Rates, yields and multiples are impacting private markets strategies, albeit not at the same pace as they have struck public markets, according to data and analysis recently compiled by JP Morgan Asset Management.
“Things are beginning to move, but they seem to be moving at different paces at different asset classes,” according to David Lebovitz, a global market strategist at JP Morgan Asset Management. “The most notable difference is real estate vs. traditional buyout funds.”
U.S. residential real estate prices have soared in markets such as Miami, and yields for investors have grown as well through the first half of 2022. However, Lebovitz predicted a decline in valuation and yields across real estate and potentially across the private capital complex this quarter as increasing interest rates and inflation take a toll.
For the three months ending August, JP Morgan has seen multiples come down a bit in private equity, but not to the same degree as public markets reacted negatively to the U.S. Federal Reserve’s 75 basis point hike last week.
Shareholders in publicly traded private equity firms themselves are not getting much of a reprieve from recent market losses — but investors in private equity funds were still making steady gains earlier this year. According to our own AW Research through late May, large private equity company share prices had fallen slightly more than the S&P and more in line with the technology-driven Nasdaq market. Meanwhile, private equity investment gains in the first quarter were up between 100%-plus to 49%.
For private equity firms, trailing EBITDA at the end of the second quarter was strong as those figures were really capturing the market as of the end of 2021. Now, Lebovitz adds investors are really watching two things in gauging the trajectory of private equity multiples going forward — relationship between yields and corporate bond multiples is one and the other is corporate earnings for Q3. The prevailing thought is both should be coming down.
At the end of the second quarter, trailing U.S. leveraged buyout multiples remained slightly higher than they were in 2021 at 11.5 times earnings and near historical highs. As trailing earning numbers are lower and interest rates are rising, Lebovitz expects that will lead to mark downs in the private equity markets.
“The private valuation issue is the next shoe to drop,” he added. “In the next quarter and coming months you will see that issue come up.”
Traditionally, private equity funds mark their portfolios twice a year, and to date Lebovitz has seen a hesitancy to market holdings lower within the private equity community. In his view, at some point he becomes difficult for the ‘pretend and extend’ approach to work and that is bound to challenge investors going forward.
The decline of equity markets holds another problematic scenario for private market capital: the denominator effect. With many portfolios remaining overweight to private markets, the expectation is for investors to move away from sectors that have done well, such as real estate, he said. These are moves that are expected to play out over the next 12-18 months.
A key shift could be in areas that provide greater diversification from traditional stocks and bonds and that would be in hedge funds and non-real estate-oriented parts of the real asset universe, such as infrastructure.
Institutional investors have been adding additional capital to private and core real estate strategies in recent weeks, according to the latest AW Research Investor Scorecard that analyzed over $15 billion in investor activity over the course of August.
Lower stock and private equity valuations, however, are not all doom and gloom for private equity firms. For instance, it will likely spur continued investment of dry powder as more companies stay private for longer, Lebovitz added in observing that the markets of previous decades relying on public equity issuance are behind us.
With $683 billion in capital raised across private markets in the first half of 2022, according to JP Morgan, there is plenty of opportunity for institutional investors to profit amid economic uncertainty.