It has been rare to attend an investment event in Hong Kong or Singapore during the past two years without hearing a panel discussion about the merits of private equity and credit.
Representatives from the large, global private equity firms extol their advantages over public markets to fund selectors, who are encouraged to persuade their wealth management clients to raise their allocations to the sector, adding juice to traditional 60:40 portfolios undermined by positive equity/bond correlations.
“As we expect higher inflation in the years ahead, the addition of private assets will benefit a conventional 60/40 portfolio as the correlation of bonds and equities typically heighten in a higher inflation environment,” Grizelda Lee, head of discretionary portfolio management at Bank of Singapore, told FSA.
Yet, the private equity landscape in Asia Pacific looks choppy at best, bleak at worst.
Asia Pacific private equity funds raised just $100bn in 2023, the lowest level in a decade, according to Bain & Co.’s Asia Pacific Private Equity Report 2024.
Deal value plunged to $147bn, extending the dealmaking slump that began in 2022, 35% below the previous five-year average and 59% below the 2021 high of $359bn, and the number of deals dropped under 1,300, 30% lower than the previous five-year average of 1,849 deals. Meanwhile, exits slumped.
“Valuations have been hammered by high interest rates during the past few years; sustained high interest rates have resulted in depressed valuations on many private equity deals, with exit activities remaining sluggish, and many buyers and sellers continuing to tug in mismatched expectations on asset value,” according to Connie Sin, head of funds and alternatives international wealth management at Nomura International (Hong Kong).
“But, as the Federal Reserve starts to pivot, this signals a shift towards more favourable conditions for private equity going forward, providing unique growth opportunities for investors,” she added.
Sin’s sector preferences range across the spectrum from growth to defensive, but with a tilt far away from mainland China.
“We see continued demand in high secular growth sectors such as AI and data centres, as well as defensive sectors such as communication services, healthcare and industrials,” she said.
Among regions, Sin she has seen increasing demand into Asian private assets for geographical diversification, including into Japan, India and Australia – but not China.
Recent Asia private equity funds reflect the sector preferences among investors, as well as their caution towards China exposure – although they have been aimed at mostly institutional investors.
For example, in February, KKR announced the final close of its Asia Pacific Infrastructure Investors II SCSp, a $6.4bn fund focused on low volatility infrastructure-related investments across the region.
The fund received backing from a range of new and existing global investors across the world, including public and corporate pensions, sovereign wealth funds, insurance companies, endowment funds, and asset managers, said KKR in a statement.
Earlier this month, Reuters reported that Blackstone, the world’s largest alternative asset manager, has started raising its third Asia-focused private equity fund, targeting at least $10bn.
The new buyout fund will primarily focus on India with the largest percentage of capital allocated there, Reuters’ sources said. China will not be a focus market for the new fund, while Japan and Australia will be two other significant markets and it will look to other countries such as South Korea and Singapore, they said.
However, “for private assets, there will always be illiquidity risk and lesser degree of transparency. Private equity is also more sensitive to economic downturns since companies are generally in earlier stages of growth,” said Lee.
Evergreen funds offer limited liquidity
“Democratising” incentives such as offering semi-liquid, open-ended “evergreen” funds which allow early redemption for investors, have more appeal to fund selectors, whose rich clients are reluctant to lock-in their capital for five or 10 years or longer.
For instance, Partners Group, a Swiss-based global private equity firm with$149bn in AUM, claims that its open-ended evergreen programmes have continued to receive healthy inflows.
“Crucially, due to Partners Group’s pro-rata allocation policy, private wealth investors in our evergreen funds receive equal access to the same high-quality investments as our institutional clients,” Henry Chui, head of private wealth Apac and head of the Hong Kong office at Partners Group.
Partners Group’s evergreen funds include a private equity fund investing in directs, primaries and secondaries, a multi-asset class fund, a “next generation” infrastructure funs, an impact fund and a credit focused fund.
The attractions of liquidity resonate with fund selectors, who nevertheless are highly picky, not least because a below-market redemption price might accompany that enhanced liquidity.
“Semi-liquid vehicles remain the most popular structure as concerns remain about sticky inflation and uncertainty about the November elections,” said Sin.
“Liquidity and selectivity remain the keys. Diversification, loss-rate liquidity and industry skillsets are on top of our clients’ mind when investing in private market managers.”
The Bain report authors attributed the declines to investors’ worries about slowing economic growth across much of the region (especially China), persistently high interest rates that raise the cost of private equity, and volatile public stock markets, reinforced by geopolitical tensions and conflicts.
Low IRRs and DPIs
However, a more fundamental reason for Asian investors’ reluctance, shared worldwide, has been falling internal rates of return (IRR) and low distributions to paid-in capital (DPI).
Private equity’s annualised IRR fell below 10% in the year to March 2024, according to PitchBook, well below the 25% the industry used to target, due to sparse exits as corporate buyers withdrew and amid little enthusiasm for IPOs. Instead, funds have turned to dividend recapitalisations – basically borrowing to pay investors dividends.
“Private equity continues to capture generational changes and human innovation, offering investors participation in companies that require a longer runway to scale or profitability,” said Christina Au-Yeung, head of investment management services and executive director at Morgan Stanley Private Wealth Management Asia.
“However, the risk currently pertinent to investors is that this runway extends so long that any return premium is beaten by compounded returns from liquid markets,” she warned.
Indeed, the average holding period for private equity portfolios has increased since 2015. According to the Bain survey, investors tried to sell half of the assets they have held for more than five years. The most common reason these efforts failed was that the buyer and the seller could not agree on the valuation.
Yield enhancement with private credit
Against this backdrop, wealth managers have been looking at alternatives within private markets, especially as interest rates and public fixed income yields fall. Private credit has the appeal of locked-in high yields – but also the pitfalls of opacity.
“Private credit offers investors current income from businesses with a growth trajectory,” said Au-Yeung.
“However, the expansion of investor flow, the proliferation of semi-liquid vehicles and the softening of credit underwriting standards all warrant a more discerning approach,’ she warned.
“Clients who have holding power should be better served by products whose tenors are more reflective of the liquidity of their underlying loans.”
The Asia-Pacific private credit market, though still at an early stage at $115bn in 2022, has grown at 24% per annum during the past five years. Private credit now represents 4% of total alternative assets under management in the Asia-Pacific region compared with 16% in Europe and 15% in the US, according to Bain.
The sector is gaining in traction among individual investors in Asia who are keen for income in a falling interest rate environment, but only if they are paid a sufficient premium, and covenants ensure they rank high in seniority and that there are restrictions on further borrowings by the issuer.
“[Private market] flows have skewed towards private credit versus private equity, as its yield served as attractive alternative income, while private equity return premiums have depleted,” said Au-Yeung.
“Clients have been keen to take advantage of the enhanced liquidity terms among private credit vehicles this year, not to mention more frequent yield distribution intervals.”
Au-Yeung has guided clients towards sectors where there is a structural need for private credit financing (for example, US mid-market direct lending), and managers with experience navigating economic cycles and workouts.
Nomura’s Sin agreed that “the loan spread on private credits remains attractive and offer investors high risk-adjusted returns, predictable yield, and diversification”.
“Private credits also offer less volatility to public credits as most of them are senior direct lending with first-in-line repayment among creditors in case of a bankruptcy, together with strong contractual covenant protections for the lender to control risks,” she said.
Bank of Singapore’s Lee also said her clients have been excited about the private credit space amid the higher interest rate environment, but “allocations to either private equity or private credit is still largely dependent on clients’ risk tolerance and investment horizon”.
Overall, the key risks for holding either private equity or private credit are the high fees and costs, liquidity and lack of transparency. Yet, with the strong demand by a range of investors, both private credits and private equities are now an established asset class and could represent a longer-term opportunity for investors.
