Alternatives Research | The Alternatives Landscape Spring 2021
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.
2020 was a year like no other. After a significant downdraft in risk asset class returns during the first quarter, the markets recovered and finished with strong results following the U.S. presidential election and the approval of two vaccines for COVID-19 in November. Public markets ended with strong returns for the year in global stocks and bonds, while alternative asset class results were mixed.
Returns for alternative asset classes were mostly positive, though varied significantly during 2020. When looking at returns over the trailing twelve months, lower volatility asset classes such as buyout, private credit and real estate produced single-digit returns while growth equity, venture capital, hedge funds, and commodities (with the exception of energy), produced strong double digit returns. Negative returns were found in infrastructure-related areas such as energy, MLPs and REITs.
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HEDGE FUND UPDATE
The broad hedge fund universe, as measured by the HFRI Fund Weighted Composite Index, generated an 11.8% return during 2020. At the strategy level, all four core hedge fund strategies produced positive returns, but the equity long/short strategy performance significantly outpaced the rest of the industry.
The equity long/short strategy performed well in the wake of strong global equity market returns and heightened volatility. While the strategy protected capital during the COVID-19 related drawdown earlier in the year, it continued to generate alpha as markets trended higher in the final three quarters. All of the underlying equity long/short strategies were positive except for market neutral funds, which generally have minimal net market exposure. The two largest underlying strategies within the HFRI Equity Hedge Index include the HFRI Fundamental Growth and Fundamental Value indices; both strategies generated double digit returns. As expected, growth-oriented managers and sectors outperformed their value counterparts given the strong performance of growth stocks throughout the year. Technology related industry exposure remained high as it comprised approximately 45% the top 50 hedge funds’ portfolios at year end1.
The event driven strategy performed well given the expanded opportunity set within distressed credit and new equity issuance. Many of the distressed and credit oriented managers opportunistically purchased high yield and investment grade credit given widening credit spreads at the end of the first quarter. These positions performed well as spreads tightened throughout the year. Managers took advantage of the elevated level of SPAC issuance and subsequent appreciation following the announcement of an initial investment in the SPAC trust.
Total hedge fund assets under management grew by approximately $423 billion during the second half of the year, as total assets were just under $3.6 trillion. The significant growth was driven by two factors with the most prevalent being strong performance. While the industry experienced net outflows for the year, it also experienced its first two consecutive quarters of positive net cash flows in over two years during the second half of the year as institutional investors began increasing allocations. Overall, the aggregate number of hedge fund managers has declined over the past six years, but this trend moderated in the second half of the year.
PRIVATE EQUITY UPDATE
After generating solid returns in 2019, private equity markets generated negative returns in the first quarter of 2020 before rebounding nicely in the second and third quarters (though third quarter data is still preliminary). Major private equity indexes continue to outperform public equity indexes over recent time periods, as shown in the first chart, due in part to protecting capital during negative returning quarters as compared to public markets.
The second quarter of 2020 experienced the lowest quarterly tally of deal activity since the third quarter of 2013; however, activity normalized in the third quarter and then set a new quarterly record in the fourth, per PitchBook estimates. On the valuation front, private equity transaction multiples remain elevated, as shown in the labeled U.S. Private Equity: Median Buyout EV/EBITDA Multiples. We believe that heightened valuations persisted due to the high quality of deal flow; companies that were bought and sold in the second half of the year generally weathered pandemic challenges well and emerged just as strong, if not stronger, later in the year. Conversely, in most cases, companies that had operating, liquidity, or debt servicing challenges did not transact at all, or in rare cases were turned over to creditors.
While year-end returns in venture capital are still being finalized, exit activity was incredibly strong to end the year. Per PitchBook estimates, U.S. venture capital generated approximately $105 billion and $138 billion in exit value in the third and fourth quarters of 2020, respectively, after generating only $46 billion over the first six months of the year. As it stands today, it looks as if 2020 will set a new annual record for venture capital exit value, surpassing the previous peak set only one year prior. We believe two factors drove this robust activity. First, software is the largest sector within venture capital, and in looking back at 2020, we saw a proliferation in demand for best in class software packages and technologies. As the global workforce shifted to a remote environment, having powerful software tools was critical to the success of businesses and software companies undoubtedly benefitted from that. Second, the routes to exits have changed; direct listings and SPAC exits have joined traditional acquisitions and IPOs as feasible exit routes, giving boards and investors even more options to choose a path that is best suited to set a company up for a strong exit regardless of the economic environment.
PRIVATE CREDIT UPDATE
Following a volatile start to 2020, credit markets experienced a sustained rebound through the second half of the year. As of the end of the fourth quarter, illiquid markets continued to outperform more liquid peers over longer-term trailing periods.
Middle market lending activity in the second quarter slowed to levels not seen since 2009. The third quarter displayed material improvement in credit issuance, followed by significantly more robust activity in the fourth quarter, with direct lenders issuing their second highest quarterly total on record2. However, despite ending the year on a high note, 2020 annual middle market issuance was down 25% versus 2019 and represented the lowest annual volume in the past decade3. Direct lending experienced the smallest decline in volume, down 18% from 2019, while broadly syndicated issuance experienced the largest decline, with volumes down 35%3.
After widening materially in the second quarter, spreads tightened across credit segments during the second half of 2020, most significantly in broadly syndicated loans. Consequently, direct lending has reassumed its historical advantage versus more liquid credits, from a relative value perspective. Across all middle market loans, all three yield components – Libor floors, Libor spreads, and OIDs (original issue discount) – tightened and contributed to lower yields3.
Unsurprisingly, the economic fallout from the pandemic sowed distress across corporate credit markets. However, after spiking in March to the highest totals since 2009, the number of corporate issuers and corporate bonds trading at distressed pricing (spread to treasuries >1,000 basis points) both receded to pre-pandemic levels. It seems that much of the credit risk investors had been pricing into corporate credit markets early in the pandemic has abated.
According to data from Pitchbook, annual fundraising for private debt funds in 2020 totaled $110 billion, down from $152 billion in 2019, and the lowest level raised since 2015. From a strategy perspective, venture debt and direct lending both experienced significant declines in the amount of capital raised, while special situations, infrastructure, and real estate strategies saw their fundraising increase from 20194.
REAL ASSETS UPDATE
The economic slowdown caused by COVID-19 heavily affected real assets. During 2020, supply and demand shocks impacted real asset prices as global economies shut down, but ongoing fiscal and monetary support, low interest rates, and the vaccine rollout shifted perspectives later in the year. While all real assets subsectors rebounded during the second half of 2020, each ended the year with negative returns aside from natural resource stocks.
Global commodity markets ended 2020 on a strong note with recovering demand buoying prices, though not enough to offset losses from earlier in the year. The impact of inflationary pressures and an expanding money supply put upside pressure on many commodities during the fourth quarter. The declining dollar created a bullish landscape for raw materials. Energy gained 16% as crude oil prices were over 20% higher for the quarter. Investments in gold continued to set new records as prices posted their best annual return in ten years, gaining 25% in 2020.
Renewables and digitization in infrastructure took hold while transportation lagged. In 2020, infrastructure deal flow rose above 2019 levels, and there was a clear preference for infrastructure with contracted revenues as opposed to more economically sensitive opportunities. Renewable energy accounted for over 50% of total transactions, remaining the most active sector for investment activity. Meanwhile, transportation experienced challenges. Activity is recovering for toll roads, but airport recovery is disparate with regional airports managing better than international airports.
Real estate investment trusts (REITs) declined the least during the first half of 2020, but failed to keep pace with the other subsectors during the rebound in the second half of 2020. Although most REIT sector returns were negative in 2020, those with the largest declines earlier in the year posted impressive gains during the fourth quarter.
Midstream master limited partnerships (MLPs) had a volatile year as energy sector conditions continued to change. During the first three quarters of the year, low oil prices, slowing production, and election uncertainty negatively impacted MLPs. However, the vaccine announcement, coupled with growing optimism surrounding a reopening economy, helped to improve investor sentiment as the year progressed.
REAL ESTATE UPDATE
The disruption caused by the COVID-19 pandemic and associated economic recession is impacting commercial real estate in ways that are continually evolving. The recovery has been uneven and has diverged meaningfully across property types and regions.
As demonstrated in the first chart, income returns held up during the year, only slightly trailing longer-term averages, while appreciation was negatively impacted, and detracted from returns. In aggregate, the income returns were able to outweigh the negative appreciation return, and the NCREIF Property Index climbed a modest 1.6% in 2020.
A total return disparity remains across real estate sectors in the aftermath of the pandemic, with industrial properties continuing to pace returns while retail and hotel properties struggle to regain momentum. Industrials generated strong income and appreciation during the year and returned 11.8%. Conversely, the retail (-7.5%) and hotel (-25.6%) sectors suffered the most in light of national and local lockdowns. Both the office sector and the apartment sector produced slightly positive returns with income outpacing negative appreciation.
As displayed in the chart below, while cap rates have continued to decline—which indicates core real estate’s valuations may be elevated—the corresponding decline in Treasury yields has kept real estate valuations relatively reasonable when compared to the 10-Year Treasury yield. The Federal Reserve has affirmed the intent to keep interest rates low for the foreseeable future to assist in the economic recovery, marking a positive development for commercial real estate.
The last chart illustrates the dramatic drop in net operating income (NOI) growth for real estate. The primary drivers in the declines are the result of 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.
COVID-19 radically affected the commercial real estate industry and has accelerated longer-term trends that were already present. Real estate values, outside of hotels and to a lesser extent retail, have held up. Returns going forward will be a byproduct of the extent of the economic recovery as well the continued momentum within the industrial and apartment sectors.
1. JPMorgan Q1 2021 Guide to Alternatives
2. Middle Market Weekly, February 12, 2021. Refinitiv LPC
3. Middle Market Weekly, December 18, 2020. Refinitiv LPC
4. Pitchbook, Inc.
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Indexes referenced on page two, chart one: Indexes referenced on page two, chart one: YTD 2020 and Trailing Three Year Performance as of December 31, 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 as of June 30, 2020: PitchBook Data, Inc. Equal-Weighted Global Buyout Horizon IRRs; PitchBook Data, Inc. Equal-Weighted Global Growth/Expansion Horizon IRRs; PitchBook Data, Inc. Equal-Weighted Global Venture Capital Horizon IRRs; 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 April 1, 2021