Private capital: out of the woods?

They say a week’s a long time in politics. But that adage could easily apply to financial markets at the moment. As if the failure of Californian Silicon Valley Bank (SVB) weren’t enough to unnerve investors, just days later came the dramatic rescue of Credit Suisse*.

The failure of SVB, in particular, has provoked some comment as to whether there are risks in private markets that are not fully appreciated. This was initiated in no small measure by the fact that many of SVB’s depositors, both corporate and individual, were ultimately connected to venture capital-backed businesses in the tech sector.  

That may be true. But at the same time, it is also something of a red herring in our view. The issues at SVB were fundamentally a classic duration mismatch, with the bank borrowing ‘short’ from depositors and lending ‘long’ via investments into corporate bonds. This was exacerbated by the fact that depositors started to draw down cash to fund operations as funding conditions in private equity softened. Again, this was exacerbated by the concentration on early-stage IT businesses with negative cashflows.  

More broadly though, it has shone a light on the possibility that a slowdown in the tech sector could create challenges for private assets. Tech is undoubtedly a significant proportion of assets in the private equity space – up to around a third of equity capital invested on some measures. For private debt, the exposure is estimated to be in the order of around 15%, which we believe is even lower in the investment-grade (IG) credit space. For real estate, the exposure is primarily to tech firms as occupiers of office space. In the UK, they have accounted for around 15% of office take-up in the past five years[1]. So, while not insignificant, we believe this is not enough to materially weaken demand/supply conditions and undermine private asset values.

Cautious on the path ahead

The implications for private markets, and our primary focus on real estate and private credit, we believe, are driven more by the impact on the macroeconomic environment. At one of our strategy meetings recently, the focus was very much on inflation and the potential for it to persist at higher levels than markets have been assuming. We were already relatively cautious on the macroeconomic outlook.

Taking the ‘dual’ banking crises together, the risk of additional downward pressure on economic growth from tighter lending standards and higher interest margins seems more likely to us. That reinforces our desire to focus on, what we believe to be, highly resilient assets and credits.

Seeing the wood for the trees?

So, how does that translate through to our sector positioning? For private credit, our investment focus has always centred on relatively highly rated assets, whether that be in fixed or floating-rate debt. We see that as particularly important at this point in the economic cycle, and in our underwriting, we focus heavily on downside resilience. Within real estate, we tilt towards sectors with relatively inelastic demand and constrained supply. Residential features strongly here – from student accommodation and build-to-rent, through to social and affordable housing – as well the industrial sector, where demand is bolstered by the need to make supply chains more resilient. Assets linked to knowledge and innovation, such as university spinouts, are also favoured. In the area of clean energy, the Inflation Reduction Act in the US and recent EU reforms, have shown that, if anything, the backdrop for renewable energy has become more favourable of late.

In summary, we are positioned for a more challenging growth environment. At the same time, we believe our investments continue to have wider environmental or social benefits, whether that be via expanding housing supply or supporting decarbonisation.

*For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

[1] Source: Burgiss as at 31 December 2022.