Fundamentals differ significantly at the sector level. For example, office remains the weakest sector, as vacancy rates remain elevated, and firms struggle to fully exit remote working.
After steadily increasing during the post-Financial Crisis expansion, and then accelerating during the pandemic, 2023 has proven to be a more challenging year for private market fundraising. Although the current pace of fundraising still points to more than USD 1 trillion being raised this year, clients are becoming increasingly concerned about the ability of private market investors to take advantage of the plethora of trends that span across the asset class going forward. The good news is that plenty of dry powder has accumulated over the past decade, with private equity – for example – sitting on more than USD 1 trillion of dry powder in the current environment; put differently, private equity has more than a full year of fundraising in its pocket. But what are the opportunities that can be taken advantage of?
Frankly, the outlook for private real estate is mixed. Overall, cap rates are moderating, as slowing net operating income growth, above average prices and higher rates have left real estate looking expensive. Similarly, transaction volumes have decreased over the last four quarters due to higher rates and sticky inflation. That said, fundamentals differ significantly at the sector level. For example, office remains the weakest sector, as vacancy rates remain elevated, and firms struggle to fully exit remote working. Meanwhile, retail is slowly softening as consumers exhaust excess savings, with vacancy rates trending lower but still above pre-pandemic levels. Residential, like retail, is mixed; low levels of housing inventories should limit the downside to home prices in certain geographies, but the upside in rents could be limited by the strength in multi-family housing starts. And finally, industrial remains the strongest part of the commercial real estate space. However, despite a historically low vacancy rate, activity as defined by buildings under construction and groundbreaking has decreased, which could provide support to rents and prices in the short-term.
At the same time, the macro backdrop has become more challenging for private equity investors. Elevated recession risk and a higher cost of debt financing both represent headwinds, but better than expected earnings and a moderation in interest rate expectations in 1Q23 drove a modest uptick in valuations. Furthermore, deal activity remains above pre-pandemic levels but below the pandemic-era highs. In terms of deal type, private equity investors continue to favor add-ons in the current environment.
In private credit, there continues to be robust demand as sources of public market financing dry up due to tighter lending standards. Importantly, private credit tends to have higher exposure to information technology and financials, while the leveraged loan market tends to have notably higher exposure to industrials, consumer discretionary, communication services and materials. Furthermore, private credit accounted for 72 of the 76 leveraged buyout financing deals in 1Q23, despite the fact that private credit transactions are about 300 basis points wide of public market pricing1, with the spread expected to widen further in the coming quarters.