Alternatives Research | The Alternatives Landscape Fall 2020
The Alternatives Landscape provides a broad overview of the current environment for the primary alternative asset classes: hedge funds, private equity, private credit, real assets, and real estate.
The first half of 2020 was marked by a return of volatility to the
global capital markets as the fallout from the COVID-19 pandemic rippled across the globe. Global equity markets experienced the fastest sell-off since the Great Depression and credit spreads widened significantly during the first quarter, but aggressive central bank policy, coupled with optimism that economic indicators had bottomed, fostered a market rally during the second quarter.
Diversifying asset classes, such as alternatives, posted negative results during the first half of the year. Hedge funds protected capital, while commodities and commodity-related investments were significantly negative through June 30. Illiquid strategies, including private equity and private real estate, generated favorable results on an absolute basis and outpaced more liquid peers for the one-year ending March 31, 2020.
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HEDGE FUND UPDATE
The broad hedge fund universe, as measured by the HFRI Fund Weighted Composite Index, declined by 3.4% during the first half of 2020. At the strategy level, all four of the core hedge fund strategies protected capital relative to the broad equity market during the COVID-19 related market volatility.
The best performing strategy this year has been macro. This strategy has historically experienced low correlations to both equity and fixed income markets and provides strong diversification during equity and credit market dislocations. The strong performance was driven primarily by discretionary trading strategies where managers construct long and short positions in equities, credit, commodities, and currencies based on macro or thematic views. These strategies benefited from a spike in volatility across various asset classes this year.
While event driven was one of the worst performing strategies, there was significant dispersion between the various strategy types. During the first half of the year, many of the distressed and credit oriented managers took advantage of widening credit spreads by purchasing investment grade and high yield debt. The managers benefited from the Fed’s accommodative response to the crisis, as it announced the purchase of high quality credit and credit spreads subsequently tightened. The distressed credit opportunity set is expected to increase going forward given elevated leveraged loan and high yield downgrade volume.
Total hedge fund assets under management declined by approximately $147 billion during the first half of the year, as total assets were just under $3.2 trillion. The industry has continued to experience modest net outflows since 2018 of which there were a total of $46 billion in the first half of 2020. Overall, the aggregate number of hedge funds has declined since 2014, which is a trend that continued in 2020. According to HFR, the number of funds in the industry peaked at the end of 2014 and has declined by approximately 10% (cumulative) since. This trend is more pronounced in the hedge fund of funds industry, which has declined by over 50% since 2007, but is also evident in the direct hedge fund space, which has declined by approximately 6% since 2015.
PRIVATE EQUITY UPDATE
After generating solid returns in 2019, private equity markets experienced a more benign decline in performance during the first quarter of 2020 as compared to public market counterparts. This short-term relative outperformance contributed to the now meaningful outperformance for U.S. buyout, U.S. growth equity, and U.S. venture over the past three and five years. Generally speaking, given the illiquidity of its assets, private equity did not see panicked selling that drove declines in some pockets of the public markets. Prior to releasing March 31 valuations, private equity fund managers were able to process information through late April and early May, at which time public equity markets had begun their recovery.
As most of the U.S. went into lockdown in late March, private equity activity slowed considerably and, in some sectors, nearly came to a standstill. Ellwood’s Private Equity Manger Research Team spent the majority of April and May discussing the portfolios of various general partners and gained key insights on defensive measures taken by managers. First and foremost, GPs worked with company management to ensure the health and safety of employees. After this, the focus turned to ensuring the health and safety of balance sheets. To that end, common defensive balance sheet measures included drawing on outstanding revolvers to improve companies’ cash positions, reductions (or eliminations) of short-term marketing/advertising spend, and postponing technology/system upgrades. In many instances, this began early in 2020 as the global supply chain was already experiencing the effects of shutdowns in China.
By July and August, despite virus cases being on the rise in the U.S., private equity investment managers had already begun working with management to pivot to more offensive measures. Add-on acquisitions came through as a key value-add measure, potentially even more so than during a normal market cycle. Many small businesses that were disproportionately impacted by partial shut-downs were more open to an infusion of capital to improve their financial standing. The next steps remain uncertain in many areas of the capital markets, but the outlook for private equity assets in the coming years is at least more positive today than it was just six months ago.
PRIVATE CREDIT UPDATE
After a strong, if uneventful 2019, credit markets have been anything but dull in 2020. Performance through the first half of the year captured a significant widening of credit spreads following the COVID-19 outbreak in March, and by the subsequent rebound and spread tightening through the second quarter. By the end of June, credit indices had largely recovered from the first quarter drawdown as illiquid markets outperformed more liquid peers on both shorter and longer-term trailing periods.
While the narrative across private credit markets in recent years has been centered on record fundraising levels and elevated debt issuance as investors searched for higher-yielding assets, the story in 2020 has shifted to a mix of opportunistic fervor to take advantage of current dislocations and anticipation of the pending distressed cycle. The COVID-19 pandemic and ensuing recession has left vast swaths of the global economy reeling as entire industries have all but shut down. The combination of evaporating revenues and bloated corporate debt levels has cast a melancholy outlook for a large number of companies. Through the first half of 2020, the number of companies in the Russell 3000 Index with an interest coverage ratio (EBITDA/interest expense of outstanding debt) of less than one, reached an all-time high of almost 600 companies which represents just under 20% of total index constituents. Further, the number of corporate issuers with debt trading at distressed prices – defined as a spread greater than 1,000 basis points versus comparable treasuries – reached a level not seen since 2009. While the number has since subsided, it remains elevated and skepticism persists as to whether underlying fundamentals have actually improved.
After years of robust activity within private lending markets, issuance slowed to a trickle in 2020, as lenders took pause to evaluate the longer-term health of the economy. Middle-market issuance during the second quarter dropped to the lowest level since 2009, by both volume and count. A strong first quarter helped soften the blow to overall 2020 issuance through June.
Unsurprisingly, in the second quarter yields ticked higher across debt markets. While direct lending has historically offered more attractive yields relative to more liquid credits, a spike in broadly syndicated yields challenged the relative value of direct lending. However, this trend is not expected to persist.
REAL ASSETS UPDATE
Real assets were heavily impacted by the economic slowdown caused by COVID-19; returns within the real assets subsectors were largely negative. Lockdowns caused supply-and-demand shocks felt across the asset class. Decreased oil demand hit the upstream energy sector particularly hard, while real estate investment trusts (REITs) experienced a relatively smaller drawdown in the first half of the year. Cash flow within REITs (measured by funds from operations) fell sharply in the second quarter. Lodging and resorts were most negatively impacted from a cash flow perspective, while infrastructure and data center REITs saw a large increase in cash flow. In an effort to preserve balance sheets, many REITs cut second quarter dividends.
While the pandemic affected the natural resources sector, energy companies were most impacted. Oil prices fell and briefly turned negative for the first time in history. Low oil prices put tremendous pressure on U.S. oil producers, as the domestic cost of production is higher when compared to OPEC member countries. Natural resources bounced back materially in the second quarter, but remain negative for the year.
Midstream master limited partnerships (MLPs) have had a volatile six months and returned –57% in the first quarter and then +50% in the second quarter. An abrupt drop in consumption and production of liquid fuels impacted MLPs. Improving supply and demand fundamentals and a reduction in capital expenditures helped to improve investor sentiment as the year progressed.
Infrastructure has been impacted by the steep decline in travel. Airports are facing a challenging environment as domestic air travel dropped by over 80% compared to June of last year. Utilities faired far better thanks to their inelastic demand characteristics.
Commodities returned -19.4% as all commodity subsectors, apart from precious metals, posted negative returns. COVID-19 caused many plants that process commodities to close, such as lean hogs and cotton, which decreased by 52% and 12%, respectively. Gold has risen over 39% since the end of 2018. The economic climate caused by COVID-19, coupled with inflation fears and Federal Reserve policy all contributed to investors’ increased appetite for gold, which tends to be a safe haven for investors during times of economic uncertainty.
REAL ESTATE UPDATE
The COVID-19 pandemic and associated economic recession have dramatically changed outcomes for commercial real estate.
As demonstrated in the top chart, income returns have held up during the first six months of 2020, while appreciation turned negative, especially in the second quarter. This led to the slightly negative -0.3% return for the NCREIF Property index.
Total returns for real estate sectors have varied significantly through the first half of 2020. As was the case in recent years, industrial properties held up best year-to-date with a 3.6% return. Conversely, the retail (-5.8%) and hotel (-19.7%) sectors have suffered the most as many parts of the nation remain under safer at home regulations. Both the office sector and the apartment sector produced slightly positive returns year-to-date with income outpacing negative appreciation. Many investors are expressing concerns about the future needs of office space as tenants seem to be functioning well working from home.
As displayed in the third chart, cap rates have continued to decline, indicating that core real estate’s valuations are elevated. Conversely, the Federal Reserve has driven down yields in order to mitigate the effects of the recession. This has kept real estate valuations reasonable relative to 10-Year Treasury yields.
The final chart illustrates the dramatic drop in net operating income (NOI) growth for real estate. The primary drivers in the declines are from the almost complete loss of hotel income and the considerable decrease in retail activity, which was already well underway with the move towards online retail.
So far in 2020, real estate values, outside of hotels and to a lesser extent retail, have held up. Lease income for office, industrial and high-end apartments are near normal. Further decreases in valuations are intimately tied to an economic recovery which is dependent on advancement towards a vaccination and medical treatments for COVID-19.
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Indexes referenced on page two, chart one: 2020 and Trailing Three Year Performance as of June 30, 2020. HFRI Fund Weighted Composite Index; HFRI Equity Hedge (Total) Index; HFRI Event-Driven (Total) Index; HFRI ED: Distressed/Restructuring Index; HFRI ED: Merger Arbitrage Index; HFRI Macro (Total) Index; HFRI Relative Value (Total) Index; HFRI Fund of Funds Composite Index.
Indexes referenced on page three, chart one: Market Performance: Cambridge Associates U.S. Buyout Index; Cambridge Associates U.S. Growth Equity Index; Cambridge Associates U.S. Venture Capital Index; Russell 3000® Index.
Indexes referenced on page five, chart one: Major Real Assets Strategy Returns. REITS, MLPs Natural Resources Stocks, Commodities and TIPS are represented by FTSE Nareit All REITs TR, Alerian MLP TR USD, S&P Global Natural Resources TR USD, Bloomberg Commodity TR USD and ICE BofA Merril Lynch 1-5 Year US Inflation-Linked Treasury Index, respectively.
Indexes referenced on page five, chart two: Commodity Sector Returns. Industrial Metals are represented by the Bloomberg Industrial Metals Subindex; Precious Metals are represented by the Bloomberg Precious Metals Subindex; Energy is represented by the Bloomberg Energy Subindex; and Agriculture is represented by the Bloomberg Agriculture Subindex.
Published October 2, 2020