What Should Private Market Investors Do in 2H 2024?

For nearly the past two years, private market investors have been shellshocked by the unprecedented increase in short-term interest rates as a response to higher inflation in the USA (and globally). Investors have been faced with deteriorating asset values, triggered by higher cap rates and the higher cost of floating rate debt. Investors have also been hit with many capital calls on existing project, refinancings that essentially wipe out the equity tranche of the capital stack (with the hope of earning it back again in the future), and curtailed distributions on the majority of projects. The environment has also been a breeding ground for fraud as developers and operators fight for survival in the most troubled sectors of commercial real estate (i.e., office) and private equity.

The supply side of the equation has also dried up, and capital partners struggle to find projects with decent economics and the equal challenge of finding investors willing to finance new projects given the challenging conditions. These challenges have impacted all private markets including commercial real estate sectors, private equity, and venture capital. Venture capital funds have struggled as each of their portfolio companies have their own unique difficulties in managing their cash burn and arranging future rounds of funding. As a result, venture funds are resorting to new funds designed to invest in their most promising venture companies in their existing fund vintages in order to provide necessary capital to grow and maximize future returns.

I will be honest; the state of private markets has shaken our faith. Especially when one looks on the other side of the aisle, public markets, and sees the NASDAQ and S&P 500 up over 20% during the past 12-months. On a positive note, this lack of correlation between private and public markets represents a key argument for maintaining a balanced and diversified portfolio. Asset allocation is everything over the long term.

How much longer will this continue? What should investors be thinking about and doing over the second half of 2024? While no person or entity has a crystal ball, there are prudent actions that private investors should ponder extensively in the coming months.

Most significantly, investors need to remain hopeful as the Federal Reserve starts to ease short-term interest rates in September 2024, and as “green shoots” begin to reveal themselves in private equity and commercial real estate (which they are).

What private market investors should not be doing?

Abstaining is action, so let us start there. In general, we do not want to repeat the mistakes of the past.

1.       How has investing in crowdfunded projects worked out for you? Do you have underwater projects from CrowdStreet or similar platforms? Stop utilizing these platforms until they can reveal a long track record of consistent success.  It might be awhile. Most platforms are silent with regard to their detailed track records on their websites.  Being honest, I have experienced no winners over the past 7 years from crowdfunding. At least they let you lose money in small amounts!

2.       Too much concentration in single sector, location in the capital stack. Taking this a step further, there have been many investors that had placed their entire life savings with one capital partner and have lost it all. Do not put all your eggs in one basket, or even two or three baskets.

3.       Maintain a prudent allocation between public investments and private investments. In my book, The Private-Passive Investor, a range of 25-25% for an allocation to private markets is suggested.

4.       Related to the above, what sectors do you wish to avoid in future based on past experience? For me, it is hotels which have too many variables upon which success depends. An example in public markets is airline stocks. Any winners there ever? If it does not work for you, stay away.

5.       Do not continue to invest with capital partners that have failed you in the past.

6.       Do not throw good money after bad in capital calls unless you have a complete business plan that makes sense on a stand-alone basis.

7.       Do not source your investment from Instagram/Social Media advertisements. Do your own research to find the best sponsors.

8.       Generally, do not quit your journey but refine your approach to investing in private markets.

What private market investors should be doing?

1.       Redefine your goals and risk tolerance, given what you have learned about the markets and emotional reaction over the past two years. For example, if you have invested exclusively in the common equity portion of the capital stack, has that worked out well? Or should you allocate more of the portfolio to preferred equity or private debt?

2.       Build and maintain cash reserves. Cash reserves serve multiple purposes, most significantly is that the presence of cash allows an investor to trust the process of investing in long-term, illiquid investments. Having the dry powder also allows an investor to take advantage of excellent deals that will eventually follow as these private markets rebound.

3.       Whittle down your list of syndicators/operators that you wish to focus on moving forward. I would rather have a small group of proven, top-tier operators than a larger group that includes sponsors that I have no experience with or are operating in troubled sectors (office).

4.       Evaluate what went wrong with each investment in your portfolio over the past 24 months in an attempt to learn from your mistakes, if any. Were all the problems caused by higher interest rates, substandard sponsor issues (bad underwriting or property management), or both. If not sure, schedule calls with your existing sponsor group to better understand what is happening or has happened.

5.       Consider simplifying your overall approach to private market investment, in general, given the constraints around having a diversified portfolio.

6.       Respecting that for most investors, an allocation of more than 25% of total invested capital in private markets is probably imprudent. Public equity and fixed income securities play a significant role in creating long-term wealth for the majority of investors.

7.       Continue to invest in private markets given that you maintain a defined level of cash reserves. A cash reserve of at least 15% of the portfolio value is recommended. Coming out the other end of this challenging period, we will see much more investor-friendly deals in commercial real estate in particular. In fact, we are already seeing better terms on the few deals that are coming to market (there is a supply problem and demand problem at present).

8.       DO NOT QUIT. Instead, refine the approach, learn, and improve. New deals with attractively valued assets are already crossing my desktop.

9.       Be ready. When short-term interest rates come down, things will move quickly in terms of transaction activity in the housing market and commercial real estate. I am already seeing healthy signs and improved activity in the multifamily market.

10.   2024 and 2025 tax planning. I imagine that private market investors are facing material capital losses in 2024 and potentially 2025. The IRS code limits capital losses for individuals to $3,000 per year. For large losses, it can take a century to deduct (and monetize) these losses absent new capital gains for offset. I have not experience realized capital losses in CRE yet in 2024, but I expect some will not survive. But when? A limited partner has no control over the timing of capital losses. So, focus on capital gains as well. Do you have unrealized capital gains in public markets? If so, save them. Also, if you get stuck with capital loss carryforwards, review your future strategy for both public and private markets. Investing in new projects with capital gains potential (rather than income) may be warranted.

Bottom line, it is time to clean up personal balance sheets, build liquidity, and be ready to deploy capital with proven sponsors as the macro environment for private equity and commercial real estate recovers.