Higher rates and inflation bolstered appeal of private debt and hedge funds in 2023
Depressed valuations contribute to difficult exit environment for PE and VC
Borrowing costs also hampered fundraising in infrastructure and real estate
December 13, 2023 (Preqin News) – Hedge funds and private debt were bright spots for private markets in 2023, while higher borrowing costs and a difficult exit environment hampered other asset classes such as private equity, venture capital (VC), infrastructure, and real estate, according to the latest Preqin research.
Interest rates were a key determinant across all asset classes in 2023 and central banks’ rate-setting policies are expected to continue to shape fundraising and financial performance through 2024, Preqin’s Global Report series forecast.
That likely spells more demand for private debt, where the floating rate nature has appealed to investors throughout the recent rate hike era, but suggests other asset classes may be set for another challenging year.
The conditions mark a continuation of the shift away from the ultra-low interest rate environment that had largely dominated since the Global Financial Crisis, when investors increasingly turned to private markets in search of higher returns and diversification.
Despite that shift, investor appetite for private market assets is expected to remain robust – not only in the asset classes and strategies that offer insulation against current market conditions – with a broadly positive long-term sentiment
Several surveys conducted throughout 2023 revealed that, given increased knowledge and evolving options for investing in the asset class, as well as the continued diversification opportunities offered, many investors intend to increase allocations to private markets in the months and years ahead.
‘Amid the formidable headwinds of rapidly tightening monetary policy and economic uncertainty, alternative assets have remained comparatively resilient,’ said Cameron Joyce, Head of Private Equity, Research Insights at Preqin. ‘The industry continues to evolve rapidly, and promising opportunities are presenting themselves in areas such as private credit and secondaries. We continue to forecast solid growth for the industry.’
Preqin Global Reports 2024 in brief:
More challenging lending markets weighed on private equity, limiting deal flow to 5,438 transactions in the first nine months of the year, with an aggregate value of $618bn. That equates to 60.3% of the total deal flow in 2022 by volume and 48.5% by value.
Depressed valuations also hampered exits: 1,255 were completed in the first nine months of the year, worth $232.4bn in aggregate value, equivalent to 80% of the number of exit deals in 2022, and 55% by value.
The exit environment will remain a key challenge for return generation over the next 12 months as cited by 72% of investors and 60% of fund managers in Preqin’s recent surveys. Optimism over a recovery in deal flow in 2024 is dependent on the view that policy rates are approaching their peak, which may help free up bank lending.
Curtailed near-term capacity to deploy capital does not distract from strong long-term investor appetite for the asset class, particularly new opportunities emerging from the opening of private wealth and innovations in the secondaries market.
Amid inflationary pressures and rapidly rising interest rates, private debt’s floating rate nature proved alluring to investors in 2023: aggregate capital raised by private debt funds globally stood at $151.9bn as of the end of the third quarter vs. $218.3bn in the whole of 2022 as LPs shifted their investment priorities in uncertain economic conditions and GPs continued to launch new funds. As of October 2023, there were a record number of private debt funds in market (1,080), up 19% from 2022.
Underscoring GPs’ optimism about the prospects for private debt, the ratio of capital targeted in 2023 to capital raised over the prior year has spiked to an all-time high of 3.0x.
As fund managers and investors become more accustomed to higher interest rates, the fundraising environment is likely to improve. Distressed debt could see increased demand given the weaker macroeconomic environment, while mezzanine debt has remained popular with investors, in part due to appetite for an asset that is safer than a traditional equity fund, but offers the prospect of higher returns than senior debt.
Private debt AUM is forecast to grow at a compound annual growth rate (CAGR) of 11% from 2022 to 2028, reaching an all-time high of $2.8tn – almost doubling the 2022 figure of $1.5tn.
A challenging exit environment, depressed asset valuations, and rising interest rates led to a turbulent 2023 for VC, and those challenges are set to carry to 2024. A total of 783 funds closed in the first three quarters of 2023 – the latest fundraising data available at the time the reports were written – an annualized decrease of 49.4% from 2022, while fundraising fell 53.2% to $85.7bn.
A temporary investor pullback is making it particularly hard for fundraising teams. LPs plan to deploy smaller amounts, and their timelines to commit capital are longer than in previous years.
Some grounds for optimism come from investor sentiment: in November 2022, only 12% of investors expected the asset class to perform better in the coming 12 months than in the past 12 months, compared with 38% as of November 2023. Given the valuations adjustment, 2023 and 2024 vintages may perform better than the previous two years.
A lull in new capital raising in 2023 contrasted with 2022’s record fundraising, when the US legislative agenda prompted a wave of new capital aimed at the world’s largest infrastructure market. Aggregate capital raised as of October 2023 was $20.9bn, equivalent to just 12% of 2022’s $176.8bn and 15% of the annual average of $136.4bn over the preceding five years. Dry powder has declined this year from a peak of $353bn in March to $338bn in September.
Given this year’s slowdown, capital raising is not expected to return to 2019 levels until 2027 – Preqin recently forecast 2024 will deliver $83.5bn in fundraising as interest rates abate – although slowing inflation may prove grounds for upside revision.
Despite a tough year, there are signs the asset class may be turning a corner: the deals market remains resilient, and activity rebounded going into Q3 2023. Meanwhile, the energy transition is expected to underpin the long-term growth of unlisted infrastructure.
Interest rates’ upward trajectory has dampened investment sentiment, leading to subdued fundraising and deal-making.
In terms of deals, 42% of the number of deals in 2022 have closed, and at an aggregate value 35% of the prior year total. Fundraising has also declined, with 306 funds closing to the end of September 2023, less than 45% of the number of funds in 2022. By the third quarter of 2023, they have raised only 56% of the aggregate capital raised in 2022.
Amid a saturated environment, the number of real estate funds in market rose from 1,777 at the beginning of 2023 to 2,258 by the end of the third quarter, a 27% increase.
Almost half (49%) of respondents surveyed in November identified opportunistic real estate investments as a favored strategy in the current market conditions over the next 12 months, indicating a preference for capital growth ahead of income return for direct property investments.
In a market defined by high interest rates, inflation, and ongoing recession fears, hedge funds provided the downside protection investors seek from the asset class. Hedge funds outperformed global equities by an average 175 basis points this year when the latter declined.
Despite the asset class’s resilience, a long-term trend of net outflows is likely to continue (over the past five years, the average outflow for negative quarters was $23.8bn, compared with $9.8bn in average inflows during the positive quarters). Preqin’s investor survey in November 2023 shows that most investors are content with their allocations and do not plan to increase their positions in the next 12 months. But outflows haven’t been uniform: North America hedge funds have seen significant net inflows at the expense of their global peers.
Despite a turbulent year, industry assets under management (AUM) is at a record high and Preqin estimates that the hedge fund industry will grow AUM at an annual rate of 3.6% between the end of 2022 and 2028, to $5.2tn. A lot of this growth will likely be driven by asset returns rather than inflows from investors.
The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin providing the information in this content accepts no liability for any decisions taken in relation to the above.