Private markets continue increase in AUM, but write-downs are coming

Most private market asset classes have yet to fully bake in lower asset values, resulting in tantalizing growth in their assets under management in 2022, a year when public market AUM fell across the board.

According to the results of Pensions & Investments’ latest money manager survey, most every private market asset class except hedge funds rose in the year ended Dec. 31 for U.S. institutional tax-exempt assets. Some of the largest increases included infrastructure, up 29.1% to $62.6 billion, distressed debt up 26% to $18.8 billion, privately placed debt up 20.8% to $138.2 billion and buyouts up 20.6% to $28.5 billion.

Hedge funds’ net assets fell 18.9% to $58.8 billion in 2022 while timber dipped 4.6% to $8.2 billion, P&I’s data show.

“Last year saw a marked shift in the macro environment, which feels as though is more than just a short-term pivot in the market,” said Darren Wolf, global head of investments – alternative investment strategies at abrdn PLC. “With this regime shift, we do not think investors can follow the same playbook over the next five years that they followed the prior 10 years — allocators (investors) are adjusting portfolios accordingly towards those strategies better suited for a higher-volatility, higher-rate environment.”

For example, U.S. institutional investor 2022 hedge fund portfolios reflected asset allocations adopted in 2021, which was “a very different market environment,” Mr. Wolf said in an emailed response to questions. In 2023, hedge fund AUM are increasing as investors adjust their portfolios for volatile market and high interest rates, he said. Most relative value, market-neutral or macro strategies “thrive” in a high-interest-rate and volatile market environment, Mr. Wolf said.

However, unlike private market assets, hedge funds mark their underlying assets to market, he said. Because hedge funds allow periodic subscriptions and redemptions, the net asset values of hedge funds’ assets are struck on a monthly basis, Mr. Wolf said.

This difference had an impact in 2022, alternative investment industry executives said.

In 2022, there was a massive dispersion between public and private markets, said Michael Langdon, director of private markets for the Oregon State Treasury Investment Division, speaking at the March 31 meeting of the Oregon Investment Council, which runs the $92.9 billion Oregon Public Employees Retirement Fund.

When it comes to private markets asset values, in the short term there is a great deal of smoothing, Mr. Langdon said in response to questions about private market valuations from a council member.

Managers have “a great incentive not to be the first one to write down their portfolios” because they still need to raise fresh capital, he said.

Oregon investment staff expects that it will take about four to six more quarters to see the asset declines already experienced in the public markets to appear in private market portfolios, depending on the private market asset class, Mr. Langdon said.

In private equity, with the rebound in the public markets, public and private market valuation multiples are slowly starting to converge.

“It is the current expectation, but that could change tomorrow,” Mr. Langdon said.

“In the short term, there is skepticism that private market values are perfectly reflective of reality,” but over the long term it evens out, he said.

Over Oregon’s 40-year history of investing in private equity, there’s never been a period of time in which realizations from portfolio asset sales weren’t in excess of stated valuations of those assets in managers’ portfolios, Mr. Langdon said.

“Generally, there’s a 20% to 60% pop at exit,” mostly from value creation by the private equity manager, he said. “Over time, we would expect there to continue to be a premium at exit,” Mr. Langdon said.

“We don’t think they are sandbagging valuations,” he added.

Private equity increased by 7% to $45.8 billion in the year ended Dec. 31, P&I money manager data shows.

Among the private market asset classes, Oregon’s investment staff expects write-downs to show up in real estate sooner than other asset classes, possibly over the next several quarters, because there are more transactions in real estate, Mr. Langdon said.

P&I’s money manager report shows that private real estate AUM rose 11.4% to $482.7 billion in the year ended Dec. 31, while the real estate investment trusts dropped 21.1% to $129.7 billion in 2022.

REITs can presage private real estate’s future, industry insiders say.

“Our belief is that the public market generally overshoots, but they are (a) good indicator of the direction of private real estate values,” said Peter Rogers, Chicago-based director, investments-Americas head of real assets research at Willis Towers Watson PLC.

And even while real estate AUM increased in 2022, it was still a tough year for all real estate sectors, with few transactions, he said.

“2022 was a tale of two halves for private real estate,” Mr. Rogers said. Total returns for core private real estate were up approximately 12% through the first half of the year but began repricing in the second half of 2022, to end the year up roughly 7.5%, said Mr. Rogers, with data reflective of the NCREIF Fund Index-Open End Diversified Core Equity index.

The market repricing continued into the first quarter of 2023, with appraisal values dropping roughly 10% from their mid-2022 peak at the end of the first quarter, Mr. Rogers said.

“Based on where we believe current transaction market pricing to be, we expect further appraisal write-downs in the coming quarter,” he said.

Property sectors that did well were those that were supported by “secular and demographic tailwinds such as single-family rental, student housing, medical office, self-storage, data centers,” Mr. Rogers said.

One of the most favored, multifamily, witnessed a slump in transactions in 2022, said Sean Burton, Los Angeles-based CEO of multifamily real estate manager Cityview, which has $3.5 billion in assets under management.

Notwithstanding rent growth as well as high occupancy in its apartment properties throughout 2022, the rapid rise in interest rates and impact of fluctuations of capitalization rate, which is a measure of property values, the spread between the price a buyer is willing to spend and the price the seller is willing to sell was “fairly insurmountable,” Mr. Burton said.

“As a result, we continued to be patient with our capital and plan to wait for the distressed buying opportunities that we expect to hit the market towards the end of 2023 and 2024,” Mr. Burton said.

As for Cityview’s existing assets, they are “well capitalized with reasonable leverage levels and we don’t have an urgent need to sell anything,” he said.

Cityview executives are biding their time and waiting to sell properties in its portfolio in “a more advantageous seller’s market,“ Mr. Burton said. In the meantime, they are focusing on maximizing net operating income, controlling operating expenses, mitigating downside risk and executing on its business plans, Mr. Burton said.

Property types such as office and certain retail properties for which there has been a fundamental shift in how people utilize the real estate will likely have more write-downs, he said.

Still, stronger property types like industrial and multifamily have seen a dislocation, but it is expected to be temporary and from that opportunities will arise, Mr. Burton said.

Despite multifamily being a more favored asset class, certain apartment building portfolios and areas are facing more headwind pressures than others, he explained.

“Portfolios largely made up of assets that were banking on significant rent growth for their valuations and those in areas that are seeing an abundance of new supply — like the Sunbelt cities — are going to feel more acute pressures than those in supply-constrained markets,” Mr. Burton said.

Cityview expects to see distressed buying opportunities to hit over the next six to 18 months, with a relatively short buying window for quality distressed assets, he said.

Overall, Julie Ingersoll, chief investment officer for Americas direct real estate strategies at CBRE Investment Management, said that even before the pandemic her firm’s Americas portfolios were underweight office as well as retail. CBRE IM executives believed there would be a reshaping of the way offices would be used and the pandemic accelerated trends that were already in place, she said.

The outlook for office worsened in 2022, Ms. Ingersoll said.

CBRE Investment Management’s real estate assets under management rose 32.4% to $14.3 billion managed for U.S. tax-exempt institutional investors in the 12 months ended Dec. 31.

Ms. Ingersoll attributed much of the increase to new funds raised in 2021 that amassed a significant amount of capital, even though CBRE IM took a “market leading write-down” for properties it could get access to appraisals in the fourth quarter.

“We thought it was prudent to recognize the new normal,” she said.
These fundraises included $2.3 billion for CBRE Strategic Partners U.S. Value 9 and its co-investment vehicle that closed in August 2021.

A portion of the capital raised for the Americas was earmarked for development and in 2022, some of those projects were completed, Ms. Ingersoll said. Among them was a life science property that had better than expected leasing and logistics properties that exceeded expectations, she said.

Christopher Merrill, Chicago-based co-founder, chairman and CEO of Harrison Street Real Estate Capital, which focuses on demographic-driven, needs-based real estate such as student and senior housing, said that in 2022 the firm “stayed in its demographic lane.”

“Our asset classes are tougher to access and are more fragmented’’ because of ownership of the properties, he said. More recently, Harrison Street has expanded into life sciences, data centers, build-to-rent housing and social infrastructure such as university and college campus power projects.

Even so, fundraising has been slower than in prior years, Mr. Merrill said.

Harrison Street had $32.2 billion in assets managed for U.S. institutional tax-exempt investors as of Dec. 31, up 17% from a year earlier.

For real estate lenders like Mesa West Capital, 2022 was a story with two chapters. Property markets were highly liquid with transaction activity ramping up for multifamily and industrial properties in the second half of 2021 and first half of 2022, said Ronnie Gul, Los Angeles-based co-CEO of Mesa West. There were fewer office transactions but the sector was still liquid, he said.

With the stunning rise in interest rates, the property markets froze up in the second half of 2022, Mr. Gul said.

Even so, real estate debt assets under management for U.S. institutional tax-exempt investors grew 5% to $75 billion in the year ended Dec. 31, P&I data show.

These days, quality assets within multifamily and industrial sectors are finding buyers and lending capital, he said. For offices, there needs to be more clarity to see what demand for those buildings will be, Mr. Gul said.

In the commercial real estate world, it takes time for the impact of the higher interest rates to result in price discovery in which buyers and sellers determine what prices should now be, he said.

“If history is any indicator, it would not surprise us if it takes the balance of this year and next year” for there to be price discovery, Mr. Gul said. However, he added, it is sector specific, market specific and asset specific.