In this article, we seek to provide an answer.
A quick recap
The current environment of high inflation, elevated interest rates, and geopolitical tension has caused periods of upheaval. In 2022, public markets fell sharply. The sell-off across private markets was less severe, while valuations weren’t uniformly affected across the asset class.
Why was this? Sector composition was one of the defining factors. Across private markets, valuations of tech-focused strategies suffered the most. Other sectors, such as energy, were more resilient, and valuations remained stable. Additionally, public and private markets have inherent differences in the way assets are valued. Private markets aren’t priced daily, so the valuations typically lag and appear smoother. Also, depending on the asset class, managers can mark assets up or down at their own discretion. This can be explained within the different private market asset classes.
Private equity
Last year, performance across private equity was negative for the first time since 2008. Such large market moves often lead to questions about whether private assets are over- or undervalued. So, which is it? Figure 1 shows an index based on private market data. Here, we see that buyout fund valuations are in line with historic norms. At the same time, many thought venture capital was wildly overvalued. But the data shows that valuations were fair.
We also see that public market volatility doesn’t always directly affect private market valuations. Factors such as the manager’s skill are at play here. They have majority control of the portfolio companies and can seek to optimise costs and drive revenue growth. They can also effectively manage regulatory risks and stakeholder expectations. In our view, utilising these strategies strengthens balance sheets, helping drive valuations and deliver sustainable long-term returns.
Figure 1: Overvaluation Index - US Private Equity Venture Capital and Buyout
Source: Burgiss, June 2023. The black line indicates whether fund assets are over- or undervalued relative to their fair market values. The coloured bars correspond to various regimes; the darker colour indicates the quarters when the US public equity markets achieved their maximum values, and the lighter colour indicates the quarters when they achieved their minimum values.
Private credit opportunities
In the realm of private credit, as public credit declined, banks pulled back, creating an opportunity for private lenders to step in. They were able to demand better pricing and negotiate stronger protections. Relative to public bonds, private credit valuations are less sensitive to rising rates, potentially offering better performance when yields climb. However, investors should apply caution. The elevated cost of debt and covenant-lite terms agreed over previous years have increased the potential for defaults. As with public debt, selectivity is therefore key. Sector selection matters, as does the ability to negotiate a deal that offers good risk/reward balance and downside protection.
Real assets
Real assets are intrinsically different from private equity and credit, and the approaches to valuations diverge.
Real Estate is arguably the most developed private markets asset class, given the size and volume of transactions. Its established market maturity and transparency means less room for a varied approach. The valuation standards across regions are well governed. For example, in the UK these are overseen by Global Valuation Standards (Red Book), published by the Royal Institution of Charted Surveyors (RICS). This involves a RICS Registered Valuer assessing the property and providing a formal independent report on the current market value monthly, quarterly, biannually, or annually. In terms of values across sectors and regions, these vary depending on demand and supply drivers and their influence on broad market trends. For example, logistics has been a hot sector for the last five years; however, this doesn’t necessarily mean these assets are all overvalued. Structural changes, such as the rise of global online retail, have driven demand in this sector. We therefore can’t draw conclusions on potential overvaluation based on transitory market movements – rather, we must consider assets individually, as well as how they will be affected by long-term trends.
This is also true with valuations across infrastructure. In the renewables sector, valuations have been rising for two decades. Again, this doesn’t automatically signal overvaluation. The long-term trend and targets around the energy transition suggest valuations will remain stable. Primary social and economic infrastructure offer additional attractive characteristics. These include long-term stable and predictable revenues, as well as inflation-linked long-term contracts, often with central governments. High barriers to entry can also help to keep demand robust.
Final thoughts…
We can’t assess inflated private market asset valuations based on market movements across public markets. Private markets are more idiosyncratic. Approaches to valuations can and do differ across asset classes. We’ve shown that valuations across private market asset classes are broadly accurate. However, this doesn’t mean they will remain unchanged. The variation across top- and bottom-quartile managers is pertinent to future value. Private market managers have the unique ability to help companies navigate through periods of market stress. They control the company, and can set the strategic direction, govern the board, manage costs, and drive revenue growth. In our view, the ability to manage these factors will determine a portfolio’s success. Diversification across asset classes is also important. Most of all, selecting top-quartile private markets managers who have the skills and expertise to unlock opportunities will be the key to delivering and sustaining long-term value.