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April 13, 2022

An Evolving Private Markets Landscape

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April 13, 2022

An Evolving Private Markets Landscape


Insight Article

An Evolving Private Markets Landscape

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April 13, 2022

 
 

Morgan Stanley’s house view on the global economy is constructive but recognizes that investment returns from traditional asset classes may be potentially more difficult to come by than in the more recent past. Public markets have delivered remarkable performance over the past few years, but we expect that returns may be lower and volatility higher going forward. It is no surprise therefore that the interest in Alternatives and Private Markets continues to grow.

Of course, Alternatives and Private Markets are not homogeneous and offer a diverse set of investment opportunities with varying return and risk profiles.1 Within the space, we see several changes brought about by shifting market dynamics, through product design and innovation, and even changes in investor priorities and conscience. In the following article, we discuss some of these dynamics which we believe may provide attractive investment opportunities and investors should be aware of.

Private Equity – Changing Secondary Market Dynamics

Private equity represents approximately 11% of the average portfolio allocations. Despite almost tripling in size since the mid-2000s (see Display 1), one could argue that this level of adoption still appears below the optimal exposure given the asset class’s attractive performance. Increasing duration and the associated illiquidity remain key reasons why this allocation gap persists. However, there are solutions available within the private equity industry to check, or reverse, this upward trend in duration and allay investors’ concerns about increasing their allocation to the relatively long holding periods.

 
 
Display 1
 
Secondaries Volume vs. PE Unrealized NAV ($B)
 

Source: Preqin, data as of 31 March 2022

 
 

In the early 2000s, the secondary market was primarily a tool for large limited partners (“LPs”), such as endowments, to obtain liquidity for their portfolios. However, we are witnessing a significant shift in the use of the secondary market and attitudes about the sector have shifted tremendously in the past decade. These markets are no longer viewed solely as vehicles for LPs to provide liquidity. Rather, they have evolved to enable complex general partner (“GP”)- led restructurings of mature funds and become an important part of the strategy for many private equity and venture capital funds.2

GPs have a significant amount of capital locked up in funds. Along with an increased volume of, and narrowing spreads in, secondary markets, longer holding periods have led to a huge growth in GP-led secondaries. These transactions now represent over 50% of the secondary market transactions (Display 2). The motivations for GP-led deals are different from traditional LP secondaries. Rather than focusing on liquidity, GPs use secondaries as an avenue to preserve the assets they want to maintain while addressing the needs of their investors. Thus, when a GP has an asset that the fund partners want to keep owning but is feeling pressure to return capital to its LPs, using a secondary with a continuation fund is an attractive option while it may provide investors with an interesting set of attractive investments. This solution may allow new investors to gain access to carefully selected high quality assets, with revised favorable terms, in deals with a shorter duration, potential for compelling IRRs and less of a j-curve (Display 3).

 
 
Display 2
 
Annual Transaction Volume ($B)
 

Source: Global Secondary Market Review, Jefferies, January 2022

 
 
Display 3
 
Potentially Beneficial Solution For All Parties Involved
 

For illustrative purposes only. The statements herein reflect our views and opinions as of the date hereof and not as of any future dates and will not be supplemented or updated. All forecasts are speculative, subject to change at any time and may not come to pass due to economic and market conditions.

 
 

The Appeal of Hybrid Private Investments

From work/life arrangements to the energies used in our cars, demand for hybrid solutions is everywhere, including investments. Indeed, we see many investors transitioning to more hybrid structures in an effort to achieve their investment goals. Similar to the growth of customization as a way to refine investment solutions over the last two decades, we are now also seeing investment solutions adopt a more hybrid approach to their structure and/or investment universe. Investors are seeking combinations of investment features such as equity-like returns with traditional bond-like characteristics and thus looking at opportunistic alternative funds. These tend to be less constrained by traditional metrics, guidelines and mandates, investing across capital structures and into more niche investment opportunities. They may offer attractive risk/return characteristics thanks to the freedom of their mandate, potentially providing complementary risk/ return profiles to traditional portfolios, public equity diversification, stable returns and alpha/growth.3

The current environment is auspicious to these less constrained funds. They have the opportunity to identify mispriced assets across a spectrum of opportunities and determine the best investment method, presenting an attractive entry point for investors. Potentially less well understood than traditional investments though, and generally less liquid, care must be taken when evaluating an investment in hybrid funds. Partnering with a specialist is therefore key.

In addition to opportunistic alternative funds, traditional asset classes such as fixed income offer new hybrid funds that have the potential to deliver enhanced yields over core fixed income (see Display 4), thanks to hybrid features such as mezzanine positions and floating interest rates offerings, as well as increased access to private credit solutions (e.g., middle-market direct lending and consumer lending). Their hybrid attributes are particularly attractive for investors who can accept some illiquidity in exchange for enhanced and differentiated yields. In addition to positive real yields, these fixed income solutions may also offer downside risk mitigation for public equity exposure, which is now less available from traditional fixed income securities.

 
 
Display 4
 
Public vs Private Credit Risk/Return Profile
 

Source: Bloomberg Barclays High Yield index, S&P Leveraged Loan Index and Cliffwater Direct Lending Index. Data as of 31 December 2021.

 
 

As a consequence of the environment and these features, there appears to be significant growth particularly in private credit. On the supply side, borrowers continue to look to the private markets. Equally, borrowers value the adaptability and partnership of private lenders, often the only—or the lead—investor in deals. From a demand standpoint, the global search for yield continues. Today, it also includes a demand for assets that can hedge inflation and protect capital in untested market environments. As a result, investors are increasing their allocations to the asset class (Display 5), achieving differentiation through the types of private credit chosen and other sources such as geographic diversification. Private credit still offers relatively high spreads over public markets (Display 6), as well as covenants (lender protection), and floating rate or asset-based inflation protection. It is also likely to continue to exhibit low volatility due to its less liquid nature.

 
 
Display 5
 
AUM of Funds Primarily Involved in Private Debt Direct Lending Has Grown Tenfold in Past Decade
 
 
 
Display 6
 
Differing Credit Source Returns %
 

Source: BofA Securities, Bloomberg, Clarkson, Cliffwater, Drewry Maritime Consultants, Federal Reserve, FTSE, MSCI, NCREIF, FactSet, Wells Fargo, J.P. Morgan Asset Management. *Commercial real estate (CRE) yields are as of September 30, 2021. CRE – mezzanine yield is derived from a J.P. Morgan survey and U.S. Treasuries of a similar duration. CRE – senior yield is sourced from the Gilberto-Levy Performance Aggregate Index (unlevered); U.S. high yield: Bloomberg US Aggregate Credit - Corporate - High Yield; U.S. infrastructure debt: iBoxx USD Infrastructure Index capturing USD infrastructure debt bond issuance over USD 500 million; U.S. 10-year: Bloomberg U.S. 10-year Treasury yield; U.S. investment grade: Bloomberg U.S. Corporate Investment Grade

 
 

Environmental Conscience and True Alignment

An increasingly prescient theme has been the growing interest and engagement in environmental investments (see Display 7). ESG, as a topic, is now mainstream, it is no longer something just additional. Risks are being considered across investments, companies are being required to address ESG issues, activities are being targeted and investors are willing to divest if ESG issues are not addressed appropriately.

 
 
Display 7
 
Attitudes Toward ESG Risks and Opportunities, % of Respondents
 

Source: PwC 2021 Global Investor Survey

 
 

According to the placement agent Campbell Lutyens, $183 billion is being raised or invested across asset classes in climate-themed investments alone. As extreme weather events make global headlines and experts warn about a shifting climate, more investors are thinking about both environmental risks and how they might affect their portfolios. They are also looking for investment decisions that may contribute to environmental protection or where the investment has tangible metrics and performance indicators. Early adopter investors are also no longer oblivious to the growth opportunities created by compelling climate innovations and changing consumer preferences. As Private Markets investors engage on this topic, we see increasing opportunities to effect meaningful change through true alignment of interest. Indeed, certain progressive thinking investment firms are implementing direct linkage between their fees and the outputs their investments have on the climate or environment, a unique and important step by managers showing both confidence in their investment acumen as well as moral compass.

Whilst these observations do not represent the full extent of developments across what is a dynamically changing private markets investment landscape, they do represent some shifts that we believe could provide differentiated investment opportunities.

For more information, please contact your sales representative.

 
 

1 Diversification does not eliminate the risk of loss.

2 This creativity to address constituent needs has been a hallmark of the secondary industry as noted by the Harvard Business School (Summary Changeof Secondary Markets review, December 2021).

3 Diversification does not eliminate the risk of loss.

 

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Risk Considerations

Historical performance information is not indicative of future results, and the historical performance information in this paper should not be viewed as an indicator of any future performance that may be achieved as a result of implementing an investment strategy substantially identical or similar to that described in this paper.

Alternative investments are speculative and include a high degree of risk. Investors could lose all, or a substantial amount, of their investment. Alternative instruments are suitable only for long-term investors willing to forgo liquidity and put capital at risk for an indefinite period of time. Alternative investments are typically highly illiquid—there is no secondary market for private funds, and there may be restrictions on redemptions or the assignment or other transfer of investments in private funds. Alternative investments often utilize leverage and other speculative practices that may increase volatility and risk of loss. Financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. Morgan Stanley Investment Management (MSIM), its affiliates and its and their respective directors, officers, members, partners, employees, agents, advisors, representatives, heirs and successors shall have no liability whatsoever with respect to any person’s or entity’s receipt, use of or reliance upon this document or any information contained herein. If such a person considers an investment she/he should always ensure that she/he has satisfied herself/himself that she/he has been properly advised by that financial intermediary about the suitability of an investment.

IMPORTANT INFORMATION
The information contained herein refers to research, but does not constitute an equity research report and is not from Morgan Stanley Equity Research. The views expressed herein are those of MSIM as of the date of preparation and are subject to change at any time due to changes in market and economic conditions. The views and opinions expressed herein may differ from those of other Morgan Stanley affiliates or businesses. The views and opinions expressed herein are based on matters as they exist as of the date of preparation of this piece and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof.

These comments are not necessarily representative of the opinions and views of any other MSIM portfolio manager or of Morgan Stanley as a whole. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness, and accordingly, we make no representation or warranty with respect thereto. The recipient should bear in mind that past performance is not indicative of future results. Keep in mind that forecasts are inherently limited and should not be relied upon as an indicator of future performance. The views expressed are subject to change based on market, economic and other conditions. They should not be construed as recommendations, but as an illustration of broader economic themes.

Information regarding expected market returns and market outlooks is based on the research, analysis, and opinions of the investment team of MSIM. These conclusions are speculative in nature, may not come to pass, and are not intended to predict the future of any specific Morgan Stanley investment. Certain information contained herein constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” continue” or “believe” or the negatives thereof or other variations thereon or other comparable terminology. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. No representation or warranty is made as to future performance or such forward-looking statements.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. There are important differences in how the strategy is carried out in each of the investment vehicles. Your financial professional will be happy to discuss with you the vehicle most appropriate for you given your investment objectives, risk tolerance and investment time horizon. This piece has been prepared solely for informational purposes and is not an offer, or a solicitation of an offer, to buy or sell any security or instrument or to participate in any trading strategy or other investment. The material contained herein has not been based on a consideration of any individual recipient circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, the recipient should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

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Persons considering an alternative investment should refer to the specific investment’s offering documentation, which will fully describe the specific risks and considerations associated with such investment.

This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

Alternative investments typically have higher fees and expenses than other investment vehicles, and such fees and expenses will lower returns achieved by investors. Funds of funds often have a higher fee structure than single manager funds as a result of the additional layer of fees. Alternative investment funds are often unregulated, are not subject to the same regulatory requirements as mutual funds, and are not required to provide periodic pricing or valuation information to investors. The investment strategies described in the preceding pages may not be suitable for the recipient’s specific circumstances; accordingly, you should consult your own tax, legal or other advisors, both at the outset of any transaction and on an ongoing basis, to determine such suitability.

Risks Relating to Private Equity Investments. Private equity funds will typically invest in securities, instruments and assets that are not, and are not expected to become, publicly traded and therefore may require a substantial length of time to realize a return or fully liquidate. There can be no assurance that any such fund will be able to identify, choose, make or realize investments of the type targeted for their fund, or that such fund will be able to invest fully its committed capital. There can be no assurance that a fund will be able to generate returns for its investors or that returns will be commensurate with the risks of the investments within such fund’s investment objectives. The business of identifying and structuring investments of the types contemplated by these funds is competitive and involves a high degree of uncertainty. In addition to competition from other investors, the availability of investment opportunities generally will be subject to market conditions as well as, in many cases, the prevailing regulatory or political climate.

Epidemics and Other Health Risks. Many countries have experienced outbreaks of infectious illnesses in recent decades, including swine flu, avian influenza, SARS and the 2019-nCoV (the “Coronavirus”). In December 2019, an initial outbreak of the Coronavirus was reported in Hubei, China. Since then, a large and growing number of cases have been confirmed around the world. The Coronavirus outbreak has resulted in numerous deaths and the imposition of both local and more widespread “work from home” and other quarantine measures, border closures and other travel restrictions, causing social unrest and commercial disruption on a global scale and significant volatility in financial markets. In March 2020, the World Health Organization declared the Coronavirus outbreak a pandemic.

The ongoing spread of the Coronavirus has had, and will continue to have, a material adverse impact on local economies in the affected jurisdictions and also on the global economy, as cross border commercial activity and market sentiment are increasingly impacted by the outbreak and government and other measures seeking to contain its spread. The global impact of the outbreak has been rapidly evolving, and many countries have reacted by instituting quarantines and restrictions on travel. These actions are creating disruption in supply chains, and adversely impacting a number of industries, including but not limited to retail, transportation, hospitality, and entertainment. In addition to these developments having adverse consequences for certain portfolio companies and other issuers, our operations have been, and could continue to be, adversely impacted, including through quarantine measures and travel restrictions imposed on our personnel or service providers based or temporarily located in affected countries, or any related health issues of such personnel or service providers. Any of the foregoing events could materially and adversely affect a fund’s ability to source, manage and divest its investments and its ability to fulfil its investment objectives. Similar consequences could arise with respect to other comparable infectious diseases.

Prospective investors should note that any information provided regarding valuations, targets and/or prior performance was determined and relates to periods prior to the widespread outbreak of the COVID-19 pandemic and does not reflect any estimated negative impact of the outbreak or the related economic ramifications. Given the significant economic and financial market disruptions currently occurring and anticipated in connection with the outbreak, it is expected that the valuation and performance of certain markets and/or investments will be materially adversely impacted for future periods (at least in the short term).

This is prepared for sophisticated investors who are capable of understanding the risks associated with the investments described herein and may not be appropriate for the recipient. No investment should be made without proper consideration of the risks and advice from your tax, accounting, legal or other advisors as you deem appropriate.

Morgan Stanley does not render tax advice on tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used with any taxpayer, for the purpose of avoiding penalties which may be imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and constantly changing. Clients should always consult with a legal or tax advisor for information concerning their individual situation.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

Indexes do not include any expenses, fees or sales charges, which would lower performance. Indexes are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

For illustrative purposes only. The statements above reflect the opinions and views of MSIM as of the date hereof and not as of any future date and will not be updated or supplemented. All forecasts are speculative, subject to change at any time and may not come to pass due to economic and market conditions. Past performance is not indicative of future results.

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