Transition opportunities: In search of differentiated return drivers

IN a world of low bond yields, burgeoning inflation, as well as fundamental and financial uncertainty, the use of traditional investment tools is being challenged. At the same time, climate change is prompting a greater focus on sustainability, as the world moves towards net zero emissions.

These factors herald a major transition and are leading to a wider set of potential outcomes, as expectations of lower market returns coupled with increased uncertainty prompt investors to incorporate more varied sources of returns so as to withstand potential market disruptions and to also benefit from the resulting opportunities.

Against this backdrop, we have seen very strong demand from our clients for solutions that provide differentiated return drivers that can help diversify their portfolios - such as those offered by well-managed, risk-controlled, multi-strategy platforms.

We are also witnessing an acceleration in the shift from public to private markets. As returns in public markets remain compressed, investors are drawn towards private markets in search of higher yields. Opportunities in the private space have historically only been available to select investors. These opportunities have recently opened up and are now accessible to the broader sophisticated investor base.

One key benefit we see in getting investors to expose their portfolios to alternative investments, including private assets, is the reduction of their beta, or overall sensitivity to global markets. Depending on risk profiles and appetites, investment time horizons and liquidity needs, investors can consider positioning around 7.5 per cent to 20 per cent of their portfolios in alternative investments.

As inflation rates remain high and the potential for hikes looms, we believe demand for resilient, income-producing solutions in a semi-liquid format will continue to increase. Overall, apart from the yield pick-up, such strategies in areas like private credit, private real estate, and private infrastructure withstand inflationary pressures well.

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For example, the floating rate exposure in private credit is a key protection against rising rates. And, their seniority in the capital structure provides further defensive capabilities. Real estate assets, meanwhile, can see a lift in operating income through market rent growth or rent escalation clauses.

Traditional private equity investments continue to offer an additional source of returns compared with those of traditional asset classes.

Private equity investing is characterised by long-term horizons and a strong alignment of interest between managers, owners, and investors. Private equity investors are attracted by this common ownership and long-term vision, and are increasingly willing to forego the liquidity offered in the stock market as they believe private equity-backed companies will outperform similar publicly owned companies over the same time horizon.

The long-term and illiquid nature of private equity makes these investments more resilient during economic contractions, relative to other asset classes. Historically, private equity valuations have not been highly correlated with public markets as the valuation and reporting timeframe, as well as the locked-in nature of the investment, discourage panic selling.

In this illiquid world of private equity, secondaries provide investors with an opportunity for faster cash flows, as well as access to diversified portfolios, at both the manager and underlying company level, and through vintages.

Secondary funds purchase existing interests in private equity funds after those funds have been partially or fully invested in by underlying portfolio companies. Stakes are usually acquired at a discount, since sellers are either distressed or looking to reposition their portfolios.

Once a nascent market, secondaries have become both a provider of liquidity for investors in a formerly illiquid asset class and an innovative tool for general partners to hold on to their best assets or crown jewels. In the last 20 years, the market has grown from less than US$2 billion to over US$100 billion in 2021, a potential record year.

With an increase in both global fundraising and a steady rise in the proportion of funds likely to ultimately trade in the secondary market, this space is currently primed for growth. Despite the global health and economic challenges that the pandemic presented in 2020, the year also provided an opportunity in the secondary market not seen since the Global Financial Crisis.

Sustainable investments are another interesting space that is increasingly becoming a focus for investors and for investment managers globally. Clients are now looking for solutions that can achieve positive returns from both financial and sustainability angles, and we strive to enable our clients to participate and benefit from this paradigm shift.

From an investment perspective, as the world moves towards net zero emissions to respond to climate change, we see great transition forces at play. Factors to consider include changing regulations, consumer preferences, infrastructure and technology.

Almost all companies have some degree of climate exposure, often to an extent that is as yet unknown. These companies are therefore not responding to the risks or the opportunities equally, creating relative winners and losers.

The market often overrates companies with a clear green label, assigning an overly positive valuation to many companies that may eventually become relative climate losers. On the other hand, the market currently undervalues and should place greater emphasis on companies that lack climate purity but are committed to transitioning towards climate-friendly business models.

Such opportunities can be captured by actively managed equity strategies as they can exploit these anomalies with the ability to go long on the winners and to short the losers.

To help our clients meet today's challenges, at Credit Suisse we focus on creating and facilitating investment products and services that not only generate financial returns, but also deliver environmental and social benefits.

• Salman Shah is head of alternative fund solutions and sustainability leader for Wealth Management Asia Pacific, Credit Suisse.
• Teo Wei Zhen is alternative funds specialist for Wealth Management Asia Pacific, Credit Suisse.