Setting sail with alternative investments
The long-term outlook for private equity, real estate and hedge funds now appears much brighter, following a tumultuous 2022
AS SAILORS will attest, setting sail is best done with the right crew and equipment.
As investors become more sophisticated, alternative investments spanning private equity, real estate and hedge funds have increasingly been added to their portfolios.
Think of some of these as specialist crew or equipment, such as those used in sailing.
Even when well prepared, experienced sailors know that conditions can change quickly.
Last year, storm clouds returned to markets in the form of inflation, interest rises, volatility, and the talk of recession.
The dark clouds merged as the US experienced the fastest rate of monetary tightening with the US Federal Reserve hiking interest rates in an attempt to tame inflation.
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The tightening caused markets – both equities and bonds – to suffer losses.
What’s the significance of this occurrence? It is only the third time in the last 100 years that US equities and bonds have registered declines in the same year.
Thankfully, rainbows often follow storms – and we believe that 2022’s turmoil may lead to potential opportunities in alternatives over the coming 12 to 24 months and beyond.
At an asset class level, the long-term outlook for private equity, real estate and hedge funds now looks much brighter than it did at the end of 2021.
A more favourable valuation environment with reduced competition from liquid capital sources should create increased opportunities for alternative investment managers to shine in 2023 and beyond.
With the weather report of Fed actions, inflation and recession, how might an investor consider crewing their boat and sailing towards opportunity?
Timeless and tactical hedge funds
While certain hedge fund strategies make sense throughout the cycle – and are seen as “timeless” – others are more reliant on the nearer-term environment, or “tactical”.
Think of “timeless” as potentially more suited to core portfolios or seeking exposure to long-term themes; and “tactical” as more opportunistic and based on the phase of economic cycle and other factors.
Timeless: Hedge funds that seek active trading opportunities informed by macroeconomic analysis – which we refer to as hedged global macro – have historically been able to generate more consistent returns without large swings in correlations to markets.
Given the current market backdrop, especially with the challenges faced by central banks in balancing inflation and growth, hedged global macro is well-positioned for active trading opportunities within fixed income and currencies.
Tactical: Bond defaults increase during economic contractions and capital becomes more expensive and harder to access. Distressed debt specialists, and managers with distressed credit experience, restructuring expertise and who can influence the process, stand a better chance of recovering greater value from defaulted debt.
These are likely to occur in the aftermath of 2022’s storm, presenting a rainbow of opportunity.
In equity markets, a bias towards high-quality companies – with high profit margins, healthy balance sheets, growing profits and/or dividends, stable forecasted cash flows, strong management and a sustainable competitive advantage – and an aversion to low quality companies presents opportunities for specialist long-short managers.
Private equity and private credit
Choosing which “crew member” – be it fund manager or fund – to invest with will be more important than ever, as performance dispersion is likely to remain high.
Favour funds focused on assets that are resilient to inflation shocks and that have demonstrated strong pricing power over the long term.
Buy-out: This is a “traditional” private equity strategy. A higher rate environment will certainly affect company selection, deal capitalisation, pricing and underwriting criteria. However, it is unlikely to have a major impact on the execution of modern buyout strategies.
This is because fund returns are increasingly derived from factors such as sales growth, margin expansion, and strategic repositioning rather than the use of leverage. This, coupled with potentially cheaper entry points, adds to the attractiveness of this crew member.
Private credit: There is significant value to having flexible capital across credit assets amid market volatility. Skilled managers that are able to offer bespoke capital solutions may be in a position of strength to negotiate attractive credit terms with high levels of protection through covenants.
Furthermore, those who have insight into issuer quality and potential capital structure events such as re-financings, debt exchanges, and outright restructurings may be able to generate very attractive risk-adjusted as well as total returns.
Real estate
Real estate investors were presented with a unique set of challenges and opportunities last year. Increased financing costs, expanding capitalisation rates and inflationary pressures presented headwinds.
But these clouds also created opportunities for rainbows: to take advantage of market inefficiencies, buy more cheaply and reposition properties to meet shifting consumer preferences.
This could open the door for well-capitalised, opportunistic managers to create value at the individual property level. Cycle-tested strategies with experienced managers are poised to perform in this dynamic environment.
Additionally, by identifying the right assets in strategic locations, rents may reflect inflationary pricing leading to appreciation in value through new leases linked directly to inflation rates.
Real estate could be a crew member to help provide dynamism through opportunistic exposure and ballast through inflation hedging.
While the big storm of 2022 is behind us, there are still clouds in the sky and uncertain weather to navigate.
We believe waiting for entirely blue skies would be a mistake, so the importance of a specialised and highly skilled crew has only increased.
Historically, the aftermath of bear markets – such as the dot-com bubble in the early 2000s and the great financial crisis – have been fruitful times for alternative strategies.
However, we do not seek to time markets via alternatives. Instead, we are willing to take to positions ahead of a trough in the markets.
We have our specialist crew. We have our specialist equipment. It’s time to set sail.
The writer is Asia-Pacific head of alternative investment sales at Citi Global Wealth Investments
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