Advisors need a new playbook
The new new office
Chapter 1
Opportunity in private credit
Chapter 2
Return of the hedge fund
The future of real estate
Private credit's ESG scramble
Chapter 3
Hedge funds see resurgence
The next big thing in private equity
Chapter 4
Opportunity in private Credit
Hedge Funds See resurgence
For many years, advisors used the 60/40 portfolio as a market proxy. They could easily increase or decrease their equity allocation to meet their clients’ needs. The 60% allocation to equities was designed to generate growth while the 40% allocation to fixed income was designed to provide income, and because they didn’t move in lockstep with one another, investors received some degree of diversification. This approach worked well during the bull market – but we believe the markets may be very different in the next 10 years than the last 10. The current market environment presents several short- and long-term challenges. Some capital market expectations (CMEs) are projecting lower equity returns over the next 10 years, and advisors may need to identify sources of incremental growth. While interest rates have been rising, they are still below their historical norms, and volatility has spiked due to a changing rate environment, geopolitical risks, and the highest level of inflation since the early 1980s. Fortunately, what in our view may be the ideal tools to meet these challenges are more accessible now than ever before – alternative investments. For decades, institutions have used alternatives as a source of incremental returns and yield, a buffer for market volatility, and a way of hedging the impact of inflation. These investments were often limited to large institutions and family offices, but in recent years, through product innovation, they have been made available to a broader group of investors at lower investment minimums.
For illustrative purposes only. Not all strategies may reflect intended objectives.
The 60/40 portfolio has served investors well over the last decade – but could fall short of meeting their goals in the decade ahead. Advisors need a more sophisticated toolbox, one that includes allocations to a broad array of alternative investments. These versatile and valuable tools may be ideal instruments for today’s challenging environment.
All investments involve risk, including possible loss of principal. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. This article was provided by Franklin Templeton. This material is intended to be for general interest only and should not be construed as general investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. Source: Franklin Templeton Capital Market Insights Group, BLS, Macrobond. Key Terms Defined: Buyout— In buyout transactions, a private equity firm typically acquires a controlling stake in a mature company. Direct lending—A form of corporate debt in which lenders other than banks make loans to companies without intermediaries, such as a private credit firm. Mezzanine Lending—The origination of unsecured, subordinated debt, often in conjunction with a private equity buyout transaction. Distressed—includes investments in debt of financially troubled companies facing liquidity issues. Interval and tender-offer funds—types of continually offered closed-end funds that frequently price shares at NAV and are not listed on an exchange, they have limited liquidity. Macro—a hedge strategy focused on macroeconomic trends. © 2022 Franklin Distributors, LLC. Member FINRA/SIPC. All rights reserved.
1
The democratization of alternatives We define alternative investments as private markets and hedge funds. Private markets can be divided into private equity, private credit and real assets. Private equity can be broken down into venture capital, growth equity and buyout. Private credit includes direct lending, mezzanine and distressed. Real assets include real estate, infrastructure, and natural resources. Meanwhile, hedge funds include equity hedge, event-driven, relative value, macro, and multi-strategy. Institutions and family offices historically used alternative investments to solve for the needs of their constituents. Public and private pension funds, sovereign wealth funds, and endowments and foundations have committed significant capital to private equity, private credit, hedge funds, real estate and infrastructure. However, until recently, these unique investments were not available to many high-net-worth investors. In the past several years, there has been a confluence of events that have helped to democratize access to alternative investments. Product innovation: In recent years, there has been significant growth in registered funds (interval and tender-offer funds) available to investors at lower minimums and more flexible liquidity options. High-net-worth demand: Increasingly, high-net-worth investors have been demanding access to alternative investments. They have primarily sought access to the private markets as a source of return, income, and diversification. Institutional access: Based on demand and structures that were more conducive to managing long-term capital, many institutional-quality managers have brought products to the market. What role do alternative investments play? Alternative investments represent versatile and valuable tools in building portfolios. Many of them can serve multiple roles in a portfolio. Consider the four primary goals of investment within a portfolio – growth, income, defense and inflation hedging. Growth – the growth in the portfolio will primarily come from the equity and equity-like allocations including US and non-US, equity hedge, infrastructure and private equity. Income – the income will primarily come from fixed income (treasuries, corporate bonds & high yield), plus real estate and private credit. Defense – the defensive portion of the portfolio may include cash, commodities (gold), macro, multi-strategy and natural resources. Inflation hedging – inflation hedging could include certain commodities, TIPS, real estate, infrastructure and natural resources.
Predictions of work-from-home becoming the new norm are being disproved by employees’ gradual return to the workplace.
View from the top
Kathrin Schindler
Despite the headlines, the death of the office is by no means imminent. The bygone Covid-19 pandemic – as well as the current inflationary climate – has posed unique opportunities for the real estate industry. And, as always, there are winners and losers across the sector. Commercial real estate underwent a dramatic change since the pandemic’s outbreak. Remote working throttled the demand for office space. Meanwhile, the industrial market saw a boom following a rise in e-commerce, and the hospitality industry experienced pandemonium as hotels cut capital expenditures and scaled down operations. Amid these disruptions, commercial real estate developers and investors have been resilient. They accelerated the adoption of new technology, created more holistic risk management strategies and embraced the changing nature of office space. The rise of e-commerce has been a big part of that, creating new structural demand for logistics. And digital working practices will continue to change the workplace as real estate companies build offices to be smarter, safer and more efficient than before. Not to mention spacious. Before Covid-19, offices were one square foot per employee; that has now changed as companies seek more space so employees can spread out at desks and have more room for amenities. IPSX CEO Roger Clarke said: ‘Macroeconomic headwinds continue to erode the growth prospects of various sectors, while global instability looks likely to persist and inflation-induced recessionary fears are fast becoming a reality. This is driving capital allocations away from speculative equities towards the few perceived safe-haven assets, with commercial real estate standing out as attractive in this context.’ While the current market situation is anything but certain, the conditions for real estate appear favorable. ‘It has become increasingly difficult to source income from a steadily reducing pool of options. Commercial real estate is uncorrelated to other asset classes and has proven its defensive nature throughout cycles, delivering the rare combination of attractive returns and capital appreciation which supports wealth preservation and acts as a hedge against a highly inflationary environment.’ Most people are trying to return to work for a variety of reasons, including home and family size, social connectivity and broadband speeds. Working spaces have become a trustworthy option for employees and companies since they allow flexibility. On top of that, they will determine the future of the office in the years to come.
Inflation and real estate Commercial real estate investment can serve as a robust inflation hedge, providing benefits such as cash flow, capital gains, portfolio diversification and favourable tax treatment. Even as inflation rates skyrocket to their highest point yet, the effect on commercial real estate remains indirect. One thing that does impact the sector is the rise in costs of construction materials, energy and commodities. But even at that, the advantages outweigh the setbacks from the perspective of a real estate investor. If the property development cost is high, there is no doubt that an investment in real estate can be a solid inflation hedge. The protection against inflation is different for rented properties than for owner-occupied properties. The rising value of the property is offset here by the ongoing costs of managing and maintaining it – which also rise during inflation. A good retirement investment is an essential factor when it comes to financial security. And investing in real estate looks to be the best alternative in these times, offering sound protection for one’s assets. Decarbonizing real estate Commercial real estate plays a key role in global decarbonization efforts as buildings are responsible for about 40% of global greenhouse gas (GHG) emissions. Significant reductions in emissions can be achieved with positive economics through technologies that already exist. Newer technologies such as low-carbon heating and cooling systems, and energy-efficient air conditioning, are all good examples of cost-effective upgrades that can create meaningful change while also de-risking assets. Investors’ commitment and increasing regulatory pressure will enforce significant change. This is seen as an opportunity to generate returns. The takeaway Working from home is here to stay, but from the trends we’re seeing in commercial real estate, companies are not abandoning their offices. On the contrary, they are expanding them. On top of that, many are trying to reel their employees back by offering incentives that are reflected in the quality of office space. Although nothing is set in stone, it looks like the economy behind real estate is here to stay. However the new workplace will look, it will undoubtedly be a collaboration between landlords and tenants as businesses respond to changing employee expectations, economic pressures and a more volatile world. Clarke said: ‘Investors would be better convinced by any means of gaining direct exposure to hand-picked commercial real estate assets which offer secure and visible income streams, with liquidity and underlying performance transparency being key considerations.’
All investments involve risk, including possible loss of principal. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. This material is intended to be for general interest only and should not be construed as general investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. © 2022 Franklin Distributors, LLC. Member FINRA/SIPC. All rights reserved. Franklin Distributors, LLC and Benefit Street Partners are Franklin Templeton affiliated companies.
As the global search for yield continues, investors are increasingly reallocating more of their portfolios away from traditional asset classes to take advantage of the return potential available in private credit. Richard Byrne, president of Benefit Street Partners (BSP), discusses the rising appetite for private debt amid a prolonged period of market volatility.
There has been a lot of capital raised in the private debt space. What are your views on that and the private debt market in general? The private debt space has been expanding. Capital has been flowing toward places where investors can potentially get an attractive return, especially in areas of fixed income, where there has been some incremental yield. Much of that capital has migrated into private credit. This asset class has demonstrated a strong risk/reward profile and is still a very robust opportunity. Non-bank lenders have benefited from the fact that banks have largely moved away from small to mid-size lending in the wake of the global financial crisis. The reality is that it takes about the same amount of bankers to underwrite a $50m or $100m private credit deal as it does to do a $5bn deal. Therefore, banks have largely moved upmarket. As a result, there is plenty of opportunity for non-bank lenders in the middle market private debt space. But while there’s been a lot of new capital, there haven’t been a lot of new entrants. If anything, the bigger firms are getting bigger, and I think that size really does matter to some extent. In the core middle market space, the lenders that can commit to full deal sizes really have an advantage; there is a difference between the haves and have-nots. Where do you think we are in the credit cycle and how does that factor into your team’s investment decisions? The credit cycle has been exhibiting late-stage behavior for some time now. We have been very cautious about our underwriting because there are signs of frothiness in the market that have been evident for some time. At BSP, we have positioned our portfolios very defensively. We typically run 80% or above 90% – depending on the portfolio – in senior secured investments, with the vast majority of that being first lien. We run a portfolio now in private debt with lower than a 50% loan to value. What is Benefit Street Partners’ due diligence process? We run our firm through an investment committee. We have four professionals on that committee who see all our deals. The investment committee meets regularly two or three times per week, plus unscheduled meetings, which are quite frequent. There is also a pre-investment committee process. Before bringing a deal to the investment committee, or in between meetings, the deal team will meet periodically with some of the investment committee members to make sure the diligence is headed in the right direction. Time is the most invaluable thing we have. We make sure to say no to deals that aren’t going to make it through our screen early so that we don’t waste time and resources. If we don’t like a deal, we’ll eliminate it right away. If it’s interesting but has some challenges, we’ll run it through some more work and another meeting. If it still has promise after that point, then we’re going to go into a deeper due diligence process and we’re going to maybe hire a qualitative earnings report. We’re going to engage outside consultants to deep-dive due diligence. Looking forward, what do you expect will be the key trends in the private debt market? We believe there are good reasons to think private debt should continue to be a strong-performing asset class. We might start seeing some stress to the fundamentals of companies going forward. We have been in a very low default rate environment since the global financial crisis. Making bad credit decisions has not been that punitive because the markets have been very liquid. Even bad companies have been able to survive by refinancing their way out of problems. However, supply chain issues, inflation, energy prices, higher interest rates, labor costs, et cetera, are going to put more and more stress on companies. Default rates for private credit might go up and also the yields. Interest rates are also likely to go up, as we have already seen. Where are you finding opportunities today? Overall, I think it is a very exciting, dynamic time for the industry and we see compelling opportunities both in the near term and longer term. Healthcare and business services continue to be our primary focus. We do have some non-correlated industrial companies, such as the salt mining business, that we find attractive in today’s market environment. Given the macroeconomic backdrop, we will continue to be more cautious on cyclical businesses while monitoring the overall stability of the US economy.
Hedge funds faced a difficult environment as the QE-fueled bull market roared ahead. But recently, they have protected investors from the market turmoil.
For over a decade after the global financial crisis, hedge funds faced a tough environment as central banks pumped liquidity into the system. As risk assets climbed, many investors avoided hedged strategies. The thinking: why pay a premium for a product that is being outperformed by a low-cost index tracker or a simple 60/40 portfolio? Proponents of hedge funds always pointed out that they can add valuable diversification to equity- and bond-heavy portfolios as well as protect investors in down markets. The recent selloff, which has seen equities and bonds falling at the same time, has provided a stress test and, on aggregate, hedge funds have cushioned their investors from the worst of the downturn. As of July 19, the HFRX Global Hedge Fund Index UCITS was down 5.5% YTD compared with 20.13% experienced by the S&P 500. The key question facing investors now is whether the treacherous market conditions of late are the start of a long-term trend marked by increased volatility and lower returns from major asset classes. And if so, how can one structure his or her portfolio in the most resilient way. Peter Reis, head of fund research at ifsam, argues that the investment climate is changing. In recent years severe market drops have been met with massive central bank interventions. But going forward, the scope for such intervention will be limited by already-high inflation and debt levels, he said. ‘That environment seems less promising for holders of investments in market indices constructed by market capitalization due to their inherent pro-cyclical characteristics.’ As a result, more diversified portfolio combinations appear to offer a higher probability of success. Enter the liquid alternative Hedge funds and their more liquid counterparts – liquid alternatives – can both optimize a portfolio by giving access to different risk premia, enhancing diversification and improving the risk-adjusted return profile of the portfolio, Reis believes. He noted that liquid alternatives in particular usually offer higher liquidity and can therefore serve as an added layer of resilience. ‘The integration of liquid alternatives can really add ongoing risk management advantages for the portfolio, but only if the main challenges and threats are avoided,’ he said. ‘We are particularly wary of liquidity mismatches, because that can lead to enormous losses in a short time frame. We have seen this in recent years – notably in the area of private credit, where some funds could not liquidate their portfolios in stressful market environments, leading to a closing of the funds and reputational disaster.’
Within the hedge fund and liquid alternatives universe, the headline performance figures don’t show the full picture of the considerable dispersion in individual fund performance this year. This reflects the very different strategies and approaches that fall under the blanket term. One of the most high-profile liquid alternatives funds, the listed BH Macro fund – which came under fire for doubling fees in 2021 – appears to have protected investors well this year. The fund net asset value (NAV) rose from £3,520 ($4,240) on January 1 to £4,680 ($5,630) on July 19. But funds with directional long equity or credit exposure – particularly those who failed to adjust their exposure after the first quarter – are likely to have seen heavy losses. Reis pointed out that relying on only one underlying style or risk premia can go along with substantial inherent risk. ‘Because the dispersion of results of liquid alternatives can fluctuate widely, and because the complexity of specific funds can be an additional challenge, the investor may be well advised to integrate a broadly based collection of liquid alternatives. If the investor is not well experienced in that market segment, a specialized asset or fund of fund manager could be a reasonable solution,’ he said. Hedging bets Tom Kehoe, global head of research and communications at the Alternative Investment Managers Association, pointed out that institutions and family offices – the traditional investor base for hedge funds – have always used the funds to help manage overall portfolio risk and preserve capital. ‘As Warren Buffett said, the first rule of investing is: never lose money. The second rule is: don’t forget the first.’ He also highlighted the high dispersion in returns among strategies and individual funds. In terms of those that have historically offered low correlation to equity markets, he highlighted managed futures and CTAs, which have done well this year (the HFRX Macro/CTA index is up 2.66% YTD through June, thanks also to some discretionary macro managers who have done well out of long energy trades). Kehoe also noted that hedge funds have protected investors in previous stress tests. ‘In March 2020, hedge funds fell off less than major markets, while in October 2008, hedge funds fell in aggregate around 20%, while markets were down around 50%. In both cases the drawdown for hedged strategies was shorter and the recovery quicker. That’s what investors are willing to pay for: the ability to protect their clients’ wealth,’ he said.
Real estate has proven to be a strong hedge against inflation. The multifamily housing and industrial warehouse sectors have had the strongest fundamentals and pricing power, and have driven significant income growth. Janet Souk, portfolio manager at Clarion Partners, shares her perspective on the post-Covid real estate market.
What are your views on the post-Covid real estate market? Covid-19 has had a huge impact on the way we live, work and play. It has also had a huge impact on the way we view real estate and different asset classes. But Covid didn’t create any of these trends – it accelerated those that we were already seeing and tracking in the market. We saw e-commerce taking over traditional retail with online shopping leading to greater industrial demand. On the multifamily side, there have been demographic trends of people moving to lower-cost, more business-friendly cities with lower taxes and better weather. There has been an upward trend in the life science sector too due to people focusing on living longer, healthier lives and on disease prevention. Do you think real estate is a hedge against inflation and what does it represent for investors? Real estate has proven to be a strong hedge against inflation. Historically, real estate performance has been strong during periods of high inflation. Favorable supply and demand market conditions typically allow landlords to pass the higher costs onto tenants in the form of higher rents. The multifamily housing and industrial warehouse sectors have had the strongest fundamentals and best pricing power, driving significant income growth. In addition, the way leases are structured can give investors a good inflation hedge. Industrial leases typically have annual bumps built into leasing contracts and residential housing features shorter-term leases, allowing for ongoing adjustments based on market rate. What is the future for opportunity zone investing? I think it’s very positive. Investors get significant tax breaks on one hand and communities get much needed investment dollars on the other. There was a lot of capital raised in the space over the past few years and I think it’s generally doing what it’s supposed to be doing – bringing capital into underserved areas that would otherwise not have seen investment. It may lead to creating housing and jobs and there’s the possibility that the program will get extended. The program needs more stringent report requirements to track the success of the opportunity zone investing – which in our view is, overall, a good thing for the real estate industry. What are the factors driving the acceleration of capital investment into the sector? A rapidly growing number of investors continue to recognize real estate as an attractive component of their portfolios. Institutional investors have been allocating a bigger percentage of their portfolio to commercial-quality real estate over the years, seeing the benefits of diversification, potential for lower volatility compared with the stock market, and generally low correlation to the broader market. We believe individual investors are now making the same realizations and seeking real estate opportunities to add to their portfolios. What are the benefits of investing in private real estate and what should investors look into? There are several benefits of investing in private real estate. One, it’s a large investable universe. Real estate is the third largest asset class, with private real estate making up 90% of the total real estate market in the US. There are various potential benefits to investing in private real estate, such as strong income to an investor’s overall portfolio – a significant portion of total return is in the form of current income. It can also provide strong portfolio diversification. Adding private real estate to a model portfolio has been shown to enhance returns with potentially lower volatility and it can also be a strong hedge against inflation. How would you define Clarion’s investment research and how does it differ from others? Every investment decision starts with our investment research team. The research team has played an integral role in our success over the past 40 years, and in fact, started tracking the e-commerce impact on the industrial sector many years ago, which led us to overweight industrial years before many of our competitors. We utilize both top-down research (tracking macroeconomic trends) and bottom-up research (running proprietary forecast models for each of our investments). Starting at a macro level, we are constantly tracking high-level trends and predicting where and how people want to live, work and play. We’re then making our real estate investment decisions based on these trends. On a more micro level, our research team runs proprietary rent growth forecasting for each of the investments that we consider, based on factors including supply/demand projections, population growth, job wage growth, and many other factors.
Past performance is no guarantee of future results. All investments involve risks, including possible loss of principal. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. Prospective investors should consult a financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. It does not constitute legal or tax advice. Views expressed are those of the author stated and do not necessarily reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. Risks of investing in real estate securities are similar to those associated with direct investments in real estate, including falling property values due to increasing vacancies or declining rents resulting from economic, legal, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest rate changes and market recessions. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Franklin Templeton nor any of its investment managers guarantees any rate of return or the return of capital invested. Note: Opportunity Zones are an economic development tool that allows people to invest in distressed areas in the US. Summit LLC, May 2021.Most recent data available. Securities Industry and Financial Markets Association, Urban Land Institute, NAREIT, NCREIF and Clarion Partners Investment Research. Annual data and estimates are as of December 31, 2021. ©2022 Franklin Distributors, LLC, member FINRA, SIPC. Franklin Distributors, LLC and Clarion Partners, LLC are Franklin Templeton affiliated companies. All rights reserved.
2
Governance has always been a predominant feature in the private credit space. Environmental and social aspects, not so much.
Scrutinizing ESG factors has become the new norm in investing, but while certain areas such as equities are well advanced in their journey, others – such as private debt – are still finding their feet. According to a whitepaper from Arcmont and KKS Advisors published in December 2021, 41% of investors in developed market equities had ‘high ESG integration’ while 47% had ‘partial’. This is in contrast to the private debt market, of which 17% of investors had high integration and 50% had partial. But in terms of the latter, the numbers grew at ‘speed and scale’, according to Talia Elsener, ESG portfolio manager at Arcmont. ‘Those who do not already integrate ESG factors into their investment process are scrambling to implement required policies and procedures to avoid being left behind,’ she told Citywire Engage. But that is not to say there aren’t significant hurdles to circumvent if the market is to evolve past the infancy stage. These include moving past a focus on exclusions and obtaining better, more consistent data. Focusing on exclusion While public markets have evolved their ESG policies to adhere to ‘do good’ rather than ‘do no harm’, private debt is still primarily in the latter camp. This is in part due to the different relationships they hold with companies. Investors in public equities are shareholders, meaning they have rights to attend and vote at general meetings and points of engagement. But for private debt managers, they are lenders. This means not doing a deal is the main way to act on ESG matters. Around 90% of participants surveyed for a European Leveraged Finance Association report have passed at least once on a deal due to ESG reasons, and more than 15% of respondents took this decision at least 20 times. ‘For debt investments, the upside is capped,’ explained Elsener. ‘Therefore, the primary objective of ESG integration for lenders is to identify and mitigate potentially material ESG risks that may impact a borrower’s financial performance and their ability to meet their financial obligations. ‘This generally means debt managers tend to prioritise ESG issues that might be drivers of risk as opposed to sources of opportunity.’
Structuring deals But there are some natural ways for private debt managers to evolve. These include structuring deals to create sustainability-linked debt instruments. Colin Greene, head of private debt at UBP, flagged that one of the primary considerations in a private debt deal is the ‘use of proceeds’. ‘In private debt transactions there is a clear link between the lender’s decision to lend and the purpose to which the borrowed funds are applied,’ he said. ‘By controlling the “use of proceeds”, private debt providers can direct the financing they provide to be applied for specific purposes, including meeting their ESG criteria.’ Another tool at the manager’s disposal that is gaining popularity is the use of KPIs to determine the discount or premium on interest rates. Laure Villepelet, head of ESG at Tikehau Capital, said her firm negotiated more than 30 deals with ESG ratchets from this method. A deal can include negotiations for three to five annual ESG targets, which, if hit, means borrowers can get a reduction in interest rate from -5 to -25 basis points. Villepelet added that they ‘would like the mechanism to allow for a margin increase should targets not be met.’ For Tikehau Capital, this allows investors to be seen as a ‘sparring partner’ for company management to ‘accelerate their sustainability roadmaps’. Elsener agreed that ESG KPIs are powerful and that she expected them to be common practice in a few years. ‘Linking the achievement of defined, material, ESG-related targets to interest rate reductions is beneficial to all parties: borrowers reduce their cost of capital, lenders lower their risk exposure, and sponsors can secure value creation from improved performance,’ she said. But not all investors are convinced by the use of KPIs. Even in the best of cases, there is no market consensus on what is the best KPI selection and margin ratchet mechanisms. Data challenge No matter how the firms choose to integrate ESG into their investment process, all agree that data is the primary challenge. ‘As opposed to public markets – where companies are required to produce certain ESG disclosures and data – the opaque nature of private markets and lack of publicly available ESG data means private market investors must conduct their own bottom-up fundamental analysis on prospective investments,’ said Elsener. She suggested that private debt managers can learn from their public peers and strive to agree on key metrics. ‘If everyone is asking for the same set of data using a consistent methodology, data generation and quality will significantly improve.’
CONTENTS
Chapter 1: The new new office
Chapter 2: Return of the hedge fund
Chapter 3: Private credit's ESG scramble
Chapter 4: The next big thing in private equity
All investments involve risk, including possible loss of principal. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. This article was provided by Franklin Templeton. This material is intended to be for general interest only and should not be construed as general investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. © 2022 Franklin Distributors, LLC. Member FINRA/SIPC. Franklin Distributors, LLC and K2 Advisors are Franklin Templeton affiliated companies. All rights reserved.
The unlikelihood of a return to high growth following the current inflationary environment makes hedge funds a solid alpha strategy.
The vast injection of central bank liquidity that began in 2008 and culminated in the Covid-19 rescue packages of 2020 had the effect of boosting markets across the spectrum. However, Lilly Knight, Co-Head of Investment Management at K2 Advisors, believes that the sea change in market conditions this year is likely to see alpha-based hedge fund strategies outperform once again. ‘The side effect of the interventions has been an artificial inflating of the market, but the stimulus has now come to an abrupt stop. We are back to relying on fundamentals and that’s why we’re excited about the prospects for hedge funds going forward.’ ‘The next three to six months will likely see macro factors continuing to drive markets as they process data on inflation and interest rate changes. But after that, with excess capital leaving the markets, companies – in fact, all asset classes – should fall back to much more diverse valuations. Odds are increasing that we’re going to see a recession, and we don’t see the Fed stepping in. So even after we emerge from a possible recession, we’re not going back to such high growth rates.’ These types of scenarios have, historically, been those in which hedge funds can excel, Knight said, because they have been able to capitalize on dispersion in markets. ‘In the coming environment, we believe equity beta will no longer be the best thing to hold. Hedge fund alpha can be an important part of investor portfolios because hedge funds typically try to capture small sources of alpha across a variety of strategies.’ This year’s unsettled markets have already been good for most hedge fund strategies relative to equity markets. ‘Hedge funds were mostly weak in the first quarter, during the first leg of the real selloff. Often hedge funds do participate on the downside during the first phase of a selloff, because there’s an overall purge in risk assets. But after that, managers quickly reduced their exposures and risk profiles, and many have done a stellar job through the second quarter,’ Knight said. ‘Looking at the first half of the year, hedge funds have proven to be defensive, just as they were in 2008. They have protected capital on the downside and that’s what we always say hedge funds will do. It’s their nature: by design they have short positions that should go up when markets are down, and they also manage their exposure to markets. As a result, they have an innate downside risk mitigation characteristic, which may well be of interest to investors who are finding their bond holdings are not offering the protection they have done in previous downturns.’ On the long side, key areas for managers to reap gains have been opportunities in commodities, while some global macro managers have benefited from energy exposures. Looking forward, in such an unsettled environment, manager selection is going to be the key to risk mitigation and generating returns, Knight stressed. ‘For the next few years, you really need to know how managers make their returns: who can add alpha rather than just relying on a beta trade? At the moment, there are so many potential dislocations. Early returners to the crypto market could make good gains, but it’s about knowing who has the skill to do that. 'There may well be more opportunities in distressed credit if a recession takes hold. But who has the skill and the gameplan to take advantage of that? And similarly, it’s about knowing who can really manage risk because the volatility is so high across the board,’ she said. In these risky markets, investors need to focus on making sure portfolios are properly diversified. ‘Concentration in a period of volatility is certainly a source of risk. Of course, investors should still hold equities and bonds, but being driven by pure beta exposures will no longer be enough. People will need differentiated return streams, which could include private equity, private credit, and hedge funds.’ But it’s often hard to invest in a single hedge fund because of high entry levels and the complexity of these strategies, she said. ‘We believe it’s better to create a portfolio that’s diversified across a few of the strategies that can take advantage of all the opportunities which are likely to arise across global markets.’ For those who require more liquidity, K2 has multi-manager investments in more liquid vehicle types -- diversified across both managers and strategies.
Popular market to find solace in emerging secular trends.
2021 marked a record year for private equity (PE) with investment activity surpassing the trillion-dollar mark for the first time. More than 24,500 deals were closed – an aggregate deal value of $1.04tn, which is nearly double the amount from the year before, according to latest S&P data. Despite capital markets going through a major convulsion in 2020, assets under management (AUM) only slipped slightly, falling to $4.4tn from its peak of $4.5tn in 2019. Right now, PE accounts for a relatively small percentage of total global market capitalisation (6.6%). If this percentage remained the same and the market cap grew at a constant rate, AUM would stand at a robust $12.8tn by 2030. So, one has to ask, what trends will shape the next decade of PE? ‘We foresee the democratization of PE as an asset class to enable retail investment flow into a product that has almost always exclusively been available to institutions and family offices,’ said Ben Meng, EVP and head of Franklin Templeton Global Private Equity. ‘Regulation is changing rapidly, and this will give retail investors more access, which we believe will drive diversification in asset allocations. As more and more companies stay private for longer, it is critical for retail investors to have access to these massive wealth-creation opportunities.’ Currently, only 2-3% of private client assets in Europe are invested in PE, according to the latest research by McKinsey. This isn’t driven by a lack of demand but because the supply of retail products has remained limited. The European Asset Management Regulation has largely confined retail investors to strategies that offer more immediate liquidity. Beyond regulatory constraints, retail offerings from PE houses have remained few and far between. Main burdens include prohibitive minimum investment amounts and a lack of transparency as private equity investors get limited information about companies and receive infrequent valuations.
In line with broadened access to PE, some market participants predict a ‘great rotation’. This would involve significant growth in illiquid investments with new models addressing risk/return and liquidity/fees gaps, and could result in the launch of ‘PE Lite’ products which include lower costs, aspects of liquidity and lower active management than traditional PE firms. ‘The old way of thinking – split by equities, fixed income, cash and a small percentage of alternatives – is going to move to a liquids-versus-illiquids concept, with investors splitting equity and credit across these two buckets. We can follow this by looking at the Swedish AP1-6 pension funds,’ said Adam Turtle, co-founder of independent PE fundraising advisory Rede Partners. ‘Up to the end of 2018, AP funds had a 5% cap on PE, which not only limited their investment options but also made them susceptible to any swings in the market. There was a lot of debate within the country about lifting this cap, with the government ultimately deciding not only to lift it but to restructure how they thought about alternatives more broadly. As a result, a new 40% cap on illiquids as a whole was implemented. Not only does this mean that there is a huge potential growth for PE, but it also opens AP funds to a broader set of asset classes to invest in, such as private credit and infrastructure.’ Emerging markets might also want to take a bite at the cherry as local pension funds mature, including rapid growth spurts of AUM over the last 20 years. This means new buckets of capital being made available online that currently aren’t allocated to PE. So, which sectors are expected to be the golden ticket when it comes to reaping the biggest future returns – European football, music royalties or digital transformation? ‘Given the massive push to decarbonize and meet NetZero goals, the energy transition sector, specifically, energy storage and grid optimization technologies, present very compelling investment opportunities while also making a positive impact on the environment,’ said Meng. ‘Similarly, other areas within climate investing such as agricultural tech also present opportunities to ‘do well while doing good’ for investors.’ But beyond specific themes, the traditional incentives of any deal remain crucial, according to Haig Bathgate, head of investment at Atomos. ‘It’s all down to liquidity: the best time for PE to perform is in a benign interest rate environment. When, like now, interest rates are rising, the market starts to dry up as PE relies on an abundance of liquidity to provide hefty levels of gearing. As rates rise, so do borrowing costs for PE firms, which pushes up the required rate of return they need from any investment and consequently reduces the valuation,’ said Bathgate. ‘With PE the timing of purchases is crucial. Counterintuitively, when the PE firms struggle for funding because of a rising rate environment, that’s often the best time to invest in this sector as the valuations that they pay for companies is less.’
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