Challenging backdrop for alternative assets warrants caution

FOR more than a decade when interest rates were ultra-low, bankers and advisers argued strongly for an allocation into alternative investments. Now that interest rates are at the highest level since 2007, many bankers continue to extol the merits of alternatives including private-market assets such as private debt. But in certain segments, the strain of higher rates has begun to show. The argument for an allocation in portfolios rests on the diversification benefits alternatives are expected to provide – lower correlations with traditional stocks and bonds, in addition to higher returns and lower volatility.

The truth is that the macro environment in 2022 was as challenging for some corners of the alternative-assets universe as it was for public markets. The confluence of three developments – war in Ukraine; soaring inflation; and an aggressive rate hike cycle by the Federal Reserve – sparked an upheaval in markets. The hedge fund universe was not spared. Of the many strategies, commodity trading advisors unsurprisingly generated double-digit returns. But some equity strategies fared poorly, particularly those with a long bias.

Private equity also had to contend with several headwinds. As S&P Global notes, PE flourished over the past few years, as low interest rates on credit fuelled risk appetite and turbocharged returns. In 2021, PE and venture capital raised US$1 trillion, and deal exits and entries hit new highs. But the proverbial party ended last year, as the prospect of higher-for-longer rates took its toll, raising questions on the viability of leveraged buyouts. Citing Preqin data for 2022, S&P said PE-backed exits slowed significantly to 52 exits worth US$23.7 billion, barely a third of the value in 2021 when a total of 196 PE-backed exits raised US$74 billion.

Now investor expectations are focused on private credit, which has had a creditable historical performance. Private credit funds lend to smaller companies, and the debt is typically a floating rate, which adds to its attraction today. But credit conditions may worsen this year. An uncertain economic environment coupled with higher interest rates raise concern over companies’ ability to maintain profitability and repay and refinance debt. Preqin notes that institutional interest remains strong. But it has also taken its returns expectations down a notch. It forecasts average annual returns for the asset class of 8.4 per cent a year between 2021 and 2027, compared to a historical return of 9.4 per cent from 2015 to 2021.

Alternative investments are available only to individuals who qualify as sophisticated or accredited – for good reasons. Lower transparency, illiquidity and the absence of mark-to-market valuations for private assets compel investors to demand a risk premium. The puzzle today is how much of a risk premium is adequate when corporate bonds deliver attractive returns and are liquid to boot.

Prudence certainly dictates that unless one’s total portfolio is large, allocations to alternatives are best kept modest, and investors should recalibrate their return expectations. In PE, for instance, exits may fall short of expectations and take longer. To be sure, the Fed will begin to cut interest rates at some point. Even so, markets are unlikely to return to a freewheeling risk-on mode, and that is not a bad thing. What recent months show is that while a portfolio of alternative assets may well outperform a balanced portfolio, they can neither defy gravity nor shield investors from losses.