Amid the worst bond returns in decades, a sharp reduction in housing affordability, and the failures of multiple banks, it’s only natural for investors to shun risk these days. But these are precisely the conditions which can create outsized opportunities for long-term investors. More specifically, we see an unusually strong demand for liquidity today, putting those willing to accept less in position to reap the rewards.
When Capital Becomes Scarce
Take borrowing, for example. As central banks combat inflation, rising borrowing costs temper demand. The resulting drop in overall lending reduces the amount of credit available across the economy, making capital for purchases and investments harder to come by. Lately, you can see this most visibly in the banking sector, where contracting deposits and heightened risk management have led to tighter lending standards (Display).
That’s not the only place it’s showing up. The funding gap also extends to private investments—increasingly important sources of financing that have been unable to raise capital at the same pace as during the past decade.
The multiplier effect of reduced credit across the economy is partly to blame. But the unique nature of this space, which tends to attract large institutions with long-term asset allocation targets, also plays a role. Many institutions are now overallocated to private investments, after they appeared to outperform (at least on paper) public market equivalents in 2022. Given the so-called “denominator effect,” where private holdings now seem to take up a larger slice of the overall pie, many institutional investors are unwilling to expand their allocations in the private markets today (Display).
Uncovering Emerging Opportunities
Ultimately, the reduced availability of capital across the economy leaves a wide range of companies and assets—many of which remain high quality, cash flowing, and growing—with fewer financing options. On the flip side, it also creates a robust pipeline of attractive opportunities for investors willing to accept some level of illiquidity. Even more importantly, the shortage allows those investors to be highly selective in choosing which assets to fund, which may partially offset the risk of a possible economic slowdown.
While private equity has become a mainstay of most asset allocations and remains a critical pillar and evergreen piece today, we'll highlight a few less well-known sectors that we consider particularly opportunistic at present.
Secondary Private Investments
While private investments typically lock up investor capital for years, in certain circumstances, investors require liquidity and are willing to pay for it. For example, following the outperformance of private investments in 2022, a large pension fund may find itself overallocated to private funds and look to sell some of its interests. To provide capital for such transactions, dedicated secondary funds have become more prevalent in recent years. But the current cycle has led to far greater demand than can be readily met. As a result, secondary buyers can pick up high-quality assets at substantial discounts, setting up an attractive risk/return trade-off.
The most direct way to take advantage of this dynamic is via funds specifically focused on such transactions. Investors should be mindful, though, of the type of assets that each fund targets. Many strategies utilize a “fund-of-funds” approach, buying up interests in diversified private funds—which tend to be more competitively priced and highly correlated with other investments. A more focused strategy favoring complex secondary transactions can secure greater discounted entry prices while emphasizing high-quality assets less prone to leverage and downside risk.
Following the Global Financial Crisis, a combination of risk aversion and more stringent regulation led banks to curtail their lending in several areas. Middle-market companies turned to private credit funds to fill that void, and these strategies have since grown into a major source of debt capital.
The current environment has exacerbated the trends that have favored private credit funds for the past 15 years. Specifically, a further reduction in middle-market bank lending—combined with reduced private market fundraising—has reduced the supply of loans and contributed to higher yields on private debt. This dynamic allows private credit investors to benefit from unusually attractive levels of income while maintaining the protection of seniority in the capital structure and collateral backing the loans. While we believe the current environment presents outsized opportunities for private credit investors, credit risk is a key consideration, and careful underwriting and risk management become even more critical amid slowing economic growth.
The outlook for commercial real estate (CRE) has come into focus lately, particularly given the structural shifts in office space use and other properties following the pandemic. Plus, regional banks—a major provider of CRE financing—have come under stress due to deposit runs.
What’s more, rising borrowing costs have raised concerns about valuation and landlords’ ability to cover interest payments. Real estate is typically a levered investment, and in the past several years, many investors purchased properties at prices reflective of very low interest rates. Now that interest rates have risen substantially, many property owners face potential distress as prices adjust and a wall of debt comes due (Display).
While all of this will take time to play out, commercial property owners’ difficulties may create a compelling opening for both debt and equity investors. With that said, real estate lenders must be highly selective when allocating capital, given the potential for falling asset values and financial distress. As the situation evolves, more opportunities for private investors to buy or recapitalize properties at attractive prices should also emerge.
The Fed’s latest moves have put companies that depend on debt financing in a bind. Higher debt levels and a turn in the cycle may ultimately lead to more bankruptcies. While equity investors in those companies will suffer, a window may emerge for patient and astute investors.
Traditional bondholders, such as mutual funds, typically sell bonds of companies at high risk of default. But distressed debt funds are designed for these special situations. These strategies aim to generate meaningful returns by taking advantage of forced sales and patiently working through the resolution.
In benign economic environments, distressed debt funds are forced to fish in a smaller pond. But amid the strains brought on by the current cycle, we could see the pool of candidates expanding. If that happens, distressed debt could be an area of significant opportunity for long-term investors.
Go on Offense
Investors are often wary of locking up funds for years. But if managed properly, illiquidity can be a substantial driver of long-term returns without meaningfully hampering near-term agility. Private investments remain an evergreen choice for investors, allowing them to further diversify, earn compensation for providing liquidity, and generate excess return potential via sound security selection and underwriting. Plus, with the current market conditions, there's never been a better time to explore their potential.
- Benjamin Goetsch, CFA
- Senior Investment Strategist—Investment Strategy Group
- Wrug Ved
- Senior Investment Strategist—Investment Strategy Group