Interest rates and bond yields hold all asset classes in their thrall as we go into 2024. This includes alternatives, such as private equity, private debt, property and infrastructure. For those alternatives in a liquid, listed wrapper – in other words investment companies and REITs – this has been particularly acute in recent years. While private markets mostly generated positive returns in both 2022 and 2023, with their (commonly) quarterly and mark-to-model (marks) valuations seemingly untouched by the spike in rates, listed equivalents have, in technical parlance, taken a bath.

This leads to three key questions for 2024. What is the future direction of interest rates? Are underlying private market valuations credible? And how attractive are listed alternative share prices in light of the previous two answers?

Trends in current data give us reasonably high conviction that interest rates have peaked, probably bond yields too, all along the curve. This is incontrovertibly positive for any business model with leverage (debt), and also for valuations (which tend to be negatively correlated with yields). At the very least, the situation for debt servicing costs or valuations based on discounted cash flows seems unlikely to be worse than expected. How quickly it improves is harder to call, but inflation pressures certainly appear to be diminishing quickly in terms of goods and more slowly in terms of services. Growth is also decelerating, meaning interest rate cuts are highly probable in 2024.

Will this have any impact on those preternaturally robust private market valuations? If they didn’t adjust lower for a 4% (400 basis points, in financial parlance) rise in yields, then why would they benefit from lower rates? That is a fair point, but perhaps misses a key but overlooked feature of private markets – they are often highly conservative. This is particularly evident in listed alternatives where the governance and oversight of valuation methodologies is perhaps most robust.

For listed private equity funds (vehicles that hold investments in assets not listed on a public stock exchange), we can look at how valuations in portfolios compare to listed companies as a guide to what constitutes fair value. But as the adage goes, something is only worth what someone is willing to pay for it. As Figure 1 shows, listed private equity funds have sold assets at a significant premium in 2023 – measured as an average uplift on valuations on sale (during an IPO drought, no less). So, to answer the second question, transactional evidence points to material undervaluation versus the consensus view that marks are simply too high.

JHI

We see a similar trend in listed infrastructure and renewable energy investment companies. These assets are valued on a discounted cashflow basis, where future earnings are discounted back to the present day using an appropriate interest rate. This ‘discount rate’ is derived from the risk-free rate (eg. short-term government bond yields) and a risk premium. Assuming the actual risk of these underlying assets has remained fairly stable (which affects the risk premium), then higher government bond yields would suggest lower valuations, as the discount rate on future cashflows has increased.

However, we have observed over the years that discount rates have remained in a tight range, even though bond yields have fallen consistently for more than a decade. This stability was achieved as valuers increased the risk premium element of the discount rate. This was done, not to reflect a higher level of risk in the underlying assets, but with the same conservatism shown by valuers of private equity companies. And, once again, beyond these mark-to-model valuation practices, we have been able to observe market transactions at levels higher than carrying values (a measure of the value of a company based on what is provided on its balance sheet).

So, as net asset values (NAVs) across these sectors have risen, but share prices have fallen, is the market seeing something else on the horizon to get pessimistic about? Well, infrastructure and renewables earnings are pretty rock solid even in a slowdown. Contracts are long dated, linked to inflation and with very strong counterparties, or backed by government subsidies. For private equity companies there is always the risk of slowing earnings, but this does not seem to be worrying mainstream index investors at the moment, in line with the consensus of a soft landing. Leverage is a concern but, so far, we see some red flags but no systemic issue.

If fundamentals look fine, and interest rates are turning into a tailwind, then what is the problem? Certainly, we think the market underappreciates some of the factors mentioned above, but that does not adequately explain why listed alternatives are trading at levels not seen since the global financial crisis – a radically more challenging time for financial markets.

We believe it is a confluence of other factors, that could loosely be bracketed under the heading of ‘technicals’. These would chiefly be:

1. A rotation into other more liquid, low-risk, income generating assets (for example, bonds)
2. FTSE 250 Index selling, based on UK economic pessimism
3. Outflows driven by new cost disclosure rules concerning investment companies. While it is hard to persuasively argue the case for investors to fall in love with the UK again, there are clear signs that selling pressures are easing. There is also progress on the regulatory front, to end the requirement for funds to aggregate costs for listed investment companies, a longstanding concern in the financial industry.

In our view, buying fundamentally strong companies at a steep discount to what you believe they are worth is typically a rewarding mix, and this is where we find ourselves today.

We also think that this environment should be supportive for REITs to potentially do well in 2024. Here, the story has been one of a material reset of valuations for properties as yields ratcheted higher. Assets have re-priced quicker than at any time in history, and while some over-leveraged players (ie, those with excessive debt) have been forced to hold fire sales, most putative sellers and buyers have not been able to agree on a price. Hence, transaction volumes have cratered and there is still some scepticism about whether we have actually reached the bottom. In the areas we like, such as logistics, build-to-rent and student property, not only are fundamentals very strong, but completed transactions also bear out valuations. Moreover, historic data suggests that REITs often start to rally in advance of interest rate cuts. The conviction that they have peaked is the catalyst.

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