Alternatives: Linked but distinct

Investors often hold a sense of mysticism about alternative asset classes, or “alternatives," that can make them seem complicated and inaccessible. We believe an interpretation of how each alternative asset class may respond to macroeconomic dynamics can improve understanding of how they may contribute to investment portfolios.

Alternatives, just like traditional asset classes, are impacted to varying degrees by macroeconomic factors, such as levels of economic growth, changes in interest rates, and the ability of companies to refinance or go public. Each alternative asset class tends to respond in its own unique way to these factors, which underpins the diversification potential that they may provide to investment portfolios.

Importantly, given the long-term, strategic nature of investments in alternative asset classes—particularly private equity—we believe manager selection is a greater determinant of an alternatives portfolio’s return than macro factors.

Key macro impacts on alternatives: Risks and opportunities

Private real estate

The long-lived and “real” asset nature of private real estate exposes this asset class to macroeconomic factors such as changes in interest rates and persistent inflation, as well as secular shifts such as population migrations and changes in consumer habits. However, the power of execution at the fund and asset level may lead to very different outcomes across investors and their managers.

For example, in 2020, the 10-year U.S. Treasury yield fell below 1%, creating a scramble for yield by investors. Many investors sought yield in real estate, which led to a subsequent flood of dollars that pushed down capitalization rates, or the yields available in real estate. Fast forward to the Federal Reserve’s rate-hiking cycle and suddenly that long-lived, fixed asset building that was bought at a 3% capitalization rate wasn’t as attractive as the 5% yield available in short-term Treasuries. The result was a major re-pricing of real estate assets.

These macro factors also create opportunities for private real estate. For example, investors can provide real estate debt financing as many traditional bank lenders have stepped back and real estate owners need to refinance. We believe there are also opportunities for investors to find yield with correlation to inflation via U.S. row crop farmland; in industrial warehouses to capture the benefit of the rise in online commerce; or in multi-family housing that has benefited from delayed home purchases in the wake of the steep rise in mortgage rates.

The key, however, lies in manager selection—finding managers that are disciplined, valuation-focused, yet flexible enough to capitalize on dislocations within their circle of competence.

Private equity and credit

Much like public equity markets, private equity and credit are exposed to macro factors such as changes in interest rates, access to capital markets, and overall economic growth. These variables can affect private equity valuations, the viability of companies, rapidity of exits, fund holdings, and potential returns. Periods of high market volatility also play a part in the opportunity set for private equity strategies, often increasing the attractiveness of the asset class in part due to the behavioral tendencies of market participants to pull away during volatile periods.

Private equity can also provide exposure to themes that are popular in public markets such as artificial intelligence (AI), biotech, and space exploration and satellites.

A key distinction with private equity is that commitments to managers are typically made with a blank slate. That is, the investor will know the manager’s strategy and the type of companies it targets—for example, early-stage tech, buyout and control of industrial companies, or others—but they won’t know the specific companies the manager will own. Investors learn this information as the manager calls capital and executes purchases. This aspect, along with the long and illiquid life of private equity funds, all but makes it impossible to “tactically” trade private equity allocations over shorter timeframes. Thus, we believe, allocating to private equity requires a steady, consistent commitment to a diverse set of managers and strategies to extract the potentially higher capital appreciation we seek from the allocation.

This sought-after appreciation is driven by unique aspects of private equity, such as being able to execute privately negotiated transactions rather than buying a public company’s stock with a price quote for all to see. Private equity managers may also invest in companies earlier in their lives to possibly capture more of their economic value. Given the continued growth of capital available for private market investments, many companies now forego IPOs and stay private for longer, and possibly permanently, which we believe creates further opportunities for private capital.

Exhibit 1: IPO activity has slowed in recent years

Source: Securities and Exchange Commission Small Business Capital Formation Advisory Committee: IPO Market Update. WilmerHale. February 2024.

Today, with higher interest rates and a tepid IPO market, we see opportunities in secondaries—or shares in established private equity funds—as large investors grapple with overallocations to private equity due to the slow pace of realizations. With large private equity investors slowing their new commitments, we also see the opportunity to commit to harder to access managers as they work to reach their fundraising goals. While discounts are available in some private market segments, other areas—such as AI and data-focused companies—have loftier valuations. In this environment, the ability to access top private equity managers is imperative, as we believe discriminating managers may be better stewards of capital.

Moreover, the return differential between top and bottom private equity fund managers can be extreme. As exhibit 2 shows, the annualized return spread between top and bottom quartile managers in venture capital was nearly 80% (-20% vs +60%), while in buyout the spread was 50% (-10% vs 40%) from 1997 through the first quarter of 2024.¹

Exhibit 2: Range of returns—U.S. private equity vs. U.S. large-cap public equity