Evaluating risk and reward in an ever-changing world

Exploring mispriced mid-market risk

Without the right skillset, determining the value of private assets can be challenging, especially given the lack of transparency surrounding pricing compared to listed companies. Unlike public markets, which are prone to bouts of volatility throughout the economic cycle, private markets can often appear more stable. Despite the wealth of potential opportunities and diversification benefits available in private markets, the space requires a set of unique skills and resources to navigate risk, and these cannot be formed overnight. Expertise developed through time in the market and deep research capabilities are crucial to identify areas – in the mid-market particularly, where risk is often mispriced – which other investors may miss. 

“In our experience, there are fewer investors looking into the mid-market space where transformation is driven, businesses scaled, and value created.  For the next stage of a company’s journey there remains a broad church of investors to which these assets can be exited,” says Rooke. “But there are risks to consider and these must be mitigated.” 

Indeed, while the mid-market may often be less explored, it could present a fertile ground for diligent investors looking to uncover mispriced risk and potentially take advantage of undervalued or overlooked assets. This might involve in-depth analysis of financial statements, assessing the capabilities of management teams, and a thorough understanding of market dynamics as well as the wider business landscape. 

Scaling up the ecosystem

Developing sector-specific knowledge plays a crucial role in allowing investors to gain a competitive edge. Engagement is par for the course. By understanding the nuances of any particular industry in the context of an interconnected world, investors may be able to identify mispriced opportunities more effectively, as the knowledge that comes with specialisation enables them to identify potentially undervalued assets and business growth prospects.

As active investors, we engage with portfolio companies, often providing strategic guidance and operational support. There is a chance to build a network and cultivate strong relationships within the mid-market ecosystem. We believe investors who actively participate in management and decision-making processes may be able to unlock hidden value and mitigate risks within private markets, thereby enhancing the potential for higher returns. We believe a long-term view is necessary: by focusing on the intrinsic value of assets and their growth prospects, investors can ride out short-term volatility and capture the full value of their investments.

Through this deployment of patient capital, fund managers are able to help scale businesses in different ways such as through operational change, bolt-on transactions, platform development, and internationalisation. This can potentially lead to strong exits or refinancing situations that ensure deep sources of capital remain available to fund the next stage of a company or project, maintaining a continuous cycle of capital deployment and reinvestment that can help support growth and development across the private market ecosystem.

Financing growth in turbulent times

Multiple shocks to economic stability over the last four years have forced the world to think on its feet as various crises unfolded in real time. Meanwhile, dramatic fiscal and macro-prudential policy changes have been implemented as asset valuations have continued to fluctuate amid ongoing uncertainty. If there’s one lesson that has been reiterated in multiplicity over the last decade, it’s that market conditions can change rapidly and without warning. 

In an ever-changing world increasingly dominated by polarising politics, asset class resilience is an ever more appealing attribute for investors as geopolitical tensions develop. Adopting a flexible approach to investing could prove vital in navigating any further turbulence on the horizon.

One particular segment of the private markets universe has managed to consistently prove its resilience in the face of adversity in recent times, offering the potential for diversified, stable income and uncorrelated returns. Once considered a niche asset class, private debt – which can encompass direct lending, leveraged loans, real estate debt and more – has gone from strength to strength, hitting $1.5 trillion assets under management by the end of 2022⁶.

The asset class plays a fundamental role in financing companies through their growth cycle. Indeed, economic growth overall could be seen as contingent on this form of non-bank lending, particularly as banks retrench and companies are increasingly relying on private markets. The US has largely gone through this retrenchment cycle, with capital markets the first port of call for almost 80% of companies.

We therefore see more growth potential in European private debt where there is much more scope for bank retrenchment. Currently 70% of companies turn to banks first, but this is quickly changing. However, there are regional variations⁷. The UK is largely capital markets-driven, whereas the Nordics is much more bank-driven. According to Preqin, European Private Debt is forecast to be the fastest growing regional segment of private debt⁸.

“Private debt isn’t a monolith and has multiple access points ranging from investment grade to high yield, corporate to real assets, senior to junior,” notes Robert Scheer, Senior Direct Lending Originator at M&G Investments.

“But divisions between asset classes are not as distinct as many might lead you to believe. For example, there’s a continuum in the corporate credit space and a blurring of lines that is particularly heightened at this point of the cycle,” he adds.

This blurring of the lines means that companies can enjoy the flexibility of prepay ability, customisation and close relationships with lenders, as well as certainty of the execution of new deals, paid for through higher spreads. From an investor perspective you also need to look holistically across the spectrum from mid-cap to large-cap and liquid to illiquid private credit to source the best opportunities. This doesn’t come overnight, access matters. Scale, tenure and on-the-ground presence is critical to sourcing and can only be built over time.

Meanwhile, despite the risks entailed – especially with the possibility of defaults on the horizon – investors may be able to take advantage of the return premium in private credit, where we believe potential yields of 8-10% are currently available⁹, as well as diversification from public credit. The largely floating rate nature of the asset class could provide further stability in the face of uncertainty from an asset pricing perspective. Rising rates, whilst increasing yields available are also an area of consideration for investors because of the rising interest burdens they create. Interest cover ratios have come down for many companies, determining whether the meticulous stress tests undertaken prior to investment have worked.

“Private credit is sub-investment grade comprising asymmetric returns, so avoiding losers in the space is key given increased defaults are expected down the line. A credible workout capability and track record will contribute to this differentiation,” highlights Scheer.

“Valuations are important, and scrutinising how managers are marking their positions to ensure distress isn’t hidden. Our process is independent from a credit risk rating perspective and asset valuation perspective.”

Winners and losers in a downturn

When hard times fall, it is often a question of sink or swim. When it comes to private equity, market downturns can widen the divide between the winners and losers.

Exit activity has declined significantly in recent times as global uncertainty took its toll on markets. In H1 2022, exit values fell by 45% following a bumper year in 2021 which was driven by record high valuations creating the ideal environment for exits to take place. Throughout H1 2023, however, the downward trend continued as exit values fell by a further 32% overall, with IPO exit values experiencing the largest reduction (down 90% compared to 2021¹⁰).

According to Broadridge, this is the main factor of falling total exit value, with 2023 seeing less than 2,500 deals compared to more than 6,000 in 2021.

Private equity assets continued to rise in 2023, reaching $10 trillion. In this challenging environment, a landscape defined by multiple headwinds, going back to the basics of the asset class could be vital in terms of good deal sourcing.

The prolonged era of artificially low interest rates is over, for now, and money is not cheap anymore. These are hard times: the cost of living crisis has impacted many businesses and people’s lives. Unfortunately, many businesses lack the robust fundamentals necessary to stay afloat amidst a turbulent macroeconomic backdrop, while others with precarious business models could still struggle to survive even with the support of distressed debt or rescue finance. When faced with these conditions, private equity investors need to make well-researched decisions to separate the wheat from the chaff as the divide widens between the winners and losers the longer any economic – and geopolitical – instability endures.

There are headwinds, the outlook is uncertain, many unknown challenges are hidden just over the horizon – but now is an optimal moment for active investors to thrive and find potential deals within private equity that may not only survive volatility, but continue to shine even after the storm is long gone. We see through the noise. By actively seeking out the best of breed managers with a track record of driving transformative change for value creation, the current landscape still offers potential opportunities in private equity.

“This for me is the very core of active investing,” says Rooke. “It’s about being hands on and growing businesses.”

In challenging times, private equity is arguably all the more important for businesses to survive and grow, especially those providing a product or service that can make a positive material difference in the world. Without that capital, there would be little hope for them to pull through.

Although fundraising has struggled to surpass the record highs of the post-Covid surge in 2021, private companies are still in need of capital – especially in a stricter lending environment – and a slowdown of rate hikes may support private equity fundraising down the line. Good deal sourcing remains crucial given money isn’t cheap in the current environment, and a different set of core principles is at play compared to the previous 15 years with interest rates remaining higher for longer.

This presents a possible opportunity for investors to take a hands-on approach, reshaping companies, redefining strategic direction and employing financial and operational levers to set companies up for future growth. Access to this universe provides investors exposure to businesses of the future, many of which are well-placed to help solve the challenges of our times, enabling them to drive transformation.

Accelerating real assets

The energy transition and other mega-trends such as digitisation and food systems are driving the need for an acceleration in capital deployment.

Whether it’s the impact of geopolitics, net zero needs, or simply the recognition of ageing infrastructure, support for infrastructure and real assets spending is widespread. Governments have enacted meaningful policies to support investment, and corporates are increasingly entering into partnerships with knowledgeable capital providers to support their transition.

An increasing need to invest in real assets could ensure a strong opportunity set for years to come, in our view. After all, investing in real assets is fundamental to long-term societal development. Whilst the overall size of the opportunity set remains vast and supportive of returns, capital has not entered the asset class uniformly. In an environment of higher capital costs, it’s increasingly important to select the right partners who can effectively drive operational value and source attractive assets.

We believe real assets have shown their strength through both the Covid-19 pandemic as well as recent macroeconomic shocks. In our view, revenues have been protected and, in some cases, grown either contractually or because the assets are providing essential services to their customers. This ability for real assets to pass through rising prices offers protection from any increases in capital cost. Nevertheless, carrying out stress tests is an essential element if investors are to make the most of the asset class’s potential.

Meanwhile, the dynamics of high capital investment needs and specialist operational expertise are proliferating across a broader set of industries as they look to adapt to a changing world. Climate (adaptation, the energy transition and sustainable food systems), geopolitics (reshoring, energy and food security) and digitisation provide a need for businesses to seek investment to help them transition.

A more sustainable world

The selection of businesses available in private markets is broad, spanning multiple industries and sectors. Not only do these companies offer investors the possibility to harness higher, risk-adjusted returns that could outperform traditional public market investments, they could also contribute to building a more sustainable world. But without the capital to back them, many may struggle to scale up in order to make any tangible difference. Investment in private markets will play an increasingly crucial role in shaping how society develops over the long-term, in our view. There will be leaders and laggards.

Through private assets, the diligent investor may be able to capitalise on the new industrial revolution, focusing on climate and technological solutions seeking to decarbonise economies, thus creating new jobs and opportunities, driving the change needed to ensure a better future.

Gaining access to an evolving landscape

Gaining entry to this exciting space can seem challenging for many investors. By their nature, private markets appear opaque and difficult to access, especially given the liquidity restraints and perceived barriers to entry entailed. 

Private assets can be more difficult to invest in, while the large number of different asset types available within the investable private markets universe adds to this complexity. As private markets have been largely inaccessible for many investors, they have gained an unwarranted reputation of lacking transparency. This is not the case. Where public disclosure is lacking, a closer relationship with borrowers allows better access to management information on the public side. This means there is a great level of transparency throughout the pre-investment process, which is supportive for decision-making, and also after the investment has taken place. But investors need to be in the flow, Rooke highlights.

“Getting in the flow is supported by having a track record of consistently deploying while also having a weight of capital from a differentiated source, so having patient capital at hand is beneficial,” he explains. 

Connections are valuable, providing access to deal flow, information, capital, sector knowledge, and exit opportunities. But expertise is also crucial, as is meticulous risk evaluation and management.

The alternatives landscape – historically dominated by institutions such as endowments, sovereign wealth funds, and family offices – is continuing to evolve and accessibility is improving. A shifting regulatory landscape and evolving regulatory regimes such as ELTIF 2.0 in Europe and the Long-Term Asset Fund in the UK. These are driving the creation of a greater number of semi-liquid vehicles and are therefore opening the doors to a broader investor base, enabling them to harness the innovation and yield potential of this expanding investment universe and fundamental engine of economic growth, in our view.