Public markets are grappling with the prospect of higher rates, higher inflation and a slower growth outlook.
- Private equity and private credit are not immune from the impact of higher interest rates or a weak economic outlook.
- Private equity valuations are proven resilient in contrast to the de-rating in public equity markets. But GPs are adopting different strategies in deal activity.
- Private credit and direct lending can do well in the late cycle, while crack in the credit market could see more opportunities within distressed debt.
The impact of persistent inflationary pressures and the tightening of central bank policy around the world can be clearly seen in the performance of equity and bond markets this year. The S&P 500 has pushed further into bear market territory, falling over 20% from its peak in early January. While the yield on U.S. 10-year Treasuries has increased by close to 200 basis points since the start of the year, meaning a large decline in prices. However, the adjustment to a higher rate and higher inflation environment can be harder to determine for many alternative assets given their less frequent pricing. Drawing on the recently released Guide to Alternatives for the second quarter, so far the counterparts in private equity and credit appear to be holding up and may even benefit from the volatility in the public markets.
It has been a challenging start to the year for private equity and deal activity is well below the exceptional level experienced in 2021 where nearly USD 1.15trillion of deals were completed. The high volume of deals led to some concerns around pricing and whether investors were simply paying too much, which is a very familiar theme in the public equity markets.
However, while public equities have experienced a heavy valuation de-rating and a drag on performance from falling price-to-earnings multiples as interest rate expectations rose, private equity valuations are exhibiting signs of resilience with debt and equity being roughly equal contributors to financing. It is possible that even with the valuation concerns in private markets, they did not move to the extremes that were experienced in public markets, and not feeling the same pressure for rising rates.
This is not to say that private equity is immune from the impact of higher rates, but the impact may be more evident through the size and structure of deals rather than simple valuations.
In the first quarter of the year, 32% of private equity deals occurred in the mid-sized USD 100 – 500million tranche compared to the long-run average of 24%, while the share happening at the very large and very small end of the market were below the long-run averages. This may reflect that General Partners (GPs) are shying away from the smaller, riskier companies, and looking at companies which are still young but with a slightly more proven track record in the mid-sized markets.
Exhibit 1: Private equity by deal size and type
Source: PitchBook, J.P. Morgan Asset Management. Private equity deal size and type activity are as of March 31, 2022.
Guide to Alternatives. Data is based on availability as of May 31, 2022.
As well as the change in approach to deal size, there has been a notable shift in the type of deals that is being done. GPs have options in deal type from a straightforward buyout or leveraged buyout, a growth and expansion strategy or pursuing and add-on strategy to create a platform of companies.
Currently less than 20% of the U.S. private equity deals are buyout or leveraged buyout. This is well below the 31% average for the last 14 years. GPs are instead opting for value-add strategies such as add-ons. Over 60% of the deals were add-on in the first quarter of the year compared to an average of 49%.
The implication from both the deal size and type is that instead of swinging for the fences with large buyout deals, GPs are opting for mid-size deals where they can combine multiple companies to create value.
When it comes to private credit and rising interest rates, the concerns often centered around the resilience of lenders in a higher rate lower growth environment given the large increase in fundraising activity and the growth in direct lending as non-bank lenders stepped into taking over from banks.
Direct lending has been a consistent performer during the periods of expansion and in late cycle cooling in the economic cycle and tends to exhibit weaker performance during a recession when compared to the public market credit (see page 53 of the Guide to Alternatives for more).
However, our view is that the near-term prospect of a recession remains relatively low and that in the case of the U.S. economy, we are shifting into the late cycle phase. This means that direct lending should be able to withstand the slowdown in growth.
Meanwhile, other areas of private credit may see increasing opportunities, such as distressed debt. In 2020, the window for distressed debt was short-lived given the policy response to contain widening credit spreads and prevent systemic issues in the credit market. However, as rates rise at a faster pace and with central banks more focused on inflation than financial market, cracks are appearing in credit markets. The spread between the top and bottom end of bonds in the U.S. high yield market (BB and CCC) increased to its widest point since 2020 at the end of May.
Public markets are grappling with the prospect of higher rates, higher inflation and a slower growth outlook. Private markets will not be immune from this shift either given the increased cost of deals. Private equity will be challenged but is so far adapting through deal size and structure. Meanwhile, private credit could see more opportunities as companies refinance at higher rates and there is more stress in the financial system.