Private Equity Managers Shore Up Funds for a Potential Downturn
Record Cash Raised to Deploy More Selectively in Alternative Global Markets, Property Types
BY MARK HESCHMEYER (via CoStar Group)
Private equity fund managers are making their best guesses on when a market downturn could occur.
Private equity funds are shoring up portfolios for a potential prolonged market correction in the next couple of years amid record high real estate valuations, slowing global growth and increased competition for commercial property.
According to Belgium accounting firm BDO’s Tenth Annual Private Equity Perspective Survey, 89 percent of private equity fund managers expect a prolonged downturn sometime in the next two years. Moreover, 22 percent anticipate a market correction in the next six to 12 months.
Whether or even if the next recession comes tomorrow or in two years, private equity firms are proactively taking steps to shore up their portfolios for potential economic headwinds. The results come as the U.S. economic expansion is on track to reach a record stretch in July 2019, prompting discussion among money managers of all asset classes on when growth will end in contraction as it has in every other period of expansion.
To prepare for a downturn, 70 percent of BDO survey respondents said they are being more selective when evaluating highly valued deals. And 14 percent are holding their current investments for longer periods, and just 8 percent are exiting current investments.
“Data suggests that there’s a shift underway in private equity, with valuations at historic highs and competition for a limited number of quality deals driving up purchase prices,” Scott Hendon, national private equity industry group leader at BDO, said in a statement with the results. “A confluence of economic factors leads us to believe a market correction may be coming and to expect valuations to be tested as buyers get less aggressive on cyclical assets.”
In the real estate sector specifically, the majority of respondents said they expect to deal activity to decrease during the next 12 months.
Most private equity professionals agree that a bear-market correction, typically defined as a 20 percent decline in the broader stock market, is in sight. However, predictions on timing vary. KKR, for example, is predicting a “mild recession” in 2019. Blackstone Group LP’s president Jon Gray, meanwhile, has gone on record to say he is “willing to bet no recession in 2019,” according to the BDO survey.
Real estate is one of KKR’s youngest businesses and the company is still scaling up in that sector. Therefore, despite anticipating a mild recession, it still sees significant global opportunities and continued ability to raise money.
“We’re managing about $6 billion in [real estate assets] through debt and equity-focused funds and permanent capital vehicles,” Scott Nuttall, co-president and co-chief operating officer, said in his company’s earnings conference call this month. “Our focus is continuing to scale the platform with additional pools of capital, both debt and equity across the U.S., Europe and Asia. In 2019, we expect to see fundraising for strategies across all three geographies, largely comprised of first- and second-generation funds.”
In his earnings conference call, Blackstone’s Gray also said he expects to see further fundraising strength. He expects to take in some $60 billion for all of its global real estate funds combined. That is up from $50 billion raised in their prior vintages.
“Demand in the market exceeds the capacity limitations we’ve placed on them,” Gray said. “In real estate, we continue to see particular strength in tech-driven office, global logistics, U.S. rental housing, and in India.”
The U.S. industrial and multifamily markets have been the primary focus of private equity firms over the past three years, substantially leading investments in other primary property types, according to CoStar COMPs data. Over the past two years, though, private equity funds have become net sellers of multifamily property while stepping up their industrial purchases.
Global markets are where a lot of private equity money is starting to head. Along with India, Blackstone is also targeting markets in Asia.
“Japan is a market that I think will continue to open up and be more receptive to foreign capital,” he said. “China, obviously a lot of discussion around the slowdown, but it is still a very large economy, growing at, call it 6 percent-plus, and we think the investment opportunities in that market will grow.”
Obviously, there are economic challenges to face, Gray said, but the bigger firms by the sheer size of the funds they have to deploy have an advantage in meeting those headwinds.
Glenn Youngkin, co-chief executive of private equity fund the Carlyle Group, noted in his earnings conference call that in this high-price environment, almost every asset is generally too expensive. Youngkin said he expects to see potentially some reduction in purchase prices internationally.
“In real estate, one of the big shifts that our real estate team was very focused on over the last few years is shifting from GDP-driven real estate investment towards demographically-driven real estate investment,” Youngkin said. “We’re very excited about the fact that the $5.5 billion new Carlyle Realty Partners VIII that we closed this past year is moving into this market with a lot of dry powder and a lot of opportunity.”
Following the release of its U.S. real estate market outlook late last month, Virtus Real Estate Capital launched its latest fund, Virtus Real Estate Capital III, with a target of raising $600 million. That would nearly double the amount raised in its second fund two years ago.
“Lofty valuations, recent market volatility, and rising concerns over the probability of recession in the coming years are keeping most investors on their heels as they head into 2019,” Terrell Gates, founder and chief executive of Virtus Real Estate Capital, noted in his outlook
Still, Gates said, commercial real estate will probably outperform other risk asset classes in 2019.
“There will be more clear winners and losers going forward, rather than the broader real estate bull we have experienced since coming out of the global financial crisis,” he said.
Property-type selection will be more important than ever, he added, with debt strategies more likely to outperform equity in the short-term.
In this environment Virtus is focusing on primary markets with sustainable growth. Its preference is for alternative or niche property types including medical office, senior living and workforce housing.