Applying a long-term lens

We enter 2022 with a lot to consider. The paths of inflation and interest rates, the profound effects of megatrends such as digitization and decarbonization and numerous sub-themes all demand our immediate attention. As private market investors we view this landscape with our own long-term lens. Our search is for idiosyncratic, resilient exposures within broad long-term trends. We see the world as:

Within private markets, getting the trend right is only the first step. With investments that are typically hand-picked and actively managed, execution and underwriting are critical. The market regime is unusual but underwriting resilient risk-adjusted returns will always be at the heart of private market investing.

Our key takeaways

• We believe that private markets risk premia are still attractive and can offer portfolio resilience.
• We expect megatrends to benefit this vintage of private markets investments, but see selection as increasingly important.
• The path to net zero is a major opportunity. Navigating the pathway will be an essential element of investment success.
• Vintage investing remains a powerful tool.

Portfolio perspectives

Portfolio construction is an increasingly important driver of returns. Below, we show how a private market portfolio can incorporate the themes presented in our 2022 Outlook. This is an illustrative exercise rather than an investment recommendation.

The starting point is a market-weighted portfolio, where allocations are sized proportionally to the assets under management in the corresponding sectors of the Preqin universe. In the thematic portfolio, we increased our exposure to infrastructure and real estate to reflect the decarbonization and digitization themes and relative value we see in these sectors. The thematic portfolio retains exposure to technology and healthcare through its allocations to private equity and credit, while the increased weightings in infrastructure and real estate significantly reduce overall risk.

Putting our themes to work

Market weighted vs. thematic portfolios (left) and reducing overall risk (right)

In our opinion, the year 2022 is set for a broader and stronger real asset market upswing. We think this cycle will be best understood by taking a 3D perspective.

For real assets as a whole, we see the cyclical rebound, technological change and the response to climate change as three dominant drivers. At the same time, the market is driven by a decoupled rebound due to variations in reopening strategies and a longer-term push towards re-shored supply chains; a differentiated market upswing across sectors; and a competitive deployment stage, due to abundant capital moving into real assets, partly reflecting a shift from other asset classes for relatively higher and more resilient yields.

For infrastructure markets, the 3Ds are decarbonization, digitalization and decentralization. The push to decarbonize the global economy requires a massive energy transition from fossil fuels to renewables, not just with the mainstays of solar and wind, but increasingly with carbon capture, battery storage and blue and green hydrogen. The digital world continues to transform our daily lives, with online work, shopping, schooling and entertainment markedly accelerated by the pandemic, as robotics and automation deliver genuine productivity gains. Moreover, infrastructure services are decentralizing on several fronts, as location becomes less important for virtual work and shopping, and as holdings diversify for resilience and operational efficiency.

For real estate markets, the 3Ds of infrastructure are similarly applicable, while we see several additional drivers at work. In particular, the wide and sustained divergence in performance between the winners (sheds and beds) and losers (hotels and retail) are likely to be sustained for now, providing considerable scope for alpha from sector selection. At the same time, distressed and dislocated real estate segments are starting to show signs of deep value, although these opportunities need on-the-ground, off-market sourcing capabilities to unlock. Looking further ahead, long-run demographic drivers remain all- important, with local differences in population and ageing trends making compelling cases for childcare centers in Australia, multifamily housing in the U.S. and senior living in Japan.

Three dimensions of change

Uneven cyclical recoveries, tech disruption and climate risks are all impacting markets

Following the re-opening rebound last year, we expect strong but decelerating growth in 2022, which remains a positive economic backdrop for credit. We expect that growth next year will differ meaningfully across regions, contributing to a wider range of outcomes.

Credit markets remain a critical source of income for investors, and we believe both public and private credit should be a core holding in portfolios. The scale and complexity of global credit markets are growing rapidly, and supply chain issues, labor shortages, cost inflation and gradual tightening of financial conditions should drive higher dispersion across sectors and among issuers.

Accelerating secular trends are impacting both issuers and investors in global credit markets. For issuers, capital is more widely available in both public and private forms, which has contributed to historically low default rates and the ongoing convergence of public and private markets as companies seek the capital best aligned to their particular needs.

As businesses adapt to these opportunities, the greater availability and flexibility of capital may make credit cycles smaller, more frequent and sector-specific as conditions become increasingly dependent on sector dynamics. The higher yield and proportion of return from income coupled with lower interest-rate sensitivity keeps credit attractive relative to fixed income assets, in our view.

Private debt is a growing source of finance

Total debt outstanding excluding dry powder (US$m notional)

Our outlook for 2022 is one of cautious optimism. Private equity as an asset class has demonstrated its resilience in the last two years. Valuations remain full, even for companies that have had to bounce back from the pandemic’s effects. Transactions continue to grow in size and are becoming increasingly global. We believe there is room for continued growth and we expect the current rapid pace of investment to continue in 2022, supported by low interest rates, open capital markets and an abundance of dry powder after two years of strong fundraising.

The size of the private equity market has tripled in the last decade, from nearly US$2 trillion in 2010 to over US$6 trillion in November 2021, according to Preqin. The number of active private equity investors has tripled as well, as access is democratized and increasingly multi-dimensional. While many may worry we have reached a peak, we see little evidence for a slowdown in the short term. In fact, we see room for growth, as private equity evolves and enlarges its still comparatively small share of the overall equity markets through tools such as secondaries and more flexible structures.

Secondaries have proven a practical tool for efficient portfolio management, as well as an effective tool for GPs or LPs seeking liquidity. The increased number of GP-led non-traditional secondaries in 2021 shows the desire for innovative structures, as GPs explore secondary capital as an avenue to achieve liquidity in specific companies. In effect, secondary capital allows GPs to own assets for up to 8-10 years versus a traditional hold period of four years.

Both LPs and GPs continue to seek creative and scalable ways to unlock greater value and extend the longevity of strong companies in their portfolios. The growth of longer-term funds, fund extensions facilitated by the secondary market and continuation vehicles or annex funds into which GPs roll existing investments are all signs of an evolving and increasingly versatile market.

More (and larger) private equity deals are getting done

Number of deals and aggregate deal value (US$b)