TRTPM monthly blog – Edition February 2025

Market activity recovering, though trade war risk

The start to the year saw a mixed picture in interest rate policy between the US and Europe. In January, the Fed opted to pause rate cuts as it awaits further progress on inflation, whereas the ECB cut eurozone interest rates by 25bps, and in February, the Bank of England (BoE) cut interest rates by 25bps. US and UK CPI inflation rose to 3% in January, driven by higher services inflation and food prices. These factors are anticipated to be temporary, and we expect the BoE’s Monetary Policy Committee (MPC) to maintain its gradual approach to policy easing, with the next rate cut projected for May.

Final investment activity figures from MSCI showed global all property transaction volumes increased 9% QoQ in 4Q24 in USD terms after allowing for seasonal effects, and 31% YoY. However, volumes remained significantly below their 2Q22 levels. NCREIF and MSCI reported stable all property capital values in the US and UK in 4Q24. On a total returns basis, at the all property level, performance was positive in both markets for a second successive quarter. The office market continued to be a drag, particularly in the US, where capital values fell 2.2% QoQ, with further declines expected. For the market overall, we expect the recovery to build in 2025, global transaction activity to rise further and capital values to also increase.

At the start of February, US president Donald Trump initiated tariffs across Canada, Mexico and China, with two more recent announcements to expand tariffs on steel and aluminum. The Canada and Mexico tariffs were subsequently postponed for 30 days. The potential US-Canada trade war has impacted GDP growth forecasts for Canada and US. The heightened uncertainty has also seen growth forecasts for Europe get dampened. Political and geopolitical uncertainties will make portfolio diversification, exploring alternative and niche markets and relying on active management strategies important for real estate investors.

Are markets souring on thematic investments?

In our 2025 infrastructure outlook, we highlighted that there is a balance between following megatrends and avoiding herd mentality. Last month, we saw some warning signs against these ‘crowded trades’, with President Trump’s executive orders and threats of tariffs souring the sentiment for renewable energy, while the success of China’s DeepSeek raises questions around AI’s long-term demand for data centers and electricity. This led to significant weakness across power generation, clean energy and data center stocks in the public markets.

We’re by no means negative on the megatrends. We’re still strong believers of the 4Ds: decarbonization, digitalization, demographic change, and deglobalization. These secular themes will change the way we live and also open up vast investment opportunities for investors. However, if investors myopically chase megatrends, they risk ignoring other important factors. These include barriers-to-entry, competitive dynamics, valuations, unit economics, regulatory support, etc. Simplistically speaking, megatrends provide certainty around ‘growth’, but it's the interaction of this growth with other variables that distinguishes the winners from the losers.

In public markets, crowded trades tend to see more aggressive pullbacks in the face of negative news. Fortunately, in private infrastructure, we’re less susceptible to this short-term volatility. For example, renewables and digital infrastructure have remained the leading sectors for infrastructure deal flows in the first seven weeks of 2025. However, it’s an important reminder that we need to remain disciplined in our investment approach and underwriting assumptions.

Positive momentum

Investor sentiment on private equity remains positive midway through the first quarter, echoing good momentum for public companies over the past month. Good public markets performance bodes well for 2025 IPO expectations, which are showing an encouraging start to the year. Exit momentum does seem improved compared to the same period a year ago.

It is early in the new US administration, but observers are noting that rates may ultimately fall more slowly should policy lean more inflationary in the coming quarters. While still seen as positive for risk assets, early policy moves have also been discouraging of cross-border activity and thereby supportive of the reshoring trends we have observed recently.

Today’s best-positioned managers have a) a strong fundamental value creation strategy, rooted in increasing top- and bottom-line company performance; b) discipline in entry multiple and investment pacing; and c) a good up-market reputation boosting exit demand.

The fundraising environment is still challenging, with funds taking significantly longer to raise than in the past (and in the case of poorly performing managers, potentially failed raises altogether). Continued public markets strength would be a tailwind for private equity which often benefits from institutional investor portfolio rebalancing under such circumstances. Large managers are having an easier time fundraising, in part due to being better-established and also because their investor base often includes institutions such as pension funds with a stable source of asset inflows. Secondaries markets are active with good transaction flow for sophisticated participants exercising valuation discipline.

Impact of higher for longer rates in corporate direct lending

Although the market has been pricing in the increasing likelihood for ‘higher-for-longer’ interest rates, the base case expectation is that the corporate direct lending market will be able to manage through the higher rate environment. For investors in corporate direct lending, the rise in interest rates has been beneficial as these floating rate loans have paid higher yields to lenders as a result of the increase in secured overnight financing rate (SOFR) or relevant base rate. Investors in the asset class ultimately are able to generate higher expected returns as a result of higher base rates.

While the increase in base rates is a positive factor for corporate direct lending investors, it does put additional strain on the borrowers as the companies experience additional cash flow strain as a result of the increase in their borrowing costs. Due to the increase in interest rates since 2022, interest coverage ratios for corporate direct lending borrowers have dropped substantially from a high of 3.4x in 2021 to 1.7x today. While this is a meaningful drop, it is within expectations given the shift from the extremely low base rate environment when we were entering 2022, to today’s more normalized rate environment.

While interest coverage ratios have compressed, most other credit metrics are stable. For instance, EBITDA trends remain positive, and leverage is relatively contained. In addition to favorable operating metrics and leverage levels, the default activity in corporate direct lending remains contained. Smaller companies with less levers to pull are finding it more difficult to deal with higher rates than larger companies. However, the overall default rate as well as the default rate for these smaller, middle market companies remained significantly lower than that of the syndicated market. Defaults have increase in private markets following the trend in the broadly syndicated market (BSL).

According to the Proskauer Index, the private credit default rate in 4Q24 was 2.7% versus 3.9% and 5.3% for High Yield and Levered Loans respectively, according to JP Morgan. Furthermore, Proskauer uses a very broad definition of default, including any covenant breaches. If you only look at payment breaches, bankruptcies and distressed exchanges, this rate drops to 1.2%, which more closely tracks the JPM High Yield data.

Finally, the asset class should be well positioned to manage through an increase in default rates given the loans are first lien in the capital structure and the higher base rates provide an additional buffer to observed losses in the event there is a turn in the credit cycle.