautious and Corsair executives expect more targeted sales, in which buyers reach out to potential sellers, than had been the norm a few years back, he said.

Another reason transactions could be just starting to pick up is that private equity managers have a total of more than $4 trillion in dry powder, said Thomas Smale, chief executive of FE International, a midmarket tech-focused M&A advisory company. So they're getting more creative to deploy that massive amount of money, including smaller deals, Smale said.

For example, private equity managers previously aiming to acquire companies above a $100 million enterprise value may now be looking at deals with a $50 million enterprise value instead, he said.

In 2024, private equity managers will remain "disciplined on the financial profile of the target company," by avoiding companies losing money, Smale said.

"Deals are happening where buyers are willing to get creative and sellers have less inflated expectations on valuations that may have happened in previous years," Smale said.

Even with a bit of a pickup in transactions, there are still fewer deals than in the past, which means that managers have to hold onto assets longer said James Reynolds, global co-head of private credit at Goldman Sachs Asset Management. GSAM has $110 billion in credit assets under management.

"With the lack of IPOs and limited exits in private equity-owned assets, the effective duration of our investments is increasing," Reynolds said. "Expect some pent-up exit activity leading to some active harvesting level in 2024 onwards."

In the last six months, Reynolds said there has been "a notable increase" in private equity-backed transactions, including some increases in deals that take public companies private, he said.

Goldman Sachs' Reynolds is optimistic that transactions will ramp up in the first half of 2024.

In the meantime, GSAM was a very active lender in 2023, he said. The higher interest rates have benefited GSAM's credit business, generating "the most attractive yields I've seen," he said.

To guard against risks of borrowers who cannot pay the elevated financing costs, GSAM lends to companies that generate predictable cash flow, Reynolds said. Those companies will continue to service the debt and to grow, he said.

Molly LeStage, managing principal, private markets consultant at Meketa, said there's been a narrowing of bid-ask spreads, which are the difference in the price a seller wants to sell and a buyer wants to buy.

"Hopefully, we will see prices coming down and transactions going up in 2024," she said.