The year 2021 was a standout for private markets, as trillions in pandemic-related stimulus fostered a surge in private equity deal volume and valuations that capped off a remarkable decade for the asset class.
However, achieving similar results in 2022 is proving to be a challenge for institutional investors who must now contend with the threat of rising rates and inflation, geopolitical risks surfacing in Europe, and the growing concern of a global recession.
“For the last 13 years, we've lived in a world where interest rates have headed towards zero and then stayed at zero,” said Scott Kleinman, co-president of Apollo Global Management at the Milken Institute 2022 Global Conference on May 3.
“When money has no cost of capital, how do you value assets? Well, it works exactly the way you would expect or fear,” he said. “I don't care what asset class you're talking about — private equity, real assets, corporate credit — valuations have gone up and up and up. If you've just bought a good asset, and not screwed it up, you've probably sold it for more than you paid.”
Kleinman believes the markets are now seeing the cost of this uninhibited growth that has been exacerbated by the central bank printing money to stimulate the global economy during the pandemic.
“That cost is inflation that's reaching shockingly high levels. The Federal Reserve is signalling that they're going to be really aggressive and try to cool things down, but the underlying economy doesn't care,” said Kleinman
“We're seeing real inflation at our portfolio companies — wage inflation, transportation and logistics inflation, material inflation — but demand is strong enough where we can pass those prices through and not affect volume. In response, the Fed is looking at that and reacting by raising rates.”
The Federal Reserve has so far enacted only one of its expected interest rate hikes this year, on March 16, which saw equity and bond markets plunge by around 15% each in response.
“On the equity markets, the growth year and long duration end of that was down by 30 to 50 percent, and I don't believe the equity markets are pricing in all of that move yet,” he said. “We went from a world of ‘purchase price doesn't matter’ and are now entering a world of ‘purchase price does matter’.”
NOT A SELLERS’ MARKET
Suyi Kim, the senior managing director and global head of private equity at the Canada Pension Plan Investment Board (CPP Investments), agreed with the current macro environment as depicted by Kleinman, but believes the picture is quite different depending on which region investors are examining.
“In the US and Europe, we are seeing high inflation and high rates,” said Kim. “But when you look at China, inflation is not there, it’s the same 2% and fiscal and monetary policy is more accommodating, or at least talking about more accommodation, not tightening.”
Canada’s largest pension fund, which manages over $437 billion in assets, still sees a lot of interesting opportunities within the private markets despite the gloomy economic outlook, according to Kim.
But in the face of the uncertainty and as a long-term investor responsible to 20 million members, CPP Investments has been sharpening its pencils when underwriting these deals and running recession and high inflation case analysis, said Kim.
Even amid the booming growth of the private markets in 2021, Kim insisted that her team assess all private market opportunities via a five-to-10-year multiple company comparison analysis, “as opposed to the current trading multiples when you're thinking about exit assumptions,” she said.
“This was very different from a lot of other investors, who were continuing to expect the multiple expansions or for values to stay at a high level,” said Kim.
“I actually find that the current environment for investors is getting more interesting in the sense that it used to be a sellers’ market and it’s now turning into an investors’ market.”
NO BASE CASE
There is often a tendency within private markets for investors to rally around a base case when vetting risks. However, when examining the current macro-economic environment of the private markets, investors also need to take the current global geopolitical tensions into account, according to Kim.
“The geopolitical tensions that we're seeing globally have been leading to supply chain decoupling, technology decoupling and potentially capital market decoupling,” said Kim. “All of these things have been really hard for investors to predict.”
These types of geopolitical tensions, such as the Russian invasion of Ukraine or the crisis, make relying on a base case for underwriting a redundant process to Kim.
“You need to prepare for different scenarios and focus on the span of possible outcomes and be clear about decision making points depending on each of these outcomes,” she said.
“It’s really difficult to forecast that, as well as the coming period of inflation,” said Kim. “I have never lived through a high inflation environment and have not met anybody so far that has invested under a 9% inflation environment. I think it's going to be a very hard environment for our guys to underwrite the deals, so we will need to have our eyes wide open.”