Private equity and private credit – will rates muddy the outlook?

As demonstrated again by our latest annual investor survey, there is still plenty of enthusiasm for strategies focusing on private markets – including private credit or debt as well as private equity, which has been around a lot longer.

It is not surprising perhaps given these strategies worked like a dream through the era of near-zero interest rates following the global financial crisis (GFC) – and outperformed hedge funds by a comfortable margin. 

Looking forward, however, will they continue to work so well in what might become a ‘higher-for-longer’ rates environment?

As at least one big allocator to alternatives – Christopher Ailman, the CIO of CalSTRS (the California Teachers Retirement System), said in a recent interview with Pensions & Investments: “We are getting close to the top of how much private equity we want in our allocations.”

Globally, private market strategies now account for even more assets under management than hedge funds. According to the latest Preqin statistics, private equity alone is now over $4.7 trillion of assets, with private credit accounting for a further $1.5 trillion – taking the combined figure well beyond the $5 trillion or so managed by hedge funds.

Given all that’s happened since the GFC this is not surprising. The subsequent era of quantitative easing (QE) and ultra-low interest rates made it virtually free to borrow. And a virtually unbroken spell of gently rising equity markets – with few bouts of volatility – made it very hard for actively managed hedge strategies to keep up.

Even prior to the GFC, private equity had long offered various structural advantages for investors. As one high-profile billionaire who has allocated a lot to the space admitted to me frankly some 20 years ago: “Private equity is essentially a tax arbitrage strategy.” 

What he was alluding to, of course, was the way private equity often borrows a mountain of debt to acquire a business – and then uses the profits of the business to repay that debt, incurring net losses which means they pay not much if anything in tax. Before exiting at a (further) profit. 

Some PE strategies also involve disaggregating a business – on the basis the parts are worth more separately than together – in a way that used to be derided by some as ‘asset stripping’. 

There are also issues with PE given the long-term nature of the strategy. That contrasts with hedge funds and CTAs – which focus on more liquid assets, which can be valued and/or sold much more quickly if things aren’t going well. 

As one of the respondents in the investor survey – Francois Cilliers of 2IP – put it: “We believe both liquidity and transparency remain of paramount importance and these factors are not typically readily available within PE and other alternatives [to hedge funds]. 

“We want the price of our investments at any point to accurately reflect the current market value of the underlying investments. And for the underlying investments to have market depth, pricing transparency and liquidity.”

As an investor, if you don’t get that, it seems to me you should indeed get paid an ‘illiquidity premium’. In return for locking up your money for so long you ought to get a better return from PE than from hedge funds.

On the other hand, we should also admit that public markets can perhaps put a focus too much on short-term thinking.

Especially with such a wall of money behind it, PE by contrast makes it more possible to turbo-charge organic growth in companies if they stay private. As Ailman also said, “They can do better by being private than being public.”

The private credit side is admittedly a little different. It has grown up since the GFC – after banks were forced to shrink balance sheets and retreat from lending in certain areas, allowing space for a new class of funds to emerge to take up some of the slack. Not all of that lending is so illiquid – it allocates across a spectrum.

As another respondent in the survey – Claire Rentzke of Sukha & Associates –explained: “There is a large segment of the economy that the banks will not lend to… [Private credit offers] access to many more sectors and businesses than the listed market. And yields can be attractive.” 

Rentzke also highlighted how private market strategies can be more well-suited for impact investing: “The opportunity to invest in the real economy … and job creation is massive,” she argued.

But as Rentzke also pointed out: “The sector does not come without risk – and understanding the complexities and risks is key.”

A key question for investors now is whether these private market strategies will continue to perform so well going forward.

There may be a growing consensus about interest rates, but still plenty of debate. Some market participants think US inflation and interest rates will start to fall back again in the next year; others that rates will stay higher but that levels of around 4-5% are just going back to ‘normal’ – after the abnormal era of QE.

If rates are indeed kept higher, it does seem to me that private market strategies must get squeezed – at least to some extent. 

On the PE side, for instance, high levels of debt are usually built in to the capital structures deployed. If those structures cost more to finance, then surely it must have some effect on returns.

In private credit, there is perhaps more flexibility – and evidence that investors are keen to protect the return of principal rather than force borrowers into distress and potential default. But overall it seems to me that higher rates surely have some potential to hurt there too – especially if there is a significant recession.

It seems to me ‘higher-for-longer’ cannot be pain-free for these strategies. And hence that their high level of outperformance of hedge funds may not continue for ever. Copyright. HedgeNews Africa – October 2023.