We believe Investors are faced with three unprecedented challenges:
- Diversifying effectively has become harder with stock/bond correlations increasing in 2022
- Inflation may be structurally higher due to unfavourable demographic headwinds, deglobalization and higher commodity prices
- Traditionally ‘safe’ asset classes are likely to deliver negative real returns.
However, for family offices, the opportunity set is deep. In our conversations with clients, this is where many investors are looking.
Private Markets
At the beginning of Q4, we brought together 30+ clients to discuss the opportunity set in private markets. Three key themes stuck out:
- The typical family office investment portfolio is down 10 – 15% in USD terms, leading to suppressed risk appetites. Rising rates and inflation, combined with persistent volatility, have pushed them to increase their cash balances. All eyes are on the extent of the earnings recession and private market markdowns in Q3/Q4.
- Private markets are top of mind for clients and maybe more so now as a way to avoid the volatility of public markets and also benefit from illiquidity premium (yes, it's back). There is demand for structured equities, capital solutions and opportunistic “stressed” situations to deploy senior in the capital structure, but with equity-like returns.
- Currently, we see three opportunities for investors in private markets:
1. Within structured equities and capital solutions is a growing opportunity set that is driven by a core theme that we are witnessing across our business: scarcity of capital.
Previously, many middle market borrowers took on floating rate debt, which, should rates continue to rise, they may have difficulty in servicing. For many direct lenders who have a growing role in this space, this has led to ‘risk-off’ positioning; this means that many of these businesses—and their owners—are starved of capital to finance strategic objectives. As you can see in the chart below, which displays an illustrative middle market company’s capital structure, a rise in the reference rate of borrowing (LIBOR) can have a materially detrimental effect on interest coverage.
Illustrative Middle Market Capital Structure & Cash Flow Proxy
Source: LCD, Refinitiv, Lincoln, as at November 2022. For illustrative purposes only.
One way that we have seen corporates address this is through bespoke structured credit and equity instruments, such as PIK preferred notes, structured equity and hybrid capital solutions—these allow borrowers to refinance their debt and continue growth. For investors, they may offer a margin of safety, with potential downside protection given significant equity cushions in the capital structure of many cash flow-generative businesses.
2. Many traditional routes to exit for buyout firms are closed (e.g. strategic buyers aren’t buying, IPOs aren’t an option and financial buyers are focusing on the operations of their existing portfolio companies). This has led to material growth in the GP-led secondary market. Buyout firms want to retain controlling interest in their portfolio companies rather than selling them directly to a competitor.
Rolling these assets into continuation funds has meant that many GPs can maintain their exposure to top-quality assets whilst managing duration mismatches between the assets harvest period and the life of their flagship funds. For secondary investors, this may present an opportunity to potentially achieve buyout-like returns with a traditional secondary-like risk profile.
3. As the economy remains choppy and dislocations appear across both private and public markets, we believe special situations investments could be a potentially attractive way to achieve low to mid-teen IRRs. Our teams continue to see opportunities to provide opportunistic capital solutions in the form of working capital receivables financing, bridge loans to stressed companies and purchases of idiosyncratic assets like California Carbon Allowances.
Public Markets
On the public side, the picture is more nuanced. 2022 has been a disappointing year, with public equities and fixed income down materially. Clients are concerned about future rate rises, earnings recession and liquidity challenges. Whilst these are all valid concerns, there are many opportunities for investors who are willing to be creative:
- Equities: Across our client base, there is little interest in allocating directly to stocks, and most clients are using passive ETFs when they do. However, we see a clear opportunity to harvest volatility premiums by utilizing defensive put writing strategies. The opportunity here is threefold:
- During periods of market stagnation and decline, put writing strategies have historically outperformed
- Rate rises, which we believe are likely to continue, can provide the potential for interest income from short duration collateral portfolios that are used by put writing managers
- Increased volatility leads to the potential for larger premium collection
- Fixed Income: This has become a major focus for us and our client base. Here, there is potential value in higher-octane, flexible strategies, such as parts of the HY market and CLOs.
In the latter, we see opportunities in both CLO BBs and CLO BBBs. As you can see from the below chart, which displays CLO BB/BBB discount margins vs. US HY BB OAS and US Corporate BBB OAS, there is a large spread basis that offers investors a potentially attractive yield profile.
Source: JP Morgan, Bloomberg and S&P Global Market Intelligence, as at 31 October 2022. For illustrative purposes only.
- Commodities / Natural Resources: Given the potential for higher commodity prices in the short to mid term, there is an opportunity here for clients. Of the many ways to allocate to commodities (e.g. futures and equities), we believe there are clear advantages to actively managed funds. Unlike futures and equities, which are typically correlated to wider stock market movements and can be complex to implement, active funds may offer investors cost-effective access to a wide, diversified pool of commodities.
