Correlation in 2022 Prompts Thoughts on How to ‘Lose Less’

Investors rethink allocations as performance volatility arises.

Allocators entered 2023 in unchartered territory. After poor performances in both equity and bond markets last year, and with limited visibility into how many asset classes ultimately ended the year illiquid, evaluating investment performance has been difficult.

Recent reports suggest institutional investors have responded by pulling back on commitments to some illiquid asset classes, including private equity, which last year  posted its first negative return since 2008. According to data from consultancy McKinsey & Co., private equity was down 9% through the end of September 2022. Private equity performance data typically lags by at least one quarter, so the full decline in performance for 2022 may not be known until April or May of this year.

Dan Zwirn, CEO and CIO at New York-based investment firm Arena Investors LP, points out that previous declines in private equity performance—like the downturn that hit the energy sector in 2016—could take as long as two to three years to become fully evident and work their way through investor portfolios.

“There’s a lot of latency in private equity reporting, and it’s not a coincidence,” he says. “There’s an enormous institutional imperative to ignore reality.”

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Investor sources say there are also new concerns about existing allocations to private and commercial real estate. While institutional portfolios rarely make significant changes in overall target allocations, they are widely expected to deploy cash to account for the shift in market conditions. Last week, Nuveen released its annual survey of institutional investors, and the findings showed 72% of investors planning to increase their allocations to alternative assets.

Private credit takes the lead

Among the top choices is private credit, as 47% of respondents told Nuveen they were looking to that part of the alternatives universe to shore up performance. This sentiment was echoed in a recent outlook report from Hamilton Lane suggesting that private credit could be bolstered by rising interest rates, which typically lead to higher yields within private credit, as most of the loans are floating-rate.

Those findings may seem counterintuitive. Typically, private equity fund managers are the biggest users of private credit, which provides leverage for buyout and other private equity transactions. So if private equity is in a slow-down, it should follow that private credit would be too. However, non-sponsor-backed businesses also use private credit and are likely to access it at a higher rate going forward, given how tight liquidity is overall.

Bill Eckmann, head of principal finance for the Americas at Macquarie Capital, says there are some secular trends within private credit that could keep the lending cycle going. Over the past five years, private equity managers and other borrowers have shifted into so-called unitranche lending, which offers similar amounts of financing as the syndicated loan market used to, but within a single structure, so there are fewer counterparties and, arguably, lower risk. Eckmann says demand for this structure has remained despite liquidity tightening elsewhere in the credit market over the past year.

Non-sponsor borrowers are also looking to private credit because the loan terms are more straightforward and the counterparty relationship is clearer.

“We’re seeing more investment-grade borrowers in the private credit market—often for the first time,” Eckmann says. “What we’re hearing is that they like being able to speak to the lending decisionmaker directly and understand why someone is making the decision to invest in the business.”

If this trend holds, it could be a boon for investors in private credit funds, but only if managers are disciplined. Arena’s Zwirn is somewhat skeptical.

“The thing no one wants to say is that private credit is good when it is good and bad when it is bad,” Zwirn says. “Are there going to be opportunities? Absolutely. But you have to trust that the manager you’re working with is going to be able to find the right ones, and in a market with high demand, discipline is not always there. Some of this is going to be intermediate knife-catching, and not everyone has the ability to do that.”

John Delaney, portfolio manager and senior investment consultant at WTW, says it is important to not only look for manager discipline, but also for what kinds of opportunities a manager has the best capabilities to assess.

“I’m not going to say all private credit is good; that’s too broad of a brush,” Delaney says. “But we’re looking more at specialist funds that have very specific expertise or are focused on underserved areas of the market. Often those are going to be more successful at generating excess returns and also managing risk.” Delaney adds that maintaining a quality tilt can keep investors out of areas that are overheated, which is when a lack of investment discipline tends to first show itself.

The gaps in available credit—and the potential for mispricing and other issues—could actually benefit investors that tilt toward quality, according to Jonathan Glidden, the CIO of Delta Air Lines’ corporate pension plan.

“If there’s a dearth of capital, hopefully that means we are getting overpaid for owning loans with good covenants or asset-backed paper,” Glidden said.

Delta pulled back on its commitment budget to private equity last year and is looking to increase its allocation to private credit as part of a long-term derisking of its corporate pension portfolio. The pension fund has been frozen since 2006 and primarily holds bonds, in addition to private asset classes. Glidden says he is not especially tactical but notes there are opportunities for investors that are willing to have strong covenants, rigorous due diligence and take a long-term view. He is positive on asset-backed alternative credit and residential lending.

“Do I wish I didn’t have 2021, 2022 vintages of private equity in the portfolio? I have some concerns,” Glidden admits. “But I don’t think you can take a short-term view of something with a multi-year investment cycle. We’re not going to be tactical in that way, but we do have to find a balance. On the lending side, I think there’s a real risk you could see some zombie banks and supply-and-demand mismatch on the credit side going forward, and that could create some opportunities.”

That’s the same math the Contra Costa County Employees’ Retirement Association seems to be doing with its alternative credit portfolio. According to its 2022 end-of-year performance review, the $9.9 billion pension fund believes “asset‐backed and distressed strategies remain the most interesting in the space.” The report goes on to state that “asset‐backed funds have found attractive yields in off‐the‐run securitized credit markets, while distressed funds benefited from value investing coming back into favor and increasing corporate stress which provides new trading opportunities.”

Arena’s Zwirn agrees that “there’s an enormous opportunity when you look at the mispricings” And adds that Arena has been involved in transactions in a new and underserved part of the lending market arising out of stress in the growth financing world. “It’s in an area where companies are faced with very dilutive down rounds on the fundraising side and so have turned to borrowing—there are very attractive returns there.”

Rethinking diversification

Another byproduct of the year when almost everything was down is that many investors are rethinking their approaches to diversification.

Alain Forclaz, the deputy CIO for multi-asset strategy  at Swiss investment firm Lombard Odier, says that because many investors are looking to shift illiquid positions, it could take a few years before those investments are fully unwound, which is likely to make diversification an ongoing conversation.

“There are other asset classes that you can turn to in the short run,” he says. “Some hedge funds—true long/short hedge funds, for example—did very well last year. There are also trend-following strategies that can be implemented.”

WTW’s Delaney agrees: “Hedge funds can provide diversification at the total portfolio level,” he says. “You shouldn’t go to hedge funds because one manager was up 20 percent last year. But if you understand the role hedge funds play in a portfolio, and it aligns with your goals as an investor, the current environment looks to be positive for hedge fund strategies.”

Multi-asset managers like Forclaz focus on diversification, typically including a wide variety of asset classes in their solutions. If done well, diversification can mitigate some volatility and preserve capital.

“Within multi-asset, I would say the recent ambition has been to lose less, rather than focusing purely on making money,” Forclaz says. “If you look at last year, when everything was down significantly, it was hard to find options that were going to perform well. But through the diversification of the strategy, you can protect assets, because there were still some pockets of the market that did well on a relative basis. Multi-asset takes advantage of some of that.”

Forclaz reports working with investors on thinking about their long-term target allocations: If inflation and interest rates remain elevated, then it may be time to adjust at the target allocation level. “That looks like focusing more on dynamic risk-based allocation and less on static, capital-based asset allocation,” he says.

Brad Young, partner and global co-CIO for private markets at investment consultant Mercer, adds that volatile markets can be a good time to look at total portfolio exposure.

“There are always concerns like concentration risk or overallocation to asset classes,” Young says. “There are a lot of ways you can manage volatility and investment risk, but doing that with a long-term perspective in mind will result in different choices than trying to make that change based on the last six months.”

Looking ahead, Young anticipates institutional investors will stick with their allocations to alternatives and are likely to keep investing in private equity, even if it is at a slower pace over the near term.

“I’ve been in this business since the mid-90s, and the percentage of private markets asset classes in portfolios has only gone up,” Young says. “I have never talked to a CIO of a larger institutional pool of capital who says ‘We’re going to lower our private markets target this year.’ It’s always a question about how we best execute in private markets.”

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