What the wealth managers are telling clients about private markets

Private equity funds that bought software-as-a-service (SaaS) companies mid-pandemic are out of favour.

“That part of the market is stressed … 2021-2022 private equity was buying these companies at very high valuations,” says independent private wealth manager Koda Capital’s chief investment officer, Norman Zhang.

“A lot of these stocks are companies, unfortunately, being disrupted quite heavily with AI in terms of valuations. A lot of public market comparables have been repriced, but the valuations in private markets, particularly in these existing funds, have lagged.”

Earlier this year, venture capital and private equity investors were unsettled by legislation that removes CGT and negative gearing concessions for investors.

“They’re worried about the impacts on the investment pipeline of high-potential companies and the attractiveness of start-ups and smaller businesses to our best and brightest talent,” says Australian Investment Council CEO Navleen Prasad.

“They’re deeply concerned about widening the valley of death beyond early-stage to later-stage businesses, as capital chooses yield, rather than growth

Watch for private credit funds with AI exposure

While private equity markets have been volatile, private debt has boomed. But as with private equity, be aware of funds in this sector that may be exposed to SaaS stocks.

“There’s been massive waves of lending towards software companies in the past couple of years, probably done with lower governance and not-as-tight conditions as some other parts of the market,” says Ventelon.

“We’re not concerned about the asset class in terms of systemic risk, but we think we are going to see a rise in defaults, probably back to where we were a couple of years ago, so around 8 per cent aggregate in the asset class.”

Until recently, returns from private credit were so healthy many investors felt they had no choice but to be exposed. Not any more.

“We are expecting lower returns over the next 12 to 18 months, because interest rates in the US have come off in the last couple of years. We think we are likely to see two more cuts next year, so the ongoing yield on those instruments will continue to come down,” says Ventelon.

“So for us, private credit is at the bottom of the ladder in terms of alternatives. It’s not a zero, I want to be very clear on that, but clearly it is an underweight. We are finding better opportunities in other parts of private markets.”

Contrarily, allocating new capital to parts of the private credit market that are under stress or distress could offer a potential investment thesis. Many of these software companies still earn attractive revenues. So the disruption is around the sentiment of markets, not necessarily around the earnings, yet.

This might prompt selling between private equity funds, looking to pick up businesses they can add value to when they are out of favour with the market, but otherwise healthy.

Also look out for new funds with a turnaround focus or special situations fund managers. Private equity funds with a turnaround focus invest in poorly performing companies the fund managers believe they can improve by doing things like retrenching staff and slashing costs. Special situations funds invest in one-off events – for instance, funds that invest in distressed SaaS firms are likely to emerge now.

“If you think about SpaceX and Open AI coming to public markets, there’s very little capital available for a much smaller business to list this year,” says Zhang.

“If PE funds need to exit, they might need to sell to other PE funds. This is where we might see some opportunities for new deployment. We’re looking at a manager that can play in that special situation space in Australia.”

Add gravitas with energy and utilities

Often structured as partnerships between the private sector and public sector, infrastructure investments are attractive for their defensive properties.

“Investors want to see visible cash flows and assets that don’t take excessive, greenfield or development risk,” says Gordon.

Infrastructure investments produce regulated, contracted, volume-linked cash flows, often underwritten by inflation-linked, long-term contracts.

“So you’re introducing inflation, GDP and more defensibility into portfolios, and when we’re building efficient portfolios we want to introduce those different risk factors rather than just adding more equity or more credit beta,” says Randall.

“At a portfolio, top-down level, we really like infrastructure, but until recently … it’s been quite difficult for private clients to access. In the past two years, you’ve seen a rapid proliferation of open-ended vehicles on a global basis. It was debt first, then private equity, now it’s infrastructure.”

There’s plenty of opportunity in private markets to explore other exposures.

“We’re looking at other diversifying strategies, so think hedge funds, think things like royalties and core insurance and other idiosyncratic asset classes that aren’t just picking up more market and economic exposures,” says Randall.

“That’s been a huge shift in trying to add more diversifying exposures to make broader portfolios better diversified, more efficient from a risk and return perspective. If you have something that is a more defensive profile that spits out steady income, that tends to resonate with a lot of clients.”

With public markets becoming increasingly concentrated, particularly around the technology side, private capital may continue to provide diversification in the savvy investor’s portfolio.

“Investors should see alternatives as an opportunity for capital growth and income generation,” says Gordon.

Read the article here: What the wealth managers are telling clients about private markets