Alternatives matter in the new age of investments

ENTERING the new decade, few would have guessed that several once-in-a-generation events would mark the 2020s. Amid ongoing socio-economic and geopolitical affairs post-pandemic, the global macro environment is far from anything near calm.

Suffice to say, the past few years have set the stage for investors to rethink their allocation strategy. Unsurprisingly, many have resorted to capital preservation strategies in risk-free assets such as Treasury bills and gold.

The more difficult – and much more crucial – question is where alpha might be found, or if it’s even worth looking for.

On that note, alternative investments have remained a topic du jour. It’s not just institutional capital allocators, but increasingly high-net-worth individuals (HNWIs), family offices, and private investors looking beyond the tried-and-tired portfolio of public stocks, bonds, and cash.

Alternative asset managers have already amassed a collective US$12 trillion in assets under management (AUM), according to Preqin. Private equity takes more than 40 per cent, the largest share, followed by venture capital funds with about 20 per cent. Private debt funds, which have quickly risen to more than 10 per cent of the total over the past five years, include areas such as direct lending, mezzanine or distressed loans.

Less common forms of investment, such as private credit, now have a strong track record of consistently outperforming public markets over several years and look set to continue that trend. They have also turned out to be much less volatile. Within private credit, investors are turning to senior private credit opportunities for returns that can outpace the current high inflation.

Where does the sudden appetite for private credit come from and how can more investors benefit from it in the year ahead?

Banks are retreating

While the recent market volatility made traditional banks more risk-averse in general, they have also been affected by structural changes. As regulators tighten lending requirements, it is getting increasingly difficult for traditional banks to finance investments that are deemed risky. And with money getting tighter, institutions are pulling back.

Investment firms are racing to fill the gap. These firms typically work with much less leverage on their books and are experienced in managing the associated risk. They have raised billions of dollars of capital for attractive strategies around diversified portfolios that can focus on performing or distressed loans.

Where is the capital coming from? Much of the raised capital resides in the war chests of investors looking for safe-haven assets. As cash becomes increasingly devalued, the pressure is on for investors to find alpha, and this is where they are turning to alternative assets, specifically private credit.

Private credit – which typically involves loans or debt securities extended to non-public entities by private lenders or investors – has gained significant appeal over private equity and venture capital due to its stable and predictable cash flows through regular interest payments, often secured by collateral, thus reducing the risk of loss.

Private credit outperformed buyout funds by 4.5 times in 2023. According to a Bain & Co report, private equity exits in the Asia-Pacific saw a sharp decline in 2023, plummeting to US$101 billion. This marks a 26 per cent drop from the previous five-year average and a staggering 51 per cent fall from the record-breaking highs of 2021. That said, the future looks bright for Apac-focused private credit. AUM in this sector are projected to soar to an all-time high of US$115.9 billion by the end of 2027, boasting a robust compound annual growth rate of 8 per cent from 2021 to 2027.

Additionally, private credit investments typically have shorter durations, providing quicker returns and greater liquidity. Private credit investments typically have shorter durations compared to private equity and venture capital, which can have lock-up periods of seven to 10 years or more. With traditional banks scaling back their lending activities, private credit funds are well-positioned to fill this gap, offering a diversified and often more secure form of investment.

Where’s the risk?

It’s imperative to contextualise the current market dynamics, particularly the prevailing high-interest rate environment. Against this backdrop, the burgeoning interest in private credit represents a noteworthy trend. However, it’s essential to note that this shift is still in its infancy and subject to evolving conditions.

Funds such as Blackstone Private Credit Fund and Hamilton Lane’s Senior Credit Opportunities Fund have adeptly navigated this landscape, capitalising on market dislocations to deliver compelling risk-adjusted returns. By focusing on higher-yielding private credit opportunities, they have been able to offer investors attractive investment options. Most recently, Goldman Sachs had also raised US$21 billion for its direct-lending fund targeting private-equity backed business.

Yet, it’s crucial to acknowledge that this favourable environment may not persist indefinitely. As more participants enter the private credit space, competition is likely to intensify, leading the spreads over the risk-free rate of return to decline.

Greater accessibility for retail investors lacking expertise about private credit could lead to issues with regulators, particularly if they invest in assets that may be illiquid, improperly marked, or not stress tested. Additionally, as market conditions evolve, interest rates may well fluctuate, impacting the attractiveness of private credit investments.

Therefore, investors should remain vigilant and consider the associated risks, and be discerning about the credibility of the financial institutions and products they place their funds in when navigating this evolving market.

The need to diversify

Diversification is key to managing risk. From that perspective alone, alternative investments such as private credit are compelling.

The case for private credit in alternative investments lies in its ability to offer superior risk-adjusted returns, diversification, and resilience in uncertain economic climates. As traditional markets grapple with volatility and interest rate fluctuations, private credit stands out as a robust alternative, providing investors with the opportunity to access unique, high-yielding opportunities that are less correlated with public markets.

Moreover, the growing sophistication and institutionalisation of the private credit market underscore its legitimacy and potential for long-term performance. As more investors recognise the strategic value of incorporating private credit into their portfolios, we anticipate continued growth and evolution in this space.

As we look to the future, the integration of private credit within a diversified investment strategy will likely prove to be a prudent and rewarding choice, solidifying its place as a cornerstone of modern investment portfolios.

The writer is head, Private Capital Markets, at Alta