Key Takeaways

As we all get back into gear at the start of 2023, we thought it an opportune time to take a step back and share a few things - four, to be precise - that are “top of mind” for us at Opto this year. 

This is not an attempt to predict exactly what will happen - there are already a lot of those out there. This is, instead, a quick look at the two big questions we think are most relevant to advisors over the coming 12 months, as well as two of the most interesting investable themes we see in the private markets landscape for this year and beyond. We will revisit these themes as the year progresses.

Two Big Questions

How far will private valuations follow public ones down?

• Valuations for private companies are likely to fall in 2023, hurting returns for funds that have already invested capital. How far they will fall is tough to predict given economic uncertainty, but history suggests not as far as public prices.¹

• Corrections are nevertheless a good opportunity to put money to work. Our analysis of historical returns data shows there is no good reason to avoid investing in private markets when valuations are falling.²

• Indeed, we continue to recommend building a sustainable private markets program by allocating as consistently as possible, ignoring short-term market movements.

It would be a great surprise if private company valuations did not fall this year and hit fund values.

Private firms are somewhat insulated from day-to-day movements in the public market, but it is likely that the valuations of many private companies will fall this year. With the S&P 500 down more than 18% in 2022, and the Nasdaq Composite off 32.5%, interest rates higher and the outlook gloomier, private fund managers will likely be forced to mark down many investments.³ The question is how far?

Attempting to put a precise number on this is very difficult (read: foolhardy), given historical data is thin and difficult to compare to public markets and that every market correction is unique. History suggests that corrections in private markets are generally shallower than those in public markets.⁴ And for good reason - why should an asset that may not be for sale, or not even eventually be sold via public markets, be marked down to the same degree as one constantly trading?

Furthermore, there is a great deal of uncertainty around Fed rate policy, the trajectory of inflation, and the extent to which we may end up in a recession. Certainly, if inflation surprises markets to the upside and the Federal Reserve is forced to hike rates beyond expectations, there is a danger of greater downside for the economy and markets - including private ones.

Amid this uncertainty, one certainty is that valuation corrections are not exclusively bad - particularly if you’re putting money to work today. Private fund returns are a function of both entry and exit points, both of which are impossible to accurately predict. And private fund managers can apply a degree of timing to both to enhance returns.

Indeed, the historical data shows that there is little reason not to invest in times of falling valuations, and in fact that fund performance often improved as public markets fell (see charts below).⁵

The chart above shows that average annualized returns from funds that started investing from 2000 onwards vary little between inception years in which public company valuations rose or fell significantly (more than 10% up or down), and generally compare favorably to public equity returns over 10-year periods. The table above shows that for each asset class in our analysis, the best year (“vintage”) for deploying capital was actually during a falling valuation environment.

The bigger picture remains that the best approach to building a sustainable private markets program is to allocate as consistently as possible, irrespective of short-term market gyrations.

Have stocks and bonds “re-correlated”?

• There is a danger worth watching carefully that bonds are returning to a positive correlation with stocks, which would damage their role as a hedge to equity investments.

• Traditional safe-haven gold and new pretender cryptocurrency both performed poorly in 2022, offering little protection from equity market declines.⁶

• Advisors may therefore need to consider integrating certain private markets strategies that could potentially provide a more effective portfolio hedge.

This remains an open question, so we will be carefully watching stocks and bonds this year for signs that they have “re-correlated” (i.e., moving in concert) after two decades of negative correlation. This situation would be far from unprecedented. Stocks and bonds were positively correlated from 1970 to 2000, when inflation and interest rates were key macroeconomic drivers (see chart below).

With rates and inflation back to the fore, advisors will want to watch stock and bond movements carefully, because the implications of a “re-correlation” are huge, demanding a rethinking of bond allocations and a fresh search for assets that can effectively hedge equity allocations.

During periods of high inflation and increased market volatility, many investors have previously turned to Gold for its purported ability to hedge against inflation and provide portfolio diversification. Unfortunately, last year gold traded more like a currency than a traditional store of value, even as inflation rose to multi-decade highs (see chart below).⁷

In addition, hopes that cryptocurrencies might adopt a similar role as a store of wealth appear to have been dashed. The largest cryptocurrency Bitcoin ended 2022 down more than 60% (see chart below), trading like an extreme risk asset, highly correlated to the stock market, while massive amounts of debt built into crypto positions were unwound as the Fed hiked rates.⁸

Traditional public market hedging instruments offered little shelter. The cumulative performance of purchasing a one-month “put option” on the S&P 500 each month yielded just 0.2% last year, meager consolation with the S&P 500 down more than 18%.⁹

With multiple public hedges seemingly increasingly moving in lockstep with equity markets, advisors may want to look for both growth and income options that offer diversification and can reduce correlations within a portfolio.

Two Investable Trends

The lasting impact of elevated energy prices

• Russia’s invasion of Ukraine pushed up fossil fuel prices sharply. This episode dramatically highlighted the importance of energy security, which in conjunction with moves to address the climate crisis has likely triggered a sharp and sustained increase in investment in green energy.

• The US Inflation Reduction Act included roughly $370 billion to support investment in energy security and climate change initiatives, which should help market growth and unlock significantly more investment over time.¹⁰

• Private infrastructure funds are well positioned to drive and benefit from this growth, as are venture capital and impact funds as innovators emerge to generate energy and climate-focused solutions.

The energy sector was thrust into the limelight over the last year following Russia’s invasion of Ukraine. Energy markets were already volatile in the wake of COVID, but the geopolitical reverberations of Vladimir Putin’s actions sent natural gas prices up sharply and disrupted oil markets (see chart below).¹¹

The implications of elevated fossil fuel prices are obviously wide-ranging from a macro perspective, but the big picture from an investment perspective is that the last 12 months should accelerate the green energy transition - even if fuel prices stabilize in the shorter term via peace or other dynamics. This episode has dramatically highlighted the importance of energy security to economic stability, which is likely to shape policy across the developed world and boost public investment in energy infrastructure. We expect this to generate huge opportunities for private finance and innovative climate tech companies over the coming decade and beyond.

The most obvious example is the recently passed US Inflation Reduction Act (IRA), which allocates approximately $370 billion through a range of measures, including rebates, grants, and tax credits, to support investment in energy security and climate change initiatives.¹² BlackRock estimates that the IRA will help boost capital spending on energy supply infrastructure by upwards of $600 billion relative to the prior spending path by 2035, and in aggregate unlock more than $3.5 trillion in incremental spending over the same period (see chart below).¹³

Given the scale of investment required, private finance will have to play a key role, particularly if we are to meet ambitious global Net Zero goals by the middle of this century.¹⁴

Clearly, the build-out of new energy infrastructure should most directly offer opportunities for infrastructure-focused funds, which PitchBook data suggests accounted for 96% of real assets capital raised across the first three quarters of 2022.¹⁵ Of this, much was aimed at funds investing in sustainable energy, the energy transition, decarbonization, and clean energy strategies.¹⁶

However, investors can also access this trend via venture capital and impact investing. Many of the most innovative energy-related climate solutions are still early in their development, and principally being spearheaded by private companies, inaccessible via public market investment.

Areas such as renewables, carbon analytics and accounting, and hydropower each have great investment potential, but two niches that are attracting attention are clean fuels, specifically hydrogen, and grid infrastructure, in particular battery storage.

1. Hydrogen: Hydrogen has the potential to be a greener alternative to fossil fuels in a huge range of industrial applications, such as in furnaces and in steelmaking, while hydrogen-powered fuel cells could ultimately prove preferable to batteries for larger vehicles, such as trucks, ships, and airplanes. And it can be produced from water via electrolysis. In 2022, venture funds deployed an estimated $2.3 billion in clean fuels investment, up 89% year-over-year, with hydrogen-related companies accounting for about 70% of deal value.¹⁷ PitchBook estimates that the market for clean fuels generation - not the overall market, just generation - will grow 17.4% annually from 2021 to 2025 to eclipse $68 billion.¹⁸

2. Battery storage: As cleaner sources of energy are rolled out, grid systems will have to be modernized to account for new energy storage needs and intelligently control output. The energy storage market is predicted to grow globally at a rapid rate of 35.2% annually over the period to 2030 - put another way, electrical storage capacity should increase by more than 11 times in just eight years.¹⁹ Furthermore, as electric vehicles continue to gain momentum, there will be a massive opportunity for companies to offer charging and battery solutions for these vehicles.

There is always a risk that new disruptive technologies emerge in these niches and derail their growth, while growth in spending on the energy transition could possibly disappoint, be that due to political shifts or economic issues. But with $3.5 trillion in incremental spending projected on energy supply infrastructure alone²⁰, even a severe undershoot would still result in a huge potential opportunity.

The ripple effects from supply-chain onshoring

• Deglobalization trends have been exacerbated by US-China frictions and the COVID pandemic to elevate supply chain pressures and drive a sustained onshoring trend.

• As multiple global corporations bring production facilities and manufacturing bases back to the US, or invest in new facilities, there are opportunities for private equity and real assets funds to capitalize.

• Less obviously, venture capital is increasingly moving into the supply chain space to help alleviate pain points via software and other tech solutions.

It is unclear how far the current broad deglobalization trend will go. What may have been an inevitable pushback against years of more open trade was exacerbated by US-China political and trade frictions and the COVID pandemic, which laid bare the risks of global outsourcing. However, it is clear that supply chain pressures, while recently moderating, remain volatile and elevated globally (see chart below).²¹

Furthermore, there appears to be real momentum behind onshoring (sometimes called “reshoring”) in the US. Onshoring is simply relocating business processes and sourcing suppliers closer to or within the same jurisdiction as where you intend to sell a product. The Reshoring Initiative - an organization promoting and assisting with onshoring in the US - estimates that over 225, 000 manufacturing jobs will have been onshored in 2022, up from under 50,000 in 2019 and a record high since the series began in 2010.²²

Some examples of onshoring announcements in the US since 2020 include:

• General Electric reshoring the production of gas turbines to the US from China.

• Ford bringing the production of electric vehicles back to the US.

• Apple investing $430 million in a manufacturing facility in Texas, which will be used to produce the new Mac Pro computer.

• Samsung planning to invest $17 billion in its US semiconductor production facilities over the next three years.

• Hasbro bringing back production of certain toys to the US, including G.I. Joe, Monopoly, and Play-Doh.

If this trend is sustained - and there is of course a risk that it reverses or stalls - some of the more obvious opportunities for private capital are in supply chain infrastructure development and semiconductor manufacturing, with the latter being increasingly onshored. Certain private equity and real assets funds can both provide exposure to and potentially capitalize on these trends. (Opto users can view a video on logistics investments here.)

Perhaps less obviously, the onshoring trend has been reflected in increased venture capital investment activity in the supply chain and logistics space.²³

Though activity reverted to around average in 2022 after a dramatic spike in 2021, we expect the general upward trend to continue in the light of continued onshoring and the need for technological solutions to drive efficiencies. Much recent VC activity has been in developing software addressing areas such as enterprise management and last-mile delivery solutions, as well as helping develop machine learning, robotics, and artificial intelligence for manufacturing processes.

We expect those trends to continue, but there is likely to be an increased focus on freight and warehousing tech designed to alleviate some of the more systemic, upstream issues with the supply chain.

Endnotes

1. Source: Financier Worldwide, “The impact of public market dislocations on private markets," as of September 2022.

2. Source: Burgiss and Refinitiv, as of January 5, 2023.

3. Source: Nasdaq, as of January 3, 2023. Total returns basis.

4. Source: Financier Worldwide, “The impact of public market dislocations on private markets," as of September 2022.

5. Source: Burgiss and Refinitiv, as of January 25, 2023.

6. Source: Datastream, as of January 6, 2023.

7. Ibid.

8. Performance source: Datastream, as of January 6, 2023. Crypto debt source: Wall Street Journal, “Crypto Volatility Creates Opportunity for Wall Street Traders,” as of October 1, 2022.

9. Source: Datastream, as of January 6, 2023. Put returns based on a one-month put option on the S&P 500 struck at 95% of the spot price.

10. Source: BlackRock Alternatives, “2023 Private Markets Outlook”.

11. Source: Datastream, as of January 6, 2023.

12. Source: The Inflation Reduction Act Of 2022.

13. Source: BlackRock Alternatives, “2023 Private Markets Outlook”.

14. Source: Intergovernmental Panel on Climate Change, “IPCC Sixth Assessment Report - Climate Change 2022: Mitigation of Climate Change,” 2022.

15. Source: PitchBook, “Global Real Assets Report, Q3 2022”.

16. Ibid.

17. Source: PitchBook, as of January 6, 2023.

18. Ibid.

19. Source: P&S Intelligence, “Energy Storage Market Size and Share Analysis Report by Type (Mechanical, Electrochemical, Thermal, Chemical), Application (Residential, Commercial, Distribution, Transmission) – Global Industry Demand Forecast to 2030,” as of January 2023.

20. Source: BlackRock Alternatives, “2023 Private Markets Outlook”.

21. Source: New York Federal Reserve, as of January 13, 2023.

22. Source: Reshoring Initiative, “2022 Q3 Data Report”.

23. Source: PitchBook, as of January 4, 2023.