Anticipating opportunities with alternative investments

For risk assets, 2022 was a tumultuous period. Alternative investments were not spared, with private equity, real estate and hedge funds suffering negative returns.

Overview

Macroeconomic uncertainty, inflation, rising interest rates, recession fears and volatile public equity and debt markets were among the challenges that unsettled these asset classes.

However, we believe that 2022’s turmoil may lead to potential opportunities in alternatives over the coming 12 to 24 months and thereafter.

At an asset class level, the long-term outlook for private equity, real estate and hedge funds now looks much brighter than it did at the end of 2021. A more favorable valuation environment coupled with reduced competition from liquid sources of capital should create increased opportunities for alternative investment managers to shine in 2023 and beyond.

In the current environment, we believe private equity, real estate and hedge funds may play an even more important role for suitable investors who are seeking potential returns, yield enhancement, and diversification against risks including inflation.

Alternative investment flows in 2022

While alternatives’ overall performance may have suffered in 2022, alternative managers managed to attract substantial funds from investors, albeit slightly below 2021’s peak levels. That said, the trend was downwards through the first three quarters of 2022. Many managers have told us investors appeared to pull back significantly in the third quarter. They also expected the fundraising slowdown to continue through the fourth quarter and into 2023 – FIGURE 1.

Such fundraising slowdowns often result from investors having become overexposed to illiquid holdings relative to suggested allocations. This happens because the valuations of their allocations to public market asset class investments have shrunk by more than privates during market selloffs.

Nevertheless, many investors keep allocating to alternatives during difficult times. They do so to seek exposure to investments from a range of different vintage years, rather than investing, say, only in the good times. Still, they tend to prefer high quality managers amid turbulence, and such managers thus see more resilient inflows in periods like today’s.

Private equity

Having reached a peak in 2021, the number of new buyout deals slowed in 2022 – FIGURE 2. This reflects both buyers and sellers adjusting to new pricing and leverage dynamics. Valuations for target companies are expected to fall as a result, due to higher interest rates, which reduce the present value of future cash flows. Also, higher rates mean it is more expensive to borrow, as buyout deals rely heavily on debt. The leveraged loan market – which buyout managers use extensively to raise debt – was effectively shut off in the third quarter of 2022.¹ As buyers and sellers work through new price discovery, we believe buyout managers may be able to enter deals at more attractive levels.

Buyout pricing remained similar to prior years through the first three quarters of 2022 at around 11 times trailing earnings before interest tax depreciation and amortization (EBITDA). By contrast, public equities saw a return toward long-term mean valuations – FIGURE 3. This typically heralds regression in private markets. The cost of leverage has also been modest until very recently, enabling buyout managers to do deals comfortably at prevailing higher valuations.

However, the increasing cost of leverage – coupled with increased uncertainty – will likely exert downward pressure on private market valuations over the coming quarters. Managers dependent on industry cyclicality and large amounts of leverage look most vulnerable to valuation declines.

In 2021, the benchmark rates for leveraged buyout (LBO) lending were near zero, with very low credit spreads. This resulted in low borrowing costs and stress-free interest coverage ratios. As of December 2022, we observe benchmark rates of nearly 4% and wider spreads driving interest costs above 10%. They may rise even more in 2023 as central banks aggressively fight inflation.

For the past nine years including 2022, buyout debt/EBITDA multiples have remained steady at just under 6. The significant increase in rates leads to reduced interest coverage, or how many times profits are sufficient to meet interest costs. It also means higher liquidity risk for investments in companies in cyclical industries if earnings fall. We believe this may lead to increased opportunities for stressed/distressed investors.

Private equity overall exit volume has seen greater declines than new deal activity, driven by a steep fall-off in public listings and mergers and acquisitions (M&A). However, sales between private equity firms have remained active in 2022 as such firms seek to exploit poor public pricing conditions for sellers – FIGURE 4.

Real estate

2022 presented a unique set of challenges and opportunities for real estate investors. Increased financing costs, expanding capitalization rates, and inflationary pressures presented headwinds. But these conditions also created opportunities to take advantage of market inefficiencies, buy more cheaply and reposition properties to meet shifting consumer preferences.

In addition, powerful trends such as digital innovation, flexible working and delayed household formation have continued to transform real estate. We believe the dynamics that have redefined business processes and models of living, working, and shopping since the pandemic erupted are here to stay, despite recent uncertainties. 

Inflation poses a particular challenge for the construction industry. In response to rising costs of labor and construction materials, new housing starts have slumped as real estate developers face greater risk of cost overruns and construction delays. Also, rising interest rates place pressure on debt service. For investors, this environment can potentially reduce returns. That said, continued rent growth in certain sectors like multifamily apartments and e-commerce related industrial properties are positive for investors.

Similar to private equity, real estate funds have experienced a gradual slowdown in fundraising activity amid current uncertainty. Through the third quarter of 2022, private real estate fundraising was down 13% compared to the same period in 2021 – FIGURE 5.²  Going forward, managers seeking to raise capital will likely continue to face difficulties as investors remain cautious about committing capital.

In this environment, we see the industrial and multifamily rental sectors as better positioned to withstand rising rates and inflation. In addition, tenants are showing a preference for Class-A offices incorporating better amenities rather than older office space. The continued corporate shift toward embracing hybrid work and digital technology are key drivers here.

Hedge funds

Hedge funds experienced a wide dispersion of returns in 2022. This partly reflects how hedge funds are not a uniform asset class and have many differing objectives. Overall, though, hedge funds preserved capital during the year better than equity and fixed income.

In this sense, the asset class fulfilled its intended role within portfolios of providing diversification to traditional markets.

Looking beyond the aggregate level, hedge fund strategy returns have seen substantial dispersion. Diversifying strategies – those whose returns typically have little or no correlation to other risk asset classes – typically saw flat to positive performance. These include global macro and relative value strategies.

By contrast, directional strategies – those that are correlated to risk assets – generally fell alongside traditional asset classes. These include equity long/short and event-driven strategies.

Potential opportunities for 2023 and beyond

Putting cash to work in a higher rate environment

Given the rapid rise in yields and the uncertain outlook for corporate profits, both credit and equity markets are largely closed to companies wishing to raise capital. Issuance of high yield bonds and loans through the end of the third quarter of 2022 stood at just 78% and 61% of levels respectively in the same period in 2021 – FIGURE 8.

It was during the third quarter of 2022 that leveraged credit markets effectively closed – FIGURE 9. Given such severe syndicated debt-issuance constraints, many companies will need to explore alternative ways of raising capital and extending debt maturities. Specialist active alternative managers can provide capital for a new debt issuance. They can also initiate exchanges of public debt directly with issuers, giving them maturity relief in return for higher yield and/or additional collateral.

When companies cannot rely on public fixed income markets to raise capital, private direct lending funds can step in. Such funds typically provide variable rate loans to the market, mitigating investors’ interest rate risk in a rising rate environment.

For example, despite the recent volatility in the technology sector, we believe in the sector’s long-term strength. Senior secured floating rate direct loans to technology companies are structured to provide both current income and the potential for capital appreciation from structured debt and equity securities. In addition, adding exposure at the highest levels of the capital structure provides downside risk mitigation relative to technology equity exposure alone.

From a real estate perspective, rising interest rates are making mortgage payments more expensive. The rate on the 30-year fixed mortgage in the US is near 20-year highs. As of December 30, 2022, it stands at 6.59%. As a result, the estimated minimum annual income needed to purchase a house surpassed $120,000 in June 2022, a doubling in just six years. Rising mortgage rates, combined with surging home prices, make home ownership more difficult and multifamily rental more attractive, delaying household formation as a growing number of millennials will rent longer than past generations.³

Multifamily rental properties, such as low-rise “garden style”, mid-to-high-rise apartment towers, and townhouse complexes, are especially resilient during periods of high inflation given the ability to reset rents more frequently as the short duration leases – typically one year – expire.

In 2022, multifamily rents have risen significantly alongside inflation: the average effective rental rate in the US grew over 10% year-on-year in the third quarter of 2022.⁴ Also, longer-term supply and demand are still in balance, though according to the National Apartment Association, the US will need 4.3 million new apartment units in the next twelve years to meet housing demand.⁵ The current insufficient supply of housing, coupled with less attainable home ownership and inflation limiting new build, is expected to continue to sustain robust rental demand.

Like multifamily, the industrial real estate sector has stayed resilient despite inflationary pressures. This is attributable to the sector’s strong fundamentals, such as the ongoing shift toward e-commerce. Online shopping took a great leap forward during the pandemic as consumers switched even more to ordering online. While e-commerce may eliminate the need for shop floor space, online transactions require three times the warehouse space of traditional retail.⁶  Each one percentage increase in e-commerce sales as a proportion of overall retail sales is expected to result in over 65 million square feet of demand for industrial space.

E-commerce demand has particularly increased the need for larger, more sophisticated and centrally located distribution centers to enhance “last-mile” facilities for same-day or next-day delivery.

With demand outpacing supply, overall US vacancy rates are historically low at below 4%.⁷ These favorable supply- demand fundamentals have contributed to rent growth above inflation, as year-over-year rent growth was 25% as of Q3 2022.⁸

Positioning for market dislocations and distress with alternatives

Financial markets tend to go through repetitive albeit uneven market cycles over time – FIGURE 10.

While certain hedge fund strategies make sense throughout the cycle, others are more reliant on the nearer-term environment. The former may be more suited to core portfolios or seeking exposure to long-term themes. The latter may be used in a more tactical, opportunistic fashion based on the phase of economic cycle and other factors – FIGURE 11.

At peaks in the economic cycle, central banks often start tightening monetary policy, aiming to cool overheating economies that run the risk of inflationary pressures. As the economy contracts, volatility begins rising across asset classes while equity and credit markets face declines. Certain hedge fund strategies such as distressed credit and actively traded, hedged global macro may potentially benefit from such conditions, however.

Traditional global macro strategies can themselves experience “boom and bust” cycles as they seek to identify and profit from a limited number of large trades on economic themes. By contrast, hedge funds that seek active trading opportunities informed by macroeconomic analysis – which we refer to as hedged global macro – have historically been able to generate more consistent returns without large swings in correlations to markets.

As a result, we see hedged global macro as well positioned for active trading opportunities within fixed income and currencies given the current market backdrop, especially given the challenges faced by central banks in balancing inflation and growth.

These strategies, as measured by the HFRI Macro: Active Trading Index, have historically shown modest correlation to more directional hedge fund strategies such as equity long-short and event-driven, which are more highly correlated to each other and to equities overall.

Credit market turmoil in 2022 has likely created a favorable investing landscape for 2023. Specifically, potential opportunities may arise for skilled alternative investment managers who seek to take advantage of volatility, capital shortages and episodes of outright stress and/or distress across public and private credit markets. Their goal is to generate returns by underwriting new debt issuance and making opportunistic secondary market purchases.

While dislocations in corporate credit markets might present a compelling opportunity set, there is significant value to having flexible capital across credit assets amid market volatility. That includes within structured credit markets where experienced managers can capitalize on complexity, inefficiency and bouts of reduced liquidity. 

Bond defaults increase during economic contractions and capital becomes more expensive and harder to access. We believe there will be potential opportunities for managers with distressed credit experience in the coming year. But they will need restructuring expertise, as managers who can influence the process stand a better chance of recovering greater value from defaulted debt.

In 2022, the universe of debt trading at stressed and/or distressed levels has expanded – FIGURE 13. This is a result of tighter central bank policy, higher bond yields and widening credit spreads, the latter owing to recessionary fears.

We see this credit market sell-off as indiscriminate, with investors overlooking firm-specific factors that may influence when and how borrowers repay their outstanding debt.

As a result, we believe that skilled managers who have insight into issuer quality and potential capital structure events such as re-financings, debt exchanges, and outright restructurings may be able to generate high total returns. 

As revenue growth slows and input costs rise, businesses could potentially struggle to meet their interest and debt obligations. When these businesses seek financing, they may be put off by the unpredictability volatile public markets.

During a time of rising interest rates and weakening corporate earnings, interest coverage ratios may worsen considerably.

FIGURE 14 compares current interest coverage to potential interest coverage ratios if interest rates rose 300 basis points and EBITDA fell 10%. The effects upon interest coverage are shown for companies grouped by credit rating.

Based on our economic outlook and the speed of interest rate hikes to date, this scenario is likely to occur in certain companies and industries and will have significant impact on those leveraged companies’ ability to service their debt and gain access to capital.

In public markets, a bias towards quality is preferred during uncertain times. Of course, “quality” investments are often in the eyes of the investor. That said, high quality companies typically have many of the following characteristics: high profit margins, healthy balance sheets, growing profits and/or dividends, stable forecasted cash flows, strong management and a sustainable competitive advantage.

Over time, equity portfolios with a quality bias have outperformed broader equity indices. And while quality companies have outperformed, companies of the lowest quality have significantly underperformed the broader market.

FIGURE 15 shows cumulative returns for the S&P 500 Index, as well as for its quality members, its lowest quality members, and a leveraged long position in the quality members and a short position in the lowest quality members. Over time, leveraged long exposure to quality combined with short exposure to the lowest quality companies could generate additional potential returns for investors.

However, getting such exposure is easier said than done. Individual investors face constraints in entering short positions,  including leverage restrictions, borrowing costs, lack of expertise, and the potential for margin calls and short squeezes.

We therefore see shorting as more the domain of the likes of hedge funds. These and other larger institutional investors have the research expertise to identify potential shorts, experience in managing a short portfolio, and  access to financing on relatively attractive terms. Identifying and utilizing shorts in lower quality stocks can not only help with a portfolio’s overall downside protection but also potentially be a meaningful source of alpha over a cycle.

In private equity and real estate, we see opportunities in funds focused on assets that are resilient to inflation shocks and that have demonstrated strong pricing power over the long term. Many of these secular growth prospects relate to unstoppable trends discussed below or are available through a diversified exposure to high quality private equity and real estate managers.

Another approach to resilience in volatile times is to seek out unique real assets that are both supply constrained and show resilient demand. These assets have the potential to preserve wealth during periods of high inflation and low real growth. While assets such as gold, art, wine and farmland are often cited as examples of this, we have focused on a strategy that specializes on making minority investments in sports-related assets. Historically, the sector has shown meaningful resilience through multiple macroeconomic shocks such as the stagflation of the late 1970s, the recessions of the 1980s, the dot-com crash and the Global Financial Crisis. Many factors contribute to this, including franchise quasi-monopolies, high customer loyalty, long-term media contracts and increased pricing power.

We are also evaluating diversified buyout managers across North America and Europe. In North America, middle-market managers are well-positioned to see significant deal flow relative to their fund sizes. Admittedly, a higher rate environment will certainly affect company selection, deal capitalization, pricing and underwriting criteria. However, it is unlikely to have a major impact on the execution of modern buyout strategies, as fund returns are increasingly derived from factors such as sales growth, margin expansion, and strategic repositioning rather than the use of leverage.

Choosing which fund manager to invest with will be more important than ever, as performance dispersion is likely to remain high. With evolving costs structures and supply chains, strategies need to demonstrate deep sector expertise and forecast where disruption will arise in each sector.

In Europe, amid challenging conditions, certain buyout strategies are using a thematic approach that focuses on high quality companies in core sectors. We see them as well placed to generate compelling investment returns. Many European companies have solid foundations. Median leverage is lower than in the US and had been falling for several quarters.

As with North America and Europe, the ability of diversified Asia buyout managers to seek to exploit market weakness and capital constraints facing companies has evolved over the past three decades. In addition, the ability to pivot between the developed economies of the region allows for a certain level of diversification in volatile times.

While record-low interest rates bought time for some real estate owners, the increasing rate cycle may lead to capitulation in private real estate markets. This could open the door for well-capitalized opportunistic managers to create value at the individual property level. Cycle-tested strategies with experienced managers are poised to perform in this dynamic environment.

Investments in real estate and hard assets can benefit investors in an inflationary environment. Higher inflation means higher replacement costs and building inputs, including lumber and steel, construction labor, and land parcels. These rising costs may limit new development projects, limiting new supply. By identifying the right assets in strategic locations, rents may reflect inflationary pricing leading to appreciation in value through new leases linked directly to inflation rates.

For example, the UK has one of the largest, transparent and liquid real estate markets globally and offers relatively good value compared with its peers, particularly given the pound’s weakness against other currencies. With the UK population growing faster than most of Europe, demand for good quality space should remain strong across the main asset classes. Accordingly, we believe that investing in quality strategically located real estate can provide a hedge against inflation as rents can be marked to market as often as monthly for apartments or even daily for hospitality.

Unstoppable trends

Digitization

The Citi Global Wealth Investments Office of the Chief Investment Strategist has consistently highlighted the accelerating adoption of technology across almost every industry and business. We see this as creating a “new normal” of an increasingly data-enabled, decentralized and flexible global economy. Among the areas of digitization that we have focused on are automation and robotics, artificial intelligence, 5G connectivity, fintech and cybersecurity.

Publicly listed digitization equities declined sharply in 2022, largely in response to the higher interest rate environment. The tech-heavy NASDAQ Index declined -32.5% for the year, as the likes of software and fintech struggled – FIGURE 16. The selloff has largely been indiscriminate, creating potential buying opportunities in companies with solid fundamentals. Valuation multiples have reset, with the NASDAQ Composite’s forward PE multiple declining from 28 at the beginning of the year to 19 at the end of December.

In the recessionary scenario we envisage in 2023, digitization equities could see further declines in the near term. However, their pullback to date has likely reduced the scope for longer-term downside from here. Admittedly, earnings estimates may not have bottomed yet. However, history suggests that digitization equities will likely bottom before earnings estimates do.

We believe there are potential opportunities for active managers to identify digitization companies trading at attractive valuations. Likely targets are those that offer ongoing growth potential, recurring revenue streams, productivity enabling services, and/or mission-critical technologies. While tech-focused equity hedge funds will pursue long investments relating to longer-term trends in areas such as cyber security, cloud, and 5G, there is scope for shorting companies facing near-term cyclical hurdles.

Venture capital (VC) managers with proven records of identifying tech winners and losers have the potential to generate value coming out of this market downturn. Private capital’s role could become even more prominent and critical to innovation in the near term, amid a pullback in public funding of technology and high growth companies. Accordingly, technology deal activity has remained strong in 2022, down 10% from 2021 highs, but still significantly higher than in any prior year. And while VC deal activity has declined for three straight quarters from the highs of 2021, year-to-date VC activity in 2022 has already exceeded all other years.

The reset of public companies’ valuations may also provide openings for buyout funds active in the technology sector. Public-to-private transactions are likely to become more prevalent and lower entry levels are likely to help generate superior returns over time. In addition, as holding periods in private markets will increase for technology assets that would have normally opted for an exit via an IPO, larger buyout funds can benefit through sponsor-to-sponsor transactions at lower prices.

G2 polarization

We believe the continued shift in economic power towards Asia to be an unstoppable trend. As Asia’s share of the world’s economy increases and the rivalry intensifies between the US and China – the “G2 powers” – we see attractive investments in Asia and Greater China for both return potential and diversification. China’s hardline anti-COVID policies – which it is now easing – have hit Chinese asset values hard. Chinese equities are trading at forward earnings multiples near five-year lows, providing a potentially attractive entry point.

At the 20th Party Congress held in October of 2022, President Xi indicated China “will favor national strategic needs, gather strength to carry out indigenous and leading scientific technological research, and resolutely win the battle in key core technologies.”

Xi’s statements appear helpful to companies within tech hardware, semiconductors, materials and pharmaceuticals. Such companies are more abundant in the China A-share  market compared to the Chinese stocks listed in Hong Kong and New York, which are consumer discretionary- and communication services-heavy. Additionally, A-shares are a far less efficient market, with low institutional ownership and trading volumes dominated by local retail investors who rapidly trade in and out, often for non-fundamental reasons. So, we see a positive environment for specialist active managers within China’s A-share markets.

We have also seen the maturation of the Asia private equity sector, with significant fundraising and capital deployment activity over the past few years. However, the pace of investments in Asia far outstrips exits compared to the US. From 2011 to the first half of 2022, the median investment-to-exit ratio of China and India are roughly 8.2 and 5.9 respectively, versus two in the US.

As a result, there is significant net inflow in Asia Pacific region. This has created a meaningful overhang of un-exited companies in funds reaching their expiration date, increasing the market opportunity for secondary managers.

Also, the secondary market in the Asia Pacific region is relatively at a much earlier stage of development than those in the US and Europe. While Asia has represented nearly 20% of global private equity fundraising and deployment over the past few years, it has only made up 7% of the global secondary market. Therefore, large specialists in GP-led secondaries in Asia may be well positioned to capitalize.

Greening the world

With the ongoing evolution of sustainable investing, asset managers are taking varying approaches. For hedge funds, certain managers are pursuing “ESG integration” within their portfolios. This approach considers environmental, social and governance (ESG) factors. Based on this, it then selects investments with attractive ESG attributes, discarding those with unattractive ESG attributes. Investors can embrace ESG integration without drastically altering the risk and reward profile of an asset class in their portfolio.

To see this in action, consider the MSCI ACWI Sustainable Impact Index. This index aims to identify companies that derive at least 50% of revenues from products and services aligned with the United Nations’ Sustainable Development Goals (SDGs). Securities are weighted within the index according to the percentage of revenue derived from these sources. The index has a correlation of 0.9 to the MSCI ACWI Index which does not consider ESG factors. The MSCI ACWI Sustainable Impact Index has returned an annualized 9.1% from inception in March 2016 to October 2022, compared to 8.6% for the MSCI ACWI.

Certain managers seeking broad exposure to equities – for example, within multi-asset and equity long/short strategies - may seek to employ sustainably-aligned investments. Managers may use this data to take long and potentially short positions within equities in conjunction with existing stock-analysis frameworks. We believe as data in the space becomes more readily available and analyzable that more managers will be able to create sustainably-aligned implementations of their existing strategies, and we encourage asset managers to continue to move in this direction.

In response to increasing investor demand, private equity managers have also begun to address ESG. Sustainable features now appear in their core offerings and in dedicated “impact” funds. For example, the depth of the climate-tech investable venture capital market has increased, with climate representing the fastest growing sector within VC.

For context, the compound annual growth rate (CAGR) of investments for the wider venture capital universe was 18% from 2013 to 2019. But for climate tech, CAGR was almost 5 times higher at 84% - FIGURE 17). We are evaluating strategies within this VC subsector as it matures in size and scope.

What to do now?

In uncertain times like these, there is a natural urge to avoid risk assets. This goes for alternatives, which may not only suffer further downside but are also harder to sell out of, given their illiquidity. That being the case, suitable investors may feel tempted to stay on the sidelines before committing capital to private equity, real estate and hedge funds once more.

We believe that waiting until the dust settles would be a mistake, however. Expected lower valuations across asset classes and the likelihood of distressed and stressed opportunities ahead potentially mean a more favorable investing landscape for alternatives managers in 2023 and beyond.

In our view, therefore, there are opportunities for suitable investors to deploy capital methodically. Our bias is toward high quality managers with enough dry powder to take advantage around the bottom of the cycle. Historically, the aftermath of bear markets (e.g., early 2000 dot-com bubble; Great Financial Crisis) have been fruitful times for alternative strategies. However, we do not seek to time markets via alternatives. Instead, we are willing to take to positions ahead of a trough in the markets.

We believe that qualified investors should consider taking a disciplined, multi-year and cross-cycle approach to allocating capital to alternatives.