Managing funds as uncertainty bites

As inflation reaches heights not seen in decades, interest rates are rising across the world. Add a poorly performing global economy to this mix, with predicted recessions in major markets, and the challenges facing the market are substantial.

The consequences are starting to be felt. Fund valuations are wobbling while managers are postponing deals or are unable to get financing at valuations which were predicated on last year’s gentler economic environment – conditions that are unlikely to return in the foreseeable future.

Rising rates

Central banks in the EU, the US and the UK have all raised interest rates this year, with more rate rises expected. Fund managers are anxious to have an idea of when interest rates are likely to peak so they can update their funding models, says James Hamelin, Director at RBS International.

“We’re having pre-emptive discussions with some clients about what happens when interest rates reach a certain point,” he says. “Whether borrowers need to seek covenant amendments or waivers for potential breaches is certainly front and centre of their minds.”

Andy Roberts, Senior Director at RBS International, says a big issue for certain fund strategies will not only be whether there is enough cash to service the debt, but the impact of the recalculation of loan-to-value ratios.

“Real Estate, Infrastructure and Renewable Energy funds in particular normally value assets based on discounted cash flows,” he says. “If the projected values of these future cash flows are worth less today than they were a year ago, there’s a detrimental impact on valuations and leverage.”

While private debt benefits from greater certainty over cash-flow timings, it may find the quality of its assets a problem.

“Private debt fills the space that banks are unwilling to lend to, and this is the space that will be the first to come under stress,” says Dr Stewart Hotston, Sponsor Coverage Director at NatWest. “Their greater risk appetite means they are more likely to bear the brunt of defaults and distress, and for this reason it could see outflows of private money.”

Meanwhile, increased foreign exchange volatility is making many consider their foreign exchange (FX) strategy. The US dollar has emerged the winner to date out of major currencies, both due to interest rate differentials and the search for a safe haven.

“The euro had started to be a safe haven, but the Russian gas situation means it’s not being favoured to the same degree now, with more money flowing into the more traditional safe haven of the US,” says Roberts.

Eyes on hedging

Funds need to think about the areas they’re exposed to in terms of volatility, whether that’s FX, inflation or interest rates. The questions fund managers should be asking include: do we have a hedging strategy; if not, should we?

It comes down to what areas the fund is exposed to, and whether the fund can mitigate that risk or whether it can live with it, says Hamelin.

“A bit of FX volatility isn’t going to turn a good underlying asset into a bad one. But for lower returning strategies, particularly those with capped upside like debt, the performance of the fund is far more vulnerable to adverse FX movements”

Andy Roberts, Senior Director, RBS International

“CFOs and finance directors will have to look at products that may not have been of interest to them before and think carefully through the impact of products such as FX and interest rate hedges,” he says.

Rates hedging has been the poor relative in fund circles for the last decade, Hotston points out.

“An entire generation of people who are now managing directors have never been through this cycle and have never had to think about the high-inflation, high-interest rate environment.

“Hedging has to return to being a normal part of what people do. The market is much more vanilla now than it used to be, but as the situation changes there is likely to be increasing interest in more complex products.

“Some fund managers are not yet thinking about how to integrate hedging into their ‘business as usual’. At the start of the year many of our clients did think about hedging and rate management, albeit in a very limited way. But funds should be asking how they can integrate this into their regular business approach – that’s the most important psychological change needed.”

Trading terms

Many alternative funds are worried that they aren’t going to hit their forecast realisations. Funds that are coming to end-of-life in the next few years find themselves unable to return to investors what is expected, says Roberts.

“We may see funds hold onto assets for longer or flipping them into new vehicles so as not to have to sell in unfavourable market conditions,” he says.  

Portfolio composition is likely to change, with clean energy generating a lot of interest given increasing fuel prices. With climate change a pressing issue, there will be substantial opportunities in adapting infrastructure and investing in renewables, while funds which invest in energy-efficient real estate could find themselves popular.

Funds are potentially likely to raise less money because of cautious investor sentiment. At some point that will change, says Hotston, and it will be a good time to buy undervalued assets.

“However that’s unlikely to happen particularly quickly,” he predicts. “Many investors want simple returns without a huge amount of risk – low interest rates and decent returns are right at the bottom of their Maslow hierarchy. As a result, we could see private equity pivot away from some of the newer unproven sectors that they’ve been moving into, and some funds could retrench.

“During the pandemic, private equity raised distress money to buy bargains. That opportunism will be par for the course. And private equity is probably the most flexible because it’s the most sector agnostic.”

Private equity’s success comes down to picking winners, says Roberts.

“A bit of FX volatility isn’t going to turn a good underlying asset into a bad one,” he explains. “But for lower returning strategies, particularly those with capped upside like debt, the performance of the fund is far more vulnerable to adverse FX movements.”

Building better

Infrastructure funds tend to perform better than private equity funds in an inflationary environment when they can pass on the costs. There may be some readjustment pain if infrastructure projects need to be refinanced but generally a several-year blip does not matter too much to a longer term infrastructure fund.

Similarly, real estate funds can counter higher interest rates with increased rents. However there are signs that real estate funds are starting to rein in on projects, with investment volumes a third lower in June 2022 than they were the year before.

Many managers are waiting to see what happens, says Hamelin, and a lot of deals are getting repriced, so something which was agreed three months ago can’t be done now.

“Higher interest rates mean that higher leveraged deals are simply no longer affordable from a debt perspective,” he says. 

Read more: Hedging strategies during time of inflation