How the interest rate environment is set to reshape private markets
As interest rates slowly retreat, private markets are undergoing a transformation, leading to a revaluation of assets, a recalibration of strategies and a careful balancing act between risks and rewards.
Relative to their public counterparts, private markets are less susceptible to short-term price movements as a result of changes to monetary policy. The turn in the interest rate cycle, however, has implications across asset classes – private credit, real estate and private equity – with each reacting somewhat differently to the change.
Private credit, one of the hottest asset classes for investors, provides a prime example of how interest rate hikes can change investor behavior – albeit differently across regions.
As Andrew Tan, Chief Executive Officer for Asia Pacific at Muzinich & Co, explains, in the US and Europe, credit deals tend to be priced on a floating-rate basis. This means when base rates come down, it leads to lower absolute returns for private credit investors.
In Asia, on the other hand, fixed-rate transactions dominate the market, offering a measure of insulation against changes to interest rates. While floating-rate deals have risen in popularity in the past couple of years, their use is still limited compared to Western markets.
“What is actually happening is that fixed-rate structures will be beneficial for the Asian strategies in private credit because while US and European private credit transaction returns start falling, Asian transaction returns will probably continue to maintain their current levels,” reckons Tan who was speaking on CFA Institute’s Private Markets webinar series. “From a relative value standpoint, what you would find is that Asian strategies become a lot more attractive to investors as compared to the US and Europe.”
Over the past two years, because of the high-rate environment, senior secured transactions in the US have yielded close to 12%. While yields in Asia may be higher, the relative value hasn’t been so compelling. As a result, Tan says a lot of capital moved into the US and to some extent Europe.
“My view is that this will soon start to reverse course, because Asian private credit opportunities will start becoming more attractive from an absolute return standpoint, all things being equal on the credit quality front,” added Tan.
Regardless, private credit returns overall have been incredibly attractive, as the asset class directly benefited from a period of higher interest rates over the past two years.
According to research by MSCI, private credit has been among the strongest performing asset classes since the beginning of 2021. It continued to outperform private equity in the second quarter of 2024, returning 2.1% versus private equity’s 0.8%. (See Figure 1.)
Overall, global private credit funds made returns of 10% in the 2023 calendar year, compared to private equity’s 5.8% and private real asset funds’ 1.1%.
Its benefits are many: consistency in performance, short tenors, lower volatility, and a pickup over bond portfolios all appeal to debt investors.
“In fact, private debt was the best performer of all private capital alternatives in 2023, and it’s quite remarkable for that strategy to outperform equity. It’s no wonder that is such a crowd favorite right now,” said Angela Lai, Vice President and Head of Asia Pacific and Valuations, Research Insights at Preqin on the webinar.
Navigating real estate investments
The rates backdrop is also reshaping the private real estate market. The real estate market broadly has suffered a two-year downturn during which US commercial property values dropped 22% as interest rates soared.
But real estate funds have continued to post attractive returns – especially at the larger end of the market. (See Figure 2.) Property values also seem to have bottomed out in the US in mid-2024, buoyed initially by expectations of a rate cut as the US economy softened.
Valuations in private real estate are also attractive relative to other asset classes, with market participants expecting a pick-up in real estate investments in some of Asia’s core markets like Japan, Australia and Singapore.
“For the past two and a half years, we have been doing a lot more credit deals [in real estate] because that has benefited us,” said Annora Ng, Managing Director, Capital Markets at GAW Capital. “In Asia, only two markets experienced positive carry amidst this very high interest rate environment: China and Japan. A lot of capital has been flooding there, and now that interest rates seem to be levelling a little bit, we’re very much open to opportunities, especially in the equity space when interest rates are going down,” she said on the webinar.
There is clear evidence in the capital markets that investors are starting to see the appeal of real estate once again.
Alan Lok, Director in the curriculum department at the CFA Institute, told the audience: “If you want to see whether the real estate market is actually back on track, or whether it’s going through a downward spiral, you should look at the bond markets, which are highly liquid and transacted by many retail, high-net-worth investors and institutions.”
He added: “And if we look at the bonds issued by the strong developers, those listed on Singapore or Hong Kong, they are trading quite well, way past their par value. This is a testimonial that people are chasing after them, so we are definitely seeing light at the end of the tunnel.”
Caution, however, remains key to navigating real estate investments in a constantly evolving environment.
“In terms of developing markets, the challenge is what kind of risk premium you want to place on investing in these markets,” said Christine Li, Head of Research, Asia Pacific at property advisor Knight Frank. “Before COVID, investors had higher risk appetite to go into some of these emerging markets because the cost of funds was almost nothing and many found real estate investments very safe, like a bond, but with a tendency to outperform bonds and fixed-income products,” she told the webinar.
That sentiment has since changed, amid a long-running property sector meltdown in China, slower residential and commercial property sales in many parts of Asia, and regulatory clampdown on the industry in countries like Vietnam.
Currency controls also feature heavily in many Asian jurisdictions, while local market regulations see constant tweaks, often being unfavorable to foreign investors.
“Entering developing markets always has country risk, so it’s really important to find the right manager or the right operating partner that can be trusted to navigate these markets, especially when there are execution risks,” said Ng from GAW Capital. “It’s definitely something to look out for when you want to invest a big amount into these markets.”
This means looking at the real estate market from a “physical point of view” will be essential when it comes to investment decisions, reckons Lok.
“For real estate investments that are performing well in a developing country, typically they are attached to a whole system of infrastructure, like dams and highways, and have resiliency measures to prevent things like flooding that can cause big damage. All these developments must go hand in hand, and be combined with business logic and abiding by the local laws,” he said.
In search of dispersion
The basic premise of a hedge fund strategy is to buy undervalued assets and sell short the assets considered to be overpriced. The goal is to take advantage of the differences in the assets’ performance, with this dispersion becoming a driver of returns.
For the past three years, this dispersion has been high due to higher rates, turbulence in financial markets, pressure on economic growth and a spike in energy prices. For hedge funds with long/short equity strategies, high dispersion has been a big driver of return.
“In a high-rate environment, there are big dispersions among good companies and bad companies, but in a zero rate environment, even if you’re not a good company, you can borrow very cheaply to grow and run your business,” said Frank Huang, Head of Fund Research at New Harvest Wealth Securities Company Limited.
“But today, a good company can still be run well, but bad companies have huge interest rate expense burden, so there will be a big dispersion,” he added. “This creates more opportunities for hedge funds to find short opportunities. So, I’m bullish on hedge funds in general.”
As with public markets, private assets are affected by changes to interest rates, and many private fund managers are optimistic for the sector as global rates decline – even if they are unlikely to go to their lows of three years ago. Capturing the opportunities presented by changes in the rate cycle hinges on the ability of the fund manager to anticipate and adapt to these shifting dynamics.
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