15 Sep 2022
Alternative funds: 2022 so far…
The year may have been an uncertain ride for fund managers, but the emergence of longer-term trends adds some much-needed context.
As legendary baseball manager Casey Stengel advised, “never make predictions, especially about the future”. In a market environment where accurate forecasts seem almost impossible, this seems more apt than ever. With experts suggesting UK inflation might hit an eye-popping 18%, we’re a long way from the Bank of England’s 2% target. As a result, interest rates are also rising rapidly.
The picture is much the same globally, with the only notable exception being China, where the priority remains boosting the economy post-Covid. To explore what this macroeconomic uncertainty means for investors and fund managers, we sat down with Neil Walker, Head of Institutional Banking, London and Ian Harcourt, Head of Institutional Banking, Luxembourg at RBS International.
High inflation and high interest rates
Harcourt says property is an early indicator of the situation. “In the alternative funds sector, the first subsector very closely tied to interest rates is real estate. At least in Europe, that is showing in the performance of funds, as they shift focus to make sure financing of portfolios is appropriate for rising interest rates. It’s one of the first sectors where we see a subtle slowdown of activity in new fundraising and the ability to get funds established.”
This is a continuation, says Harcourt, of a pre-Covid trend for increasing market polarisation, with bigger funds getting bigger, often at the expense of smaller players. “There is a natural flight to quality,” he says. “Larger, more established fund managers have access to a more diverse funding portfolio and a wider investor base, and as a result they’re coping a lot better. They are able to establish new funds more easily than small start-ups or new entrants to the market.”
Walker adds that, due to the increased rate volatility, funds are seeking hedging and risk management products. “We’ve been in such a low-interest-rate environment for so long that fund managers haven’t been that concerned about rate volatility,” he says. “That’s changed in the last six months, and it will remain this way for a while. It’s leading to interest in products like caps and collars, which have been out of fashion for a while. There is more discussion of interest rate fixing to help mitigate the credit risk, particularly in real estate.”
Recent speculation about institutional investors and pension funds exiting private markets at great pace and volume is, Walker says, overdone. “With interest rates heading up, pension fund liabilities are falling. So, yes, some are rebalancing portfolios and decreasing their asset book. But it doesn’t mean they’re running for the hills, dumping alternative investment funds as they go.”
He points to a healthy secondary market and a nascent trend for more continuation funds, as investors delay cashing out in order to enjoy a healthier exit later. “The secondary market is buoyant and is a key component of a well-functioning market. Because of the cloudy macro picture, investors are hanging on to assets for an extra few years, leaving the business to execute to their plan. They can see there’s another turn for investors.
“Funds are launching continuation vehicles and, while LPs aren’t obliged to, a lot are saying they want to follow their money, because they can see value in that asset.”
And even though there are record amounts of dry powder, the outlook is causing a slowdown in M&A.
The industry, therefore, is having to learn to be more open to different sources of capital. “There is a potential strain on capacity from a debt perspective,” Walker says. Many fund managers and LPs are seeking higher leverage for longer across the fund’s lifecycle, tying up funding and reducing liquidity.
This combination of factors causes strain on capacity, but presents opportunities. Conditions are, says Walker, forcing people to think differently. “This low-yield environment in recent years has attracted non-bank lenders into the alternative funds market. They’ve been trying to get into a very attractive credit profile with relatively attractive yields.”
This has led to more so-called ‘club’ arrangements and banks working with non-bank lenders. “As a result of funds having larger debt requirements for longer, the landscape is changing,” says Walker. “Even if early funds have been funded by a small group of banks, in later rounds some additional capacity might be coming from non-bank lenders in order to satisfy this increased demand. Institutional entities like the big asset managers are setting up vehicles to allow them to invest alongside traditional lenders.”
The effects of non-bank lenders
Harcourt says one big shift is in how risk is assessed. “There have been instances where credit ratings have been introduced to help institutional investors step in more easily,” he says. “But at the moment, there's still a need for them to partner or to be working with banks, primarily to originate the debt that they're putting on their books.”
Walker says most banks welcome these collaborations. “You’d think we’d try to discourage this to defend our position,” he says. “But we know it’s necessary if we want to continue supporting successful customers. We welcome this liquidity and it’s often on a non-compete basis. They don’t have a large, experienced team like we do, or a 25-year track record. They come in on a partner basis, and don’t offer the operational banking services, hedging products and depository services we can provide.”
These new sources of finance will obviously influence distribution. Recent estimates suggest the call subscription market would top $700bn, up from an estimated $500bn two years ago. “One of the pressures that banks are facing is an exponentially growing market,” says Harcourt. “Distribution and diversification of funding channels is therefore a key theme for the market to sustain that growth.”
Predictions for the rest of 2022
Harcourt predicts a circa 15% to 20% growth in alternatives in Europe, with a strong nexus to Luxembourg alternative fund growth. “That means banks will need to have distribution capabilities, because they can't just continue to grow exponentially, indefinitely. They need the ability to free up capital to continue supporting clients with liquidity requirements. That trend for banks to work together with other institutional sources of capital and with non-bank capital is going to be important.”
But there are drawbacks here. “One challenge in this distribution model, and in collaboration with non-bank lenders, is a mismatch in preferred tenures. A lot of institutional lenders, especially mutuals and pension funds, are looking for longer tenures than the subscription financing market offers. But for the moment, predicted market growth should give them comfort there is enough critical mass for it to be a worthwhile long-term play.”
Walker adds: “There’s an obvious link between capacity and the changing landscape and distribution, both front-end distribution and through-the-cycle.”
However, for Walker, appetite for borrowing among some managers may be tempered if rates climb too high. “It will be interesting to observe lender appetite if revolving credit facilities see lower, or less predictable, utilisation levels. If we see a shift towards many facilities reverting back to being more standby or administrative in nature, we may see a shift in lenders’ appetites, particularly from those who need to demonstrate high utilisation levels.”
Ultimately, market uncertainty will drive new behaviours.
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