Shannan Simmons

Hello, everyone. I'm Shannan Simmons, PineBridge’s Global Head of Consultant Relations and I am delighted to be joined by members of PineBridge’s Alternatives Platform, including Joe Taylor from Private Credit, Justin Pollack from our Private Equity Team and Joseph De Leo from the PineBridge Benson Elliot European Real Estate Team.

We're thrilled to have you here today to discuss the key themes driving your respective markets and what it means for investors. Welcome, and thanks so much for being here today. Why don't we start on the private credit side? Joe, what is the key driver or theme impacting your market? And how is it affecting valuations?

Joe Taylor

Thank you, Shannan. appreciate everyone's time here. So, the bottom line for private credit is that this continues to be a very strong vintage opportunity for new originations. And the reason for that is that companies and we are focused here on the performing category or private credit. The companies that are new originations, new LBOs, new platforms that are coming and looking for financing are typically going to be companies that have proven to be resilient. And what I mean by that is, that these companies in a very short timeframe, as we're all aware of, have had to navigate COVID, they've had to navigate high inflationary pressures, obviously, a high base interest rate environment, in addition to wage retention challenges, and logistical challenges.

And so, what we see is that companies that have been able to prove out their business models through the strength of both their management teams and their operational efficiencies, in getting through those challenges are typically going to be very good base businesses that are going to in the future, we believe, have strong risk adjusted profiles. When you add into the fact that base rate environment is high for longer and higher than I think most folks probably had anticipated a couple of years back, and likely going to be for the foreseeable future in that same category. This does present an opportunity for investors to garner on strong platforms, very high risk adjusted return profiles.

Now, that doesn't mean that everything in the market is, is rosy. So, the challenge in this particular segmentation and market right now is really focused on the heritage portfolios. And those are the companies that have either for their challenges, that they have not been able to navigate as well on the prior items that we have spoken about, or were burdened by over leveraged situations, either pre COVID, or even post COVID, when interest base rate environment was much lower. Those companies are going to continue to be a drain of both human capital resources, and also from a financial aptitude perspective, they are going to be companies that are going to be focused on getting through an environment where private equity firms may be in a situation of having to pick and choose what companies they are going to support.

And you also have the fact that enterprise values for the segmentation, although they continue to be at a higher level than the mean, they are going to be compressed. And so, we believe that in this particular market environment, you will begin to see divergence of returns from private credit managers and it’s really heavily skewed towards historic portfolio performance.

Shannan

Thanks, Joe. So, while we continue to see headlines paint broad strokes about private credit, it's clear there's still opportunity, depending on the types of companies you're lending to, I imagine the same holds true for real estate. But Joseph, please talk about valuations and the drivers in your market.

Joseph De Leo

Thank you, Shannan. Yes, I specifically will discuss what's going on in European markets. These are the markets we currently operate in. And I think it will be of no surprise to anybody that really the real estate markets have come to a grinding halt here in Europe. Our cycle effectively ended at the end of 2021, following the onset of war between the Ukraine and Russia, that necessitated an energy crisis here, because we're an importer of energy in Europe, that then translated into a cost-of-living crisis. And then fundamentally, that was the beginning of an almost two-year run of a rapid rise in interest rates and real estate being an interest rate sensitive asset class, and obviously are highly correlated to interest rates, the market has come to a grinding halt.

We’re already probably two and a half years into a correction in the market, we've seen on average, a 25 to 30% drop in valuations, I would say, at the level of the entire market. Of course, real estate is not a homogenous asset class, it varies from sector to sector, on the one extreme, you've got the office and the retail sector that continues to likely be exposed to further valuation declines. And on the other extreme, looking at, you know, say, logistics in the industrial sector along with the housing sector, I would characterize what we're seeing in the market today as a kind of a flattening out of valuations where they were seeing stability or peak yields being achieved there today.

So, a sense of normalcy. So really, since the beginning of this year, we've seen yields peak, meaning remain stable on a period-over-period basis. So, it's very difficult to call the bottom of the market. But certainly, it really feels like, we are there, we are there today. Interest rates have been a clear driver of what's been happening on the valuation front, my expectation is that there isn't anything that I'm observing in the markets that would suggest, we're going to start to see that reverse. If I can put that in a little bit of historical context, it took us almost four years post the GFC, to see a normalization of real estate markets in Europe.

So call that 2012, I would expect, at least to replicate that this time around. And we see the signs of that in the investment volumes for the market. We peaked in 2021, at almost 400 billion of activity in the key Western European markets. That was already up by about 50 billion on average, let's say in the five-year average period leading up to COVID. Pre the period between 2010 and 2014, we were probably half of that. And today, we're back to where we were in volumes in the post GFC period. And that’s really relevant because if you're asking me about what is the driver that I'm looking for, that starts to maybe push the valuation cycle upwards? It's not going to be interest rates, obviously, we're well aware of, you know, in our part of the world, certainly in Europe, you know, inflation has come down quite significantly.

There's a very strong indication that we're going to see some rate cuts coming through the rest of the year, we're even starting to get some economic growth albeit it's anemic, but at least its growth. And the fundamentals of our market remain stable. But none of that really I see as being a driver that may propel the market forward. It's really capital. And right now in our part of the world, there's a lack of availability of capital, and I think that is going to keep our markets depressed, certainly in the medium term.

Shannan

Thanks, Joseph. It’s evident real estate isn't a one size fits all asset class and to quote you “not homogeneous”. Justin, “secondaries”, a buzzword we are hearing about often, can you talk about the impacts you are seeing in your sector and how these are affecting valuations?

Justin Pollack

Thanks, Shannan. We're seeing is a bit of a split right now from the voices of private equity fund managers. On the client side they're acting a lot like a grumpy neighbor I used to have who would complain about all the kids in the neighborhood and you know, they're disrespectful and they are too noisy. And that's what a lot of private equity fund managers are talking about when they review why they're not doing more deals right now. Deal volumes are down and it's because all these companies you can buy and the people who own them, they want too much money for it. They're in denial. They don't understand that, you know, their business isn't worth as much as it was two years ago, because of rising rates, it's ridiculous. Can you believe these people?

And then there's the “but” which is that neighbor I had was also a parent who when talking about their own children, it was “my children are angels”. And these fund managers are doing exactly that. It's, “well, my companies are the exception, my companies are perfect, they're great. I don't understand why everyone doesn't believe the values I have on them”. And this is the real fundamental problem that we're seeing right now. Deal activity is down on the buy-side, because the feeling is that everyone wants values they saw two years ago when interest rates were lower.

But on the sell-side, for those same managers who own probably a dozen companies or more, which is the case in many private equity firms, they don't understand why no one accepts the values that they have and how perfect their businesses are. Because, of course, they also want valuations from a couple of years ago. And what that's led to is a bit of a conflict where private equity managers can't accept the trend. And when they are compared to the public markets, they've tried to continue to promote the idea that they're outperforming the public markets. And that's something that's held true in private equity for the better part of 20 years and across a variety of time periods.

But if you look back in the last three years, public equity came down 15%, a few years ago in 2021 and into 2022. And private equity was flat. But then following that, we saw a really strong rebound in public markets as they roared all the way back, and oddly private equity, kept afoot when things go up. What we're seeing is private equity fund managers are sort of having this denial of physics, it's what goes up, never comes down in their portfolios. And when the public markets show positive trends, they pick up on those, when they show negative trends, they act in denial about them.

The consequence of all this is a lack of distributions, because you can't sell a business, if you think it's worth 100 and someone's only offering you 90, you don't sell it, you're not going to generate capital back to investors. And the consequence is a tightening of the markets in terms of liquidity created and one measure, we look at is how much book value was there at the beginning of the year for the whole private equity industry, and then how much of that has been returned in cash during the year. So last year, 2023, we look at all-time low for distributions and about 10% of the beginning of the year book value came back in cash, meaning companies were sold in some fashion. Historically, that's been 20%. So, on average, about a five year turnover, for private equity portfolio companies.

Doubling that number means that investors are getting stuck in private equity. It doesn't mean the companies are bad, it doesn't mean that they're not growing. But it does mean that the self-realization of a portfolio where you put money in, it comes back out hopefully at a profit, and then you put more money to work into new private equity, it’s coming to a halt. And what the consequence is a significant pickup in the secondary market where investors are saying: “if I can't get natural liquidity, if the fund manager I've invested with won't sell the companies, then maybe I'll just sell the entire fund interest that they're holding of my whole portfolio with them because I need that cash to do other things, whether it's make new commitments in private equity or fund other purposes, it doesn't really matter.

But that's one of the trends that we're seeing, it’s that rising valuations and having them sort of stuck in place, leads to investors getting frustrated that, either something's wrong with their portfolio, either it's overvalued, or the companies aren't sellable. So, they need to take liquidity in their own hands. But the reality is, there is nothing wrong with these portfolios, there's just this perhaps temporary phenomenon of lack of liquidity where being a liquidity provider can be a really attractive place to be.

Shannan

Thanks Justin. So, moving on to the next question, actually, we'll start with you, Justin. Dry powder has accumulated to record highs. What is the impact of all this excess capital across your market? And what opportunities does it present?

Justin

Dry powder is something we look at closely and this is how much capital has been raised by private equity firms but not yet invested, keeping in mind that they typically have a fixed amount of time, five or six years to put that capital to work. Otherwise, the capital is released, and it can't be invested. And therefore, they can't make any carried interest on money they haven't invested. It's pretty important for them to try and identify good investments.

And one element we've seen that was an interesting little blip, was dry powder was rising at a compound rate over 10% for the last 12 years. And in April 2024, it finally declined, but it declined by 1%, which is to say that it's basically been flat and may actually be picking up again. So, investors are giving new money to private equity managers faster than they can invest it and that's been true for a long time, but as it builds, what it generates is more competition. Simply put, the more money there is to invest, the opportunity set hasn't changed in terms of number of companies that presumably are attractive to acquire. So, you may end up paying more for them.

And that's why it's a concern for us. Is there too much dry powder? Or will it raise the price that you have to pay to buy a business and take it private in some fashion? Or is there some way around that and when we start sorting through the dry powder figures, what we see is, it's really bifurcated. Most of that increase in dry powder for the last bunch of years and a much higher growth rate was in large cap managers, that manage multi-billion dollar type funds. And there's a very simple reason for that, even as distributions have slowed down, and investors have become a little more reticent to give new money to managers who, number one, haven't returned as much cash as they hoped for or promised, and two, have already raised a lot of money they haven't invested.

Large managers are very well set up with great investor relations programs, and salespeople and programs to help convince investors to give them more capital, sometimes at a discount, or to help build up their program or different strategies. So that's where a lot of the money is migrating, it’s towards the large cap. And that's where a lot of competition is bubbling over, because that large cap probably represents about 200 firms.

The contrast is in the middle market, which are typically groups that managed fund sizes below $2 billion, they're buying companies that are well below a billion dollars in enterprise value, that rate of growth has been much slower dry powder, it had a smaller base. And there's 1000’s of these firms. And they have a much bigger opportunity set of underlying companies with tens of thousands globally that are in the criteria set.

So, our feeling is, there's still a nice opportunity. You just have to be careful about where you're looking to spend your capital and your investor capital. If it's going to be in a larger part of the market, you should expect a lot more competition. If it's in the middle-market, you may have a better opportunity for choosing the right managers who can still pick through this really dense area with a lot of opportunity.

Shannan

Thanks, Justin. Joe, can you comment on dry powder and private credit? And are you seeing the same bifurcation in dry powder that Justin just spoke to, depending on where you are in the market?

Joe

Yeah, Justin makes some very good points. And for private credit, it is a very similar theme. You know, a lot of the headline news that's out there and what everybody's reading on Bloomberg, and the rest of the news rags out there, is all related to the upper end, large cap segmentation. And in private credit, that is really where the vast majority of the capital has been raised and is being tried to be deployed in. The middle-market, which we call “the core” and the lower-mid-market has been and represents a much more balanced supply demand dynamic and very similar to what Justin had mentioned in regard to the private equity universe.

In regards private credit, when you take a look at the upper end of the market, there are a lot of different financing options, which can lead to and it generally does lead to a kind of fight for financial optimization. When you get into the core and the lower-end-mid market, the reason it's more balanced is one, there's less private credit capital that's been raised, so i.e. there is less available dry powder to be deployed. So, you can be more selective. But number two, which is a very big factor, which we believe is more of an intermediate trend at this juncture, is that the regional banks and this is US, that we’re focused on, the regional banks and smaller have been risk off in regard to leverage lending deployment.

And this has been driven by a lot of factors and the heaviest one being the focus on shoring up balance sheets in that particular segmentation for commercial real estate in particular, which is going to be a challenged asset class for the next couple of years for sure and has required the regional banks who had been one of the competitors in the segmentation to effectively exit. So, it creates for the private credit managers in core and lower-mid-market, even a better opportunity set and the ability to be highly selective in their asset origination.

Now, the other factors which are important to differentiate is, one is that there really are only two ways to finance on a leveraged basis, core and lower-mid-market, which is private credit, and banks/ banks mezz. So, one, we effectively have got rid of one of the core competitors.

Number two is that, as Justin had mentioned before, you know, there is on a relative basis, much more dry powder in the private equity world, even at the low and core mid-market segmentations, so that is still continuing to keep enterprise values high. So, you have the ability for the lower and core mid-market managers on private credit to be highly selective in their asset choosing. The second item, which is important to identify is that enterprise values continue to be above the norm, the median, right, so, in our segmentation, historically, enterprise values have ranged somewhere between eight and a half to 10, maybe 11 times, and you're certainly at least one to two terms above that, on average, even in this environment. It's not at the 18 month-24 month ago peaks, which, you know, are hard to justify, even in that particular environment. And it was driven by a lot of the fact that base rate was below 1%.

And you also have the fact that as a pure governor, because of the higher actual cash interest burden of these companies, leverage has to come down. And so from a prudency perspective, you are having the ability to leverage good platforms, as we talked about earlier, new originations, resilient companies, being able to be highly selective, entering into these transactions at a lower than historic norm leverage level, and also having a very strong cushion of equity contribution coming in behind you, because of the elevated enterprise values that still exist in this marketplace.

So, you know, it does put private credit managers in a pretty advantageous position in the core, in the lower-mid-market. Now with that, you have to be prudent, these are smaller companies. So, you have to make sure from a diligence perspective, that you are checking off all the boxes, and this is typically more of a bilateral type of a situation. But with that, on aggregate, for this current environment, it is presenting a very strong risk adjusted potential for investment.

Shannan

Thanks Joe. Joseph, are you seeing the same, the rise in dry powder for real estate in a specific market or on the whole?

Joseph

Well, after listening to some of those comments, clearly, I'm representing the asset class, that's the poor cousin of private credit and private equity. In Europe today, I would say we really are not facing a situation where we have significant capital sitting on the sidelines, I would say the exact opposite in my view. We're coming off a decade of significant capital flows into our asset class post, really 2012, every year was a new record year. And that was really driven by a need for an alternative to fixed income. And the view was real estate provides a yield and, and so let's shift out of fixed income. And in a European context, that all got done at a period of time when we were in, you know, a zero-interest rate environment and so an enormous amount of capital flow to our sector, that fueled an enormous amount of investment activity.

And here we are today, two and a half years post the end of the last cycle, and you're having to dig deep down in your pockets to find a few nickels or lift up the cushions from the sofa, capital’s that scarce in the market. And when I think about the main pockets of capital that fuel the market here in Europe, my outlook certainly in the medium term remains very subdued. If I look at the closed-end fund operators, which are principally the private equity firms, in our market it is highly bifurcated, on one end you have the big global asset managers, publicly traded asset managers and they’re accruing capital, not too dissimilar to some of the comments that have been made today.

And then on the other end of the dumbbell, you have the mid-market managers like ourselves. And in the last two years between 2022 and 2023, we've had less than 10% of global allocation of capital to our market. In fact, between 2022 and 2023, in aggregate that was less than what was raised in 2021 and during the COVID period.

And given most of the comments that have been already made, they're very applicable in real estate private equity as well. Institutional Investors are all today sitting well above their target allocations for real estate, there are no distributions coming in. So, it's very difficult to make future commitments. And the investment markets, continue to remain weak, and therefore, it's hard to see where liquidity events are going to come from. And so. I think closed end-fund structures are going to remain on the sidelines, for the most part in the medium term.

There is some incremental remaining capital on the sidelines available, but you know, that's an aged capital, it was raised in 2021/22. And now, that money's coming to the end of its investment period, and as I think, as Justin had mentioned, that money is going to have to go back. And as I go further across the capital sources, the public companies in Europe, they're pretty much out of business, they can't raise equity, can't raise debt, and can't use their assets for currency, because there's still questions remain about valuations.

And then the other major source of capital, which represents the majority of volume in this part of the world in Europe, comes principally from the open-ended fund operators in the UK, France and Germany. And all of those investors are out of the market. The UK investors have effectively been seeing consistent rising redemption requests since 2016, since the Brexit vote, and moving to the French and to the German open-ended fund operators, after a decade of record capital aggregation, they themselves now are two years into consistently rising redemptions. And so, we don't have a lot of dry capital. In fact, what is driving the opportunity in European real estate today is the scarcity of capital.

And so, for mid-market managers who have got discretion, there's a lot of interesting opportunities that are emerging in the marketplace, principally, driven by broken capital structures. And so, there's liquidity that is needed to pay down debt, in order to get an extension, there is liquidity needed to pay for capex that will drive revenue at the asset level.

And sometimes I see situations where liquidity is required to cure covenants. And so, it’s a really interesting time, though, for managers who have got some discretionary capital, to generate interesting returns. And we always like to say in real estate, you know, the best returns will always accrue to those who move before capital markets normalize. So, I'm optimistic for those who play in the mid-market space about the opportunity set going forward.

Shannan

Thanks, Joseph. You're right, a very stark contrast to our other two colleagues in terms of dry capital.

Thank you, Joseph, Joe, and Justin for the insights you provided discussing the variety of alternative investments. And thank you to our listeners. Please tune in for part two, where I welcome the three of them back to discuss our collective focus on middle market space, and lessons learned post crisis. In the meantime, for more of our market and Investing Insights, please visit our website at www.pinebridge.com.

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