OVERVIEW
Institutional allocators are undertaking a robust monitoring of their portfolios and reviewing asset allocation to meet target objectives as market participants closely parse the latest signals that could indicate a slowing inflationary trend and moderate impact on economic growth from the ongoing interest rate hikes. Top of mind are diversification, yield, inflation protection and a consistent income stream – attributes delivered by alternatives, private credit, and real assets. A selective approach in these asset classes, via asset managers with experience through market cycles, is key to success. Here, three specialist managers offer timely strategies for investors to consider: abrdn on hedge funds and alternative macro and credit strategies; Macquarie Asset Management on real assets including infrastructure, agriculture and real estate; and PineBridge Investments on private credit direct lending in the middle market segment.
BRING IN ALTERNATIVE DIVERSIFIERS
The reemergence of inflation in 2022 and slowdown in global economic growth pushed institutional investors toward greater asset diversification. With traditional 60/40 asset allocations not delivering on target returns, many investors turned to alternative assets and strategies that could provide a ballast in challenging markets. This year, persistent inflation, restrictive monetary policy by central banks and potential recessionary impacts will continue to necessitate a close focus on the specific risk-return trade-offs for alternative asset classes. Among them, hedge fund strategies are poised to draw strong attention as alternative diversifiers that can help investors manage through the current market complexity.
MEETING THE MOMENT
Relative to traditional assets, alternatives — such as hedge funds, private equity, private credit, venture real estate and alternative risk premia — cover a broad spectrum of investments that provide additional diversification. Hedge funds and alternative risk premia are defined as strategies rather than asset classes since their risk profiles and return potential shift in response to economic pressures and overall market dynamics.
“Our view is that private equity and private credit can be considered distinct asset classes but that hedge funds overall consist of a set of underlying trading strategies that we at abrdn broadly categorize as macro, credit, event-driven and equity-hedge,” said Darren Wolf, CFA, senior investment manager and global head of investments for alternative investment strategies at abrdn.
A number of these hedge fund strategies can perform well in challenging markets because of their flexibility in taking advantage of pockets of opportunity across the short and long term, and their ability to cover diverse nontraditional strategies. “For investors with a 60/40 portfolio, it will be difficult to assess the equity and fixed-income markets over the next couple of years. They may need to turn to hedge funds and other alternative strategies to get their required rates of return, which is setting up to be an attractive situation for hedge funds over the same period,” Wolf said.
MARKET UNCERTAINTY TO PERSIST
Over the past decade, equity investments were characterized by high returns, low volatility and historically high Sharpe ratios, which led to a reduced focus on diversification, with many investors hard-pressed to explain allocations to alternatives or any assets considered a drag on equity returns, Wolf pointed out. That environment has changed significantly, with future return estimates for traditional assets far lower than before.
“Inflation running high without a strengthening economy is making it difficult for the Federal Reserve to orchestrate a soft landing,” Wolf said. “We are also fairly confident there will be some form of recession in 2023.” What makes a strategic asset allocation difficult today is that it is too early to forecast the depth or length of a possible recession. “Abrdn is positioning their client portfolios accordingly, because alternatives, especially hedge funds, are generally well situated for this environment,” he said.
Asset owners should carefully consider the type of alternatives today, given that many have already made considerable allocations to private markets over the past couple of years, he added, noting that abrdn expects a pause on private asset inflows this year. New allocations could be hampered in the first half of 2023, when the lag in private-market valuations catches up to the public market. However, the firm expects positive inflows this year in hedge fund strategies that can take advantage of opportunities in the current market uncertainty.
MANAGER EXPERTISE IS KEY
The expertise and experience of the alternative asset manager is critical to delivering on asset owners’ targeted portfolio outcomes over the long term. “The challenging investment atmosphere this year can shed light on which asset managers are investing in a complex package of alternative-risk premia versus those providing strategies that genuinely deliver alpha. A high-volatility stress environment should make it easier to see who is doing something unique,” Wolf said.
Across its hedge fund sub-strategies, abrdn looks at global market dynamics to determine exploitable opportunities. “Issues like inflation are global. COVID is a global pandemic, and what is happening in Russia and Ukraine is impacting commodity prices worldwide,” Wolf noted.
Abrdn considers macro, volatility-oriented and credit strategies to be well positioned this year. Typically, discretionary macro strategies are based on global macroeconomic research that compares trade data, interest rates and the impact of political risk across different countries and regions. Quantitative easing and other economic stimulus undertaken by central banks that artificially suppressed interest rates only allowed macroeconomic research to be taken so far. However, “we are now in a different situation. The Fed is responding to fundamental economic drivers, inflation being the prime example, which allows managers performing macroeconomic research to thrive in these markets. We don’t think anything will hinder that trend and expect macro strategies to remain fairly attractive throughout this year,” said Wolf.
TAIL PROTECTION
Another macro-related approach with above-average performance potential is volatility-oriented strategies. The options market for volatility trades is the most persistently dislocated asset class, especially in the current market environment, Wolf said. “Many large investors fear left-tail risk in the market and have to rely on static, persistent options-buying programs to try to insulate their portfolios. These strategies create significant distortions across the volatility curve and create trading opportunities for hedge fund managers that trade relative value in the options market,” he said. “This is a broad macro-investing category that is well suited for this coming year.”
Read: Hedge Funds: investment solutions for a volatile world?
Credit should be another attractive sector, according to abrdn’s strategists. “Capital markets have become much more discerning and have made it more challenging for certain companies to push fiscal issues into the future or extend maturities by refinancing. This has resulted in considerably more credit dispersion, allowing distressed and fundamental credit-oriented managers to add value in this market,” Wolf said, adding that it sets the stage for a credit-pickers’ market over the next two years.
CHALLENGES AHEAD
Despite the positive outlook on these hedge fund strategies, investors should be cognizant of the possibility that conditions may not transpire as expected. The greatest challenge for the hedge fund market is unanticipated and systemic risks, Wolf said, such as dislocations in the repo markets — the vast repurchase market for short-term borrowing activity between financial institutions.
“Hedge funds largely rely on the repo markets for asset financing. So when there are problems, it impacts the funds [involved] and, potentially, the entire hedge fund market. Our biggest concern, not to be too flippant about it, are the unknown risks. For example, we couldn’t predict a global pandemic, which wasn’t on our list of stress tests in December 2019,” said Wolf, referring to the COVID-19 outbreak in March that froze up the repo market.
Asset managers also need to carefully assess and manage potential liquidity risk, even if that is lower than in prior years, Wolf said. “Although underlying market liquidity [overall] is lower today than it has been, hedge funds and other alternative managers got one thing right over the last decade: appropriate matching of assets and liabilities. A manager’s ability to deal with this [matching] and meet underlying client redemptions is now more appropriate than in the past, making it a less substantial or notable risk than it may previously have been,” he added.
Regardless of the potential challenges, Wolf said that the overall outlook for alternatives, especially hedge fund strategies, is favorable. “Alternatives are in a good place and should experience positive fund flows as investors recognize the increasing difficulty in achieving meaningful returns with traditional assets. We expect a continuation of 2022, including higher volatility, a more demanding environment for traditional assets and hedge funds performing quite well meeting their role in the portfolio.”
REAL ASSETS OFFER BALLAST IN NEW MARKET REGIME
Last year’s inflation spike and global slowdown in economies led institutional investors to search for yield and defensive strategies, bringing real assets — investments that include underlying physical assets — to the fore. Infrastructure and select real estate sectors can offer inflation protection, yield, diversification, and exposure to underlying structural growth. Agriculture also has provided an inflation hedge and a consistent-return profile. While the current environment is challenging, market disruptions present potential opportunities for investors to take advantage of cyclical pricing softness in property.
In our view, the outlook for a number of real assets is favorable, despite significant economic challenges. The cash flow-producing abilities of real assets are attractive to investors in uncertain economic environments when income opportunities are harder to find. In the near term, specific sectors will have more substantial investment prospects than others, said Daniel McCormack, Head of Research at Macquarie Asset Management. “In general, infrastructure and agriculture are likely to remain resilient and we see opportunities for investors to deploy capital into property this year,” he said.
SELECTIVE VIEW IS KEY
Macquarie Asset Management’s view is that some economies are already in recession and macroeconomic pressures will likely intensify this year. “The U.K. and Europe are already in recession. The U.S. should also be [in recession sometime in] the first half,” driven by increases in interest rates and their effect on the economy, McCormack said. Before the shift into economic recovery, “impacts will continue to broaden and deepen with multiplier effects kicking in as we roll through this year.”
Read: 2023 Outlook
Given this outlook, investors need to selectively allocate to real assets over the next 12 to 24 months to meet their strategic objectives across the risk spectrum. Core investments, especially in infrastructure, have offered yield and stable returns, while real estate can provide the opportunity to take advantage of pricing pressures and potentially acquire assets below their replacement cost, McCormack said.
TIMELY INVESTMENT
“To date, infrastructure has held up very well based on various metrics, including returns, deal flow and fundraising. We think that infrastructure will perform relatively well in this macro environment,” he said, which is characterized by high inflation, gross domestic product growth volatility and recession. That’s due to infrastructure’s inherent attributes of inflation protection and defensiveness, McCormack added.
In addition, “infrastructure assets have a high yield, [which is] essential in periods with high inflation and volatility because yield becomes disproportionately important as a driver of total return,” he said. Finally, infrastructure and select real estate sectors benefit from structural growth drivers. “Whether it is demographics, decarbonization or digitalization, these growth drivers also make real assets important in a world defined by cyclical growth.”
POSITIVE FUNDAMENTALS
“Agriculture has most of the same traits [as infrastructure], but perhaps not to quite the same degree. It has shown good inflation protection, reliable-return delivery and can offer a good yield. We think agriculture is a small asset class and reasonably attractive in a volatile environment,” McCormack said.
What’s also positive for the asset class are structural drivers, such as the conditions underpinning farmland: the per capita increasing global demand for protein alongside the decreasing amount of arable land, he noted.
CYCLICAL OPPORTUNITY
Cyclical downturns often present potential opportunities for those investors with liquidity and capital to deploy to take advantage of current market disruptions in property. This includes sectors with solid fundamentals that are seeing improved valuations in both public and private markets, said David Roberts, global head of real estate strategy at Macquarie.
While valuations have been under pressure in some real estate sectors, pricing has some support from positive fundamentals, McCormack added. “Construction costs in property are probably up by 25% relative to the pre-COVID-crisis period. That will provide a floor on valuations in some instances; in others, it will mean opportunities will arise to acquire properties below replacement cost,” he said.
Today investors should focus their real estate strategy on income generation and, at this point in the cycle, buying at below replacement costs, Roberts said. “It means increasing cash flow rather than using significant amounts of leverage to boost returns and drive performance. [While] the latter certainly performed well over the last decade, it will be difficult to achieve in this higher interest rate environment.”
IDENTIFYING SECTORS
Property sectors with better quality and stronger fundamentals are those exhibiting high demand, and stable supply underpinning income growth as a high percentage of total return, Roberts said. Examples are the rental housing and logistics sectors. Investors such as Macquarie are increasing their exposure to sectors that are less sensitive to GDP growth, such as the build-to-rent sector in developed markets, and data centers or self-storage.
On the flip side, sectors under more pricing pressure include discretionary retail in noncore locations and secondary offices given rising capital expenditure requirements and refinancing risks, Roberts noted.
“Generally, we favor increased exposure to operating companies and real estate platforms in sectors with strong fundamentals. It means taking [positions] at the operating-company level alongside direct real estate investments to hit target returns, without relying on high leverage,” Roberts said. “As real estate prices adjust, there are opportunistic prospects like privatizations and equity debt injections as borrowers refinance,” McCormack added.
Following a period of market uncertainty, investors should start to regain some interest in core real estate because “it has all the traits that are attractive at the current macroeconomic juncture and are likely to [keep] the asset class in good stead from a relative-return point of view,” McCormack added.
WIDER PORTFOLIO ISSUES
Liquidity is another a key aspect of real asset allocations, though it has not been as significant a concern as it has been with private market funds in other sectors that could face unexpected liquidity crunches. “For both property and infrastructure, there are decent secondary markets. Those situations can offer opportunity for investors who don’t face liquidity pressures to pick up assets below their net asset value,” McCormack said.
Of course, investors need to carefully watch the denominator effect for real assets, he noted, referring to the situation in a diversified portfolio when a steep decline in traditional stocks and bonds leads alternative assets to exceed their target allocation. “When listed markets fall away, the [percentage] allocation to real assets goes up. It can actually drive a need to lower exposure to real assets, which can be due to the allocation issue or concerns about the pricing outlook.”
Despite allocation reductions that are likely to impact real assets in some respect this year, Macquarie Asset Management’s view on the sector is to see continued fund flows, given its inflation protection and attractive yields. Over the long term, with pricing improvements across subsegments as economies shift into stronger recoveries, real assets will continue to offer strong diversification potential for institutional portfolios.
PRIVATE CREDIT: OPPORTUNITIES IN DIRECT LENDING
Private credit direct lending in 2023 continues to offer opportunities for institutional investors seeking enhanced risk-adjusted returns, and PineBridge’s outlook for the sector in general is favorable for the year.
Facing high interest rates and increased costs, as well as a potential slowdown in certain areas of consumer spending, some portfolio companies may see margin compression and face uncertain growth prospects this year. However, companies with positive cash flows, strong market positions and nimble capital structures will likely be better able to navigate the current economic challenges. Recognizing that not all private credit direct-lending strategies are the same, it is more important than ever to partner with an experienced private credit manager that can deliver attractive risk-adjusted return potential for investors across economic cycles.
Institutional investors’ interest in private credit direct lending will persist in 2023, given its attractive yields and diversification attributes, especially in the current environment, said Joe Taylor, CFA, head of capital markets, private credit at PineBridge Investments. “Private credit generates a desirable yield relative to other public and private debt asset classes. Having some downside protection and diversification benefits in the current interest rate environment, from a comparative perspective, is of interest to many investors.”
Investment performance is predicated on the quality of the private credit portfolio — companies with strong cash flow and solid management. Moreover, the deal pipeline is healthy for experienced managers like PineBridge, Taylor said, which benefit from a robust existing portfolio that can generate meaningful add-on activity in addition to new buyout opportunities.
INFLATIONARY IMPACTS
Current macroeconomic issues affecting the private credit direct-lending market are likely to continue for at least the next two years because specific inflation components may be difficult for the Federal Reserve to tackle via monetary policy alone, Taylor said. Portoflio companies will likely have to live with higher input and energy prices; service-based companies will be more susceptible to wage pressures.
The inflationary environment has a twofold impact on private credit investment opportunities, said Doug Lyons, head of origination for private credit at PineBridge. “On the positive side, the increasing Secured Overnight Financing Rate [SOFR] can boost yields for investors in the strategy. However, on the negative side, rising wages and a strained supply-chain environment can cause margin compression, depending on a company’s ability to pass on price increases,” he explained. PineBridge places a high priority on closely monitoring the impact of rising inflation to ensure the cash flow of its portfolio companies remains strong to support its investments.
CYCLICAL SLOWDOWN
PineBridge’s view is that the U.S. is in the beginning stages of a cyclical 12- to 18-month slowdown in economic growth. Already some companies are finding it harder to pass through price increases to consumers, while some discretionary sectors are also seeing a moderation in consumer and commercial spending, Taylor said.
“Many of these companies have to deal with high interest rates, which is a cash outflow they have to service,” he added. “So liquidity for companies in potentially weaker sectors or with overly aggressive or complex capital structures will start to show some pain towards the middle of the year, once we get the full impact of the high-rate environment and the slowdown. “Over the second and third quarters, we’ll really see how companies, from a margin perspective, are going to be able to navigate this new environment,” he said.
Despite the macro challenges, investors should continue to regard private credit direct lending as part of a diversified fixed-income portfolio that offers attractive yields, Lyons said. “As a result of what we see in the market, overall leverage levels appear to be coming down. Yields are being enhanced and credit agreement provisions with respect to covenant levels and baskets provide strong protections for investors.”
LOWER MIDDLE MARKET FOCUS
PineBridge targets the lower middle-market segment, consisting of companies with earnings before interest, taxes, depreciation and amortization ranging from $7.5 million to the high 20s. “We don’t look at just revenues per se. We look at the company’s historical performance, which in many cases is 20-30 years, to assess its real cash generation and competitive ‘moat’ or relevance to its client base,” Taylor pointed out.
The firm continues to see a strong pipeline of established, family-owned businesses that are for the first time teaming with private equity firms to access growth capital so they can take advantage of a weakened peer group, or execute on growth plans, he said. “These are businesses that are fairly stable, both during stronger economic times as well as during weaker economic times,” he noted.
Strong deal flow is coming from both new pipeline opportunities and from existing portfolio companies. “Where we would normally have a mix of, say, 75% new deal flow and 25% existing-portfolio upsizing, in this environment we’re probably looking at around 40% to 45% from existing-portfolio companies and 50% to 55% coming from new deal flow,” Taylor noted.
TARGETING RESILIENT SECTORS
PineBridge focuses on specific sectors that benefit from new public and private capital spending, have a competitive “moat” and are resilient in the face of business shocks, which represent good opportunities for investors, Taylor said. Business services continues to be a fairly healthy economic sector, along with consumer, health care and food and beverage. Educational services is another sector where federal and local districts are spending a lot of money to ensure the educational system is up to standard, especially after the COVID-19 outbreak. “You have companies that will benefit from the infrastructure spending across the nation,” Taylor added..
Businesses sensitive to economic shocks, primarily in commercial and consumer spending, may not perform as well. “There will be continued pressure on traditional retail, hospitality, restaurants, and some consumer discretionary sectors,” Taylor said.
LIQUIDITY AND TRANSPARENCY
Investors and managers are focused today on both the liquidity profile and the transparency of prices and valuations in private credit platforms. The weakened economy and high interest rate environment will strain the cash-generation capacity of some portfolio companies, Taylor said, noting these may have been levered off of an adjusted EBITDA number and overvalued from the start.
Besides liquidity, another top concern for investors is transparency. “Because there is no liquid secondary market, investors are curious and even a bit suspect of what they are seeing from a mark-to-market perspective on private credit portfolios,” he said. “Time will tell, but it’s certainly a conversation that asset managers are having with their investors, and investors are putting a high bar [on] it,” he added.
MANAGER SELECTION
As investors consider private credit today, they should look under the hood at what’s behind each manager’s investment strategy. “Make sure you understand the composition of the yield being marketed, because not all platforms are the same,” Lyons advised. “Dig below the advertised or headlined potential yield and also look at the amount of leverage used and the composition of the first lien, the second lien and the mezzanine positions. All these factors matter as you think about the cost-benefit of the asset class,” he said.
“Experience matters in this asset class. There is no free lunch,” said Taylor, adding that investors must do the due diligence on the health of the asset manager’s existing portfolio as well as their new pipeline. “It’s great that yields are attractive, but that comes at a cost. The cash interest from a company, its well-being and longevity, and the [private credit] manager’s due diligence and evaluation process will ultimately determine the success or failure of a particular investment.”
Source:pionline.com
