Private Markets: Uncertainty in the Golden Age

Over the last decade private markets have outperformed versus public markets, but given the recent public market volatility, will private markets continue to attract investors? Head of Brokers, Asset Managers, and the Exchanges Team Mike Cyprys and Head of European Asset Managers, Exchanges, and Diversified Financials Research Bruce Hamilton discuss.

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Mike Cyprys: Welcome to Thoughts on the Market. I'm Mike Cyprys, Morgan Stanley's Head of Brokers, Asset Managers and Exchanges Team.

Bruce Hamilton: And I'm Bruce Hamilton, Head of European Asset Managers, the exchanges and Diversified Financials Research.

Mike Cyprys: And on this special episode of the podcast, we'll talk about our outlook on the private markets industry against an uncertain macro backdrop and market upheaval. It's Tuesday, November 1st at noon in New York.

Bruce Hamilton: And 4 p.m. in London.

Mike Cyprys: We spend most of our time on this podcast talking about public markets, which are stocks and bonds traded on public exchanges like Nasdaq and Euronext. But today, we're going to talk a little bit about the private markets, which are equity and debt of privately owned companies. You probably know it as private equity, venture capital and private credit, but it also encompasses private real estate and infrastructure investments, all of this largely held in funds owned by institutions such as pension funds and endowments and increasingly high net worth investors. Today, there is nearly 10 trillion of assets held across these funds globally. But despite the different structure, private markets have been faced with the same macro challenges facing public markets here in 2022. So Bruce, before we get into some of the specifics, let's maybe set the context for our listeners. How have private markets fared vis a vis public markets over the last decade?

Bruce Hamilton: So the industry has grown at around 12% per annum on average over the past decade in terms of asset growth and a faster 17% over the past three years, driven by increasing allocations from institutional investors attracted to the historic outperformance of private markets versus public markets, a smoother ride on valuations given that assets are not mark to market, unlike public markets, and an ability to source a more diversified set of exposures, including the faster growth in earlier stage companies.

Mike Cyprys: And what are some of the near-term specific risks facing private markets right now amidst this challenging market backdrop?

Bruce Hamilton: The near-term concerns really focus around the implications of a tougher economic environment, impacting corporate earnings growth at the same time that increasing central bank interest rates across the globe are feeding into increased borrowing costs for these companies. This raises questions on how this will impact the profitability and investment returns from these companies and whether investors will continue to view the private markets as an attractive place to allocate capital. The uncertain economic outlook has dramatically reduced the appetite to finance new private market deals. However, there are factors that mitigate the risks forced to refinance in the short term. Secondly, corporate balance sheets are in relatively good health in terms of profits to cover interest payments or interest cover. Moreover, flexibility built into financing structures such as hedging to lock in lower interest rates should reduce the impact of rising rates. Importantly, the private market industry also has significant dry powder, or available capital, to invest in new opportunities or protect existing investments. For players active in the private markets. We think that there are undoubtedly risks in the near term, linked to congested fundraising with many private market firms seeking to raise capital from clients against a decline in public markets, which has left clients with less money in their pockets. From the performance of existing portfolio companies, given the more difficult market and economic environment and from subdued company disposal and investment activity linked to the more difficult financing markets. This has kept us pretty cautious on the sector this year.

Bruce Hamilton: But Mike, despite these near-term risks and concerns, you remain convicted in your bullish outlook on the next five years. In a recent work, you've outlined five key themes that you see lifting private markets to your 17 trillion assets under management forecast. What are these themes and how do you see them playing out over time?

Mike Cyprys: Look, clearly, I would echo your concerns in the short term. And I do think growth moderates after an exceptional period here. But we do see a number of growth drivers that we feel are more enduring. Specifically, five key engines of growth, if you will. First is democratization of private markets that we think can spur retail growth and unlock a $17 trillion addressable market or TAM. This is the single largest growth contributor to our outlook. Product development, investor education and technological innovation are all helping unlock access here as retail investors look to the private markets for income and capital appreciation in addition to a smooth ride with lower volatility versus the public markets. The second growth zone is private credit that we think is poised to penetrate a $23 trillion TAM as traditional bank lenders retrench, providing an opportunity for private lenders to step in. For corporate issuers, private credit offers greater flexibility on structure and terms, and provides greater certainty of execution. For investors, it can provide higher yields and diversification from public credit. The third growth zone is infrastructure investing, which we think can help solve for decades-long underinvestment and addresses a $15 trillion funding gap over the next 20 years. This is underpinned by structural tailwinds for the 3 Ds of digitization, decarbonization and deglobalization. The fourth growth zone is around liquidity solutions. As you know, the private markets are illiquid. And so as the asset class grows, we do expect some investors will want to find ways to access some degree of liquidity over time. And that's where solutions such as secondaries and NAV based lending can be helpful. The fifth and final growth zone is around impact in ESG investing. In public markets, we've seen significant asset flows into ESG and impact investing strategies as investors look to have a positive impact on society. And we expect that this will also play a role in the private markets, though it's a bit earlier days. Today we estimate about 200 billion invested in private market impact strategies, and we think that can reach about 850 billion in five years time.

Mike Cyprys: So for investors, this does boil down to an impact on publicly traded companies. Given the specific challenges of the current environment, Bruce, which business models do you think are best positioned to succeed both near-term and longer term? And what should investors be looking at?

Bruce Hamilton: Well, Mike, whilst we think the challenging macro conditions could continue to weigh on the sector near-term, we think that investors may want to look at companies with the best exposure to the five growth themes that you mentioned, who are building out global multi-asset investment franchises with diverse earnings streams, a high proportion of durable management fee related earnings—rather than heavy reliance or more volatile carry or performance fees—and deployment skewed to inflation protected sectors like infrastructure or real estate.

Mike Cyprys: Bruce, thanks for taking the time to talk.

Bruce Hamilton: Great speaking with you, Mike.

Mike Cyprys: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.