Industry Trends
Encouraging trends in private markets for Q4 2024
As we enter Q4 2024, private markets are returning to pre-pandemic levels in fundraising, investment activity, and valuations, creating a favorable environment for new investments. Central banks in the US and Europe have reduced policy rates, and further reductions are anticipated, alongside recent stimulus measures in China, providing tailwinds to the global economy and private market investments. Sectors like real estate and venture capital show early signs of recovery, with AI driving significant investment activity. Private market investments aligned with long-term mega-trends such as AI, decarbonization, deglobalization, and demographic changes are particularly attractive.
Private equity is experiencing positive momentum, with deal and exit volumes normalizing. Small to mid-sized buyouts are favored due to a more favorable dry powder environment and valuation discounts. Venture capital, especially in generative AI, is seeing increased investment. Geographically, North America, Western Europe, China, and India are attractive markets.
Infrastructure debt offers stable cash flow, while alternative private debt and credit remain appealing due to strong returns and cash distributions. The energy transition segment in infrastructure is compelling, driven by decarbonization and energy security concerns, with renewable energy investments expected to grow significantly.
Real estate markets are stabilizing, presenting opportunities to access assets with solid fundamentals at attractive valuations. Repricing in the UK and the industrial sector offers strong relative value, with significant opportunities in warehousing and logistics. Investors can benefit from value-added growth opportunities by upgrading buildings for modern use, focusing on sustainability and operational capabilities. Given ongoing geopolitical risks, a highly selective and diversified approach is essential.
Source: Schroders
Sector Update
Private Equity eyes the skilled trades sector
Private equity firms increasingly target skilled trades companies such as HVAC, plumbing, and electrical businesses for acquisition and consolidation. Since 2022, nearly 800 companies in these industries have been acquired by PE investors, creating a new class of millionaires and making skilled trades careers more attractive. This trend also drives a 16% increase in vocational-focused community college enrolments from 2022 to 2023. Traditionally, family-owned or employee-passed businesses are now being sold to PE firms, offering lucrative exit strategies for owners. Skilled trade investments can diversify portfolios for PE firms, balancing their holdings across different sectors. PE firms are buying up smaller trade service businesses to create larger, more efficient operations with more significant market share and economies of scale.
Skilled trades appeal to PE firms due to their essential nature, consistent demand, and pricing leverage. By consolidating smaller businesses, PE firms aim to create larger, more efficient operations with greater market share and economies of scale, ultimately selling them at higher valuations. While PE investment can boost worker salaries and improve business efficiency, it has potential downsides. Local ownership and control may be lost, leading to a profit-driven approach that could prioritize cost-cutting over long-term sustainability. Employees might face job insecurity, reduced benefits, and more demanding conditions. The traditional path to business ownership for skilled workers may become less attainable, and the unique culture of small trades businesses could be replaced by a more corporate approach, potentially affecting service quality and company reputation.
Source: Forbes
Expansion of private equity in sustainable asset markets
Global investments in climate solutions have surged in recent years, with Europe leading the charge. In the first half of 2023, Europe accounted for approximately 84% of climate assets under management (AUM). Europe, the United States, and China represent nearly 98% of total climate investment. Since 2018, global climate funds’ AUM has grown at a CAGR of around 71%, highlighting the increasing prioritization of sustainable and green investments, especially post-COVID-19. Major private equity firms like KKR, TPG, Bain Capital, General Atlantic, and Brookfield have established dedicated climate funds, reflecting sustainability investments' financial and environmental benefits, driven by ESG concerns, regulatory pressures, and technological advancements.
The most significant investment theme has been efficient and decarbonized energy use, accounting for about 54% of climate venture and growth investments. Other key themes include decarbonizing the energy supply (20%), sustainable food production (18%), and climate management services (7%). From 2020 to 2023, the largest investment subcategory was decarbonized transportation and mobility, including electric vehicles and hydrogen-powered transportation, which comprised 49% of global climate investments.
Investments also focus on renewable energy, energy distribution infrastructure, energy storage solutions, circular economy solutions, and sustainable food production. The increasing allocation of PE funds towards sustainability assets signifies a transformative shift in global investment strategies, driving the transition towards a more sustainable and resilient future. This trend underscores the critical role of PE in promoting renewable energy, circular economy solutions, and sustainable food production.
Source: LEK Consulting
Market Opportunity
The expanding rationale for investing in AI via private markets
Private banks encourage investors to explore artificial intelligence opportunities through private markets, with wealthy families leading the charge. UBS highlights the diversification potential in private markets due to expanding AI adoption and spending trends. Laeticia Friedemann, Alternative Investment Strategist at UBS Global Wealth Management, notes that private equity opportunities will grow as venture capital-financed start-ups mature. AI is expected to become integral to private market firms, similar to ESG's role over the past decade. Venture capital deals in AI and machine learning have been significant, with the US leading in AI investment due to its talent pool, start-ups, and research institutions.
Barclays Private Bank reports growing demand for private markets, driven by private wealth investors seeking higher returns and diversification. Private equity funds have shown resilience, raising substantial capital despite economic challenges. Family offices and high-net-worth individuals increasingly allocate to private markets, including venture capital, to align with personal values and global trends. Disruptive deals, such as those in AI, are particularly attractive.
Experts recommend balancing investments between public and private markets. UBS favors stable assets within digital infrastructure and publicly listed AI companies. Despite recent market volatility and concerns of an AI bubble, long-term opportunities in AI remain promising. However, private credit's rapid growth raises caution due to new managers' lack of experience and high financial leverage. Investors are advised to scrutinize the sustainability of past performance and potential style drift in managers' investment strategies.
Source: Financial Times
Midyear Review
Q3 2024 private equity pulse: A recap of important insights
EY highlights the significant role of technology in the current market landscape. Technology has emerged as a dominant theme, driven by a shift towards growth-oriented assets due to rate cuts and the sector's long-term potential. In Q3, technology deals constituted 40% of private equity deployment by value, an increase from 34% in Q1. Data infrastructure, in particular, continues to garner substantial interest. A notable example is Blackstone's US$16 billion acquisition of AirTrunk in partnership with CPPIB, marking the quarter's largest deal. This acquisition is part of a broader trend influenced by long-term secular themes such as the ongoing transition to cloud computing, the Internet of Things (IoT) expansion, and the escalating data requirements driven by AI adoption. GenAI applications are expected to significantly amplify data demands, potentially leading to a fiftyfold increase in the number of workloads processed globally by 2028. Reflecting this trend, 70% of General Partners surveyed anticipate a rise in tech deals over the next six months, the highest expectation among all sectors. Overall, the technology sector's growth is underpinned by both immediate market dynamics and enduring structural changes, positioning it as a key area of focus for private equity and investment activities.
Source: EY
Market Sentiments
PE-Backed firms suffering higher default rates, Moody’s says
According to a report from Moody’s Ratings, companies owned by private equity firms are defaulting more frequently than other speculative-grade borrowers. Between January 2022 and August 2023, private equity-backed companies had a default rate of 17%, double that of non-private equity-backed companies. Among the 12 largest private equity sponsors, the default rate was slightly lower at around 14%. Platinum Equity had the highest number and share of defaults, followed by Apollo Global Management and Clearlake Capital Group. Both Platinum and Clearlake had the highest leverage ratios, while Apollo's leverage was near the average of the 12 sponsors. Apollo noted that their leverage is among the lowest in the industry and criticized Moody’s for categorizing normal term loan extensions or opportunistic debt exchanges as defaults.
Private equity-backed companies generally have more debt and lower credit ratings, contributing to the higher default rate. Higher interest rates have also impacted corporate balance sheets, especially for those with floating-rate debt. Most defaults were due to distressed debt exchanges, a strategy favoured by private equity sponsors to preserve equity and exploit loose governing provisions. Private equity firms have also borrowed against their funds’ combined assets, tapped private credit, and used payment-in-kind features to manage cash flow. Additionally, they have turned to more debt to fund dividends, a strategy that has not led to many defaults due to higher-rated portfolio companies.
More sponsors are now turning to private credit for rescue financing and greater flexibility. At least nine companies refinanced publicly rated debt with private deals and are no longer rated. Firms like Vista Equity Partners, Carlyle Group, and Thoma Bravo are now more likely to borrow from direct lenders.
Source: BNN Bloomberg
Expert Opinion
The growth of private credit and its future possibilities
The private credit landscape has evolved significantly, marked by record fundraising, strong performance, and substantial growth. Despite recent market changes, opportunities for investors remain robust. New players are entering the space, and established firms like Antares, with nearly 30 years of experience, continue to thrive. Investors globally are in an accumulation phase, seeking to diversify their portfolios, particularly in regions like South Korea and the Middle East.
Vivek Mathew, President and Head of Asset Management at Antares, highlights that the total addressable market for private credit is expanding faster than the capital inflow, suggesting a promising future. Private equity's penetration in middle-market companies is still low, indicating high-quality investment opportunities. The market is expected to grow rapidly, potentially leading to a surge in mergers and acquisitions.
Risk management remains a priority, with the US economy's resilience contributing to manageable portfolio risks. While some sectors, such as aerospace and specific consumer and healthcare subsectors, face challenges, overall portfolio growth has been positive. The focus is on liquidity and restructuring capabilities to navigate higher rates and potential losses. The competitive environment is evolving, with a growing total addressable market and improved functioning of broadly syndicated loans. Companies are exploring broader product capabilities and geographic expansion to enhance their market presence. Scale and access are becoming crucial for adding value, particularly for smaller managers.
Brian Vickery, Partner at McKinsey, and Vivek Mathew emphasize the importance of diversification in terms of portfolio composition and capital base. They foresee changes in market spreads and a shift in investor focus towards alignment and incentives, potentially altering traditional investment approaches.
Source: McKinsey
Artificial Intelligence Scope/Trends
How AI is transforming the landscape of private equity and hedge funds
Artificial Intelligence is rapidly transforming private equity and hedge funds by enhancing decision-making, improving operational efficiencies, and providing a competitive edge. AI can analyze vast amounts of data quickly and accurately, enabling fund managers to identify trends, predict market movements, and make informed investment decisions. It also automates routine tasks, reduces manual labor and errors, and allows managers to focus on strategic decisions. AI-driven personalization tailors investment strategies to specific investor preferences, while advanced trading techniques for hedge funds optimize trade execution for maximum returns. AI tools streamline operations, reduce costs, enhance productivity, and assist in regulatory compliance by automating checks and reporting. Natural Language Processing (NLP) analyses large volumes of text data, aiding in contract review and summarization. AI accelerates data collection and analysis during due diligence, providing deeper insights and increasing efficiency. However, challenges such as data quality, market volatility, integration, operational risks, ethical concerns, and adherence to laws must be addressed. High-quality data management, regular model updates, careful integration planning, and robust risk management practices are essential. Despite these challenges, AI offers substantial benefits and is a fundamental shift in PE and hedge funds' operations. Embracing AI technologies can enhance decision-making, streamline operations, and deliver personalized investment strategies, ultimately driving better investment outcomes. As AI continues to evolve, its role in these sectors will expand, offering innovative solutions and opportunities for those willing to embrace change.
Source: Marcum LLP
AI fuels ongoing venture capital investments
This analysis highlights the current venture capital investment landscape, mainly focusing on AI-related companies and the broader startup ecosystem. Most funds are directed towards building the foundational infrastructure for AI, such as developing and training models. Entrepreneurs are advised to incorporate AI into their business plans to attract investor attention, as companies need a clear AI vision to raise funds. The energy sector is also noted as both an opportunity and a limiting factor in the adoption of AI, with ongoing interest in how these sectors will evolve. The venture capital market is characterized by a "have" and "have-not" atmosphere. In the US startup ecosystem, there are 54,000 VC-backed companies, with just over half raising funds since 2022. Only 12% of these companies have raised $20 million or more. Those who have yet to raise funds recently are nearing the end of their two-year runway and will need to secure capital soon. Founders are reminded that venture capitalists prioritize investing in people over ideas. Investors look for leaders and management teams that can navigate challenging times and inspire their teams. Those who demonstrate resilience and a solid plan are more likely to gain investor confidence. It underscores the importance of strong leadership and a clear vision for AI in securing VC funding in the current environment.
Source: EY
Others
Infrastructure debt vs direct lending: A comparative analysis
This study outlines the benefits and characteristics of infrastructure debt and direct lending as components of a diversified investment portfolio. Infrastructure debt finances essential large-scale projects like roads, bridges, and renewable energy initiatives, offering stable and predictable cash flows due to strong lender protections and supportive regulatory frameworks. This type of debt is less correlated with broader market cycles, providing valuable diversification and aligning with sustainability goals.
Direct lending, particularly to middle-market companies, offers elevated returns driven by the illiquidity premium and perceived credit risks. These loans are typically structured as senior debt with floating or payment-in-kind (PIK) coupons and may lack financial covenants. The focus sectors include software, insurance services, education, healthcare, and business services, which exhibit some cyclicality in cash flows.
Both asset classes benefit from geographic and sectoral diversification, balancing risk and return by capitalizing on market dynamics and regulatory environments. Historical performance data shows infrastructure debt's resilience and reliability through various economic cycles, while leveraged loans offer steady growth. The key to successful investment lies in collateral quality, thorough due diligence, and understanding borrower objectives and risk tolerance. Technological advancements are expected to streamline the lending process, making it more efficient and accessible. Leveraging the expertise of knowledgeable managers is crucial for making informed investment decisions.
Infrastructure debt and direct lending are essential for a comprehensive private market and diversified credit portfolio, offering secure, steady returns without compromising performance.
Source: Macquarie
