Seeking private alternatives
Investors squeezed between the fear of equity market volatility and the reality of low fixed income yields are looking at private credit and private equity in search of better yields and risk-adjusted returns.
Head Multi-Managers Private Equity, Real Estate & Private Markets
Investors have identified a number of potential market risks on the horizon for 2020. How do you believe alternative asset classes such as private equity will perform in this environment?
History has shown that private equity can deliver superior risk-adjusted returns to public equities through the cycle and through the toughest economic conditions. This was proven clearly in the crucible of the financial crisis of 2008/2009, when the drawdown was significantly lower and the drawdown timing was delayed versus public equities. Illiquidity has its merits.
This important proof point for private equity prompted a broad variety of investors to increase their allocations. We expect the private equity market to deliver important portfolio benefits in the event of future cyclical changes, not just in terms of absolute returns but also in terms of diversification. As an asset class, we believe that private equity is highly important both as an investment vehicle and a catalyst for economic growth.
But this is not only due to illiquidity but due to the asset class itself. Private equity is a skill-based asset class and as such has different return drivers than public equities. Most notably there is value addition performed by the fund managers and the underlying portfolio companies that can work in all economic circumstances.
Both current trends and investor sentiment are indicative of private equity's increased appeal as an asset class. We expect the larger fundraisings of recent years to continue, with PE managers hungry to lock in capital during this extended period of economic expansion. The increased investor appetite for PE means that capital will continue to flow into the asset class. The record level of uninvested capital will see more cash put to work than at any other time in history according to the 2019 Preqin Global Private Equity & Venture Capital Report.1 We consider this a digestible amount for the industry. We also expect to see new strategies and firms widening their investment scope to regions such as Africa.
What is current investor sentiment towards private equity (PE)?
Both current trends and investor sentiment are indicative of private equity's increased appeal as an asset class. We expect the larger fundraisings of recent years to continue, with PE managers hungry to lock in capital during this extended period of economic expansion. The increased investor appetite for PE means that capital will continue to flow into the asset class. The record level of uninvested capital will see more cash put to work than at any other time in history1. We also expect to see new strategies and firms widening their investment scope to regions such as Africa.
What role can alternatives such as private equity play in the investor portfolio?
In our view, selection and diversification will play an even more significant role in investors' portfolio construction processes as a means of increased downside protection. Today's crowded market means that fund managers have to think more carefully about how they deploy capital. Achieving appropriate sector diversification in order to avoid region specific concentration and return dependence will likely be a key driver of growth in private equity. In general, we take a top-down approach regarding the regional allocation of the underlying assets. This general strategic allocation is overlaid with tactical considerations influenced by the individual investment opportunities available.
We currently target funds actively investing in the growth, small buyout and mid-market buyout spaces. These tend to be more conservatively valued, and have a history of strong strategic and operational involvement in their portfolio to boost company revenues and profits.
Head of Hedge Fund Specialists, UBS Hedge Fund Solutions
What has driven the tremendous growth of private debt investment strategies, and how might market 'surprises' or a recession affect their performance next year?
The regulatory regime put in place in the wake of the Global Financial Crisis 10-plus years ago has fueled the boom, with private credit stepping in to fill the lending hole created by traditional lenders leaving the market. At the same time, the demand for yielding assets has grown steadily thanks to the ongoing environment of low-to-negative interest rates. As the pool of capital investing in private credit assets has grown, the available yield in on-the-run lending strategies has declined markedly, leaving investors stretching for yield and taking on greater risk through longer duration and illiquid fund structures.
We're not saying that this will end in tears. While alternative credit is often viewed as a highly cyclical opportunity, we believe the strategy can perform well in numerous market environments due to the general dearth of capital from traditional lenders, as well as its idiosyncratic nature. As with all asset classes, there is a risk vs reward relationship here that needs careful watching. And in our opinion in today's market there are still pockets of value, albeit limited, in both traditional and private credit.
One of the virtues of private credit is that it is not subject to event-driven short-term volatility and flows to the same degree as more liquid credit investments, so market 'shocks' are not as big an issue. Overall, the more illiquid nature of private credit strategies somewhat smooths returns through the cycle.
What adjustments are you making to respond to the macro outlook?
In the current environment we're more inclined to favor asset-backed strategies over corporate. Over the past few years the corporate credit and loan markets have become increasingly dominated by large passive investor pools. The net result has been that volatility and liquidity 'gaps' have become more frequent and greater in magnitude. We're also wary of generally lower underwriting standards and relatively high valuations in these markets. We feel that asset-backed collateral, in particular residential real estate, offers higher quality collateral with more attractive risk-adjusted returns.
In our work across this wide universe, we've identified the 18 month to three year range in the private credit yield curve as delivering more attractive risk-adjusted returns than longer term credit with greater duration risk. We favor self-liquidating loans that should offer low correlation to credit markets and limited interest rate risk, as well as stable yields. We see an advantage in being nimble; opportunities and dislocations in the credit markets tend to have limited lives and we need to be able to pivot to different strategies as markets evolve or as interest rates fluctuate.
How would a change in interest rates affect performance?
We believe that the world will be in a 'lower for longer' state for the foreseeable future. But we have always maintained that spending a large proportion of portfolio risk budget on the direction of interest rates is extremely sub-optimal.
Our current focus on intermediate-term private credit has obvious benefits if rates should rise, since we will be able to reinvest the maturing loan principal at higher yields. But in a scenario of falling rates, longer duration assets should benefit from positive convexity (sensitivity to rates). However, our goal is to benefit from idiosyncratic carry, rather than from broader yield compression. And since our loan programs will return principal at a more rapid pace, we should be able to pivot to new idiosyncratic opportunities as they arise. In short, there are potential positives and a broad universe of opportunities in either scenario and we believe that we are not dependent on the direction of rates to generate returns.
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