Diversify with alternatives

Infrastructure-linked assets have shown resilience to macroeconomic and interest rate pressures while benefiting from policy and structural tailwinds. According to preliminary Cambridge data, infrastructure investments returned on average 9.13% in 2023.

• High barriers to entry, monopolistic positioning and the high degree of cost passthrough of many of these assets make them less sensitive to the business cycle. We maintain a positive view on the asset class. Infrastructure sits at the heart of powerful structural trends—like deglobalization, demographics, digitalization and decarbonization.
• Not all infrastructure assets are created equal, however. And we expect fundamentals to matter more moving forward. In the current environment, we recommend investing in core/core plus assets that benefit from robust, predictable, and inflation-linked cash flows that are less exposed to cyclical pressures and that have appropriate leverage levels.
• From a thematic perspective we recommend looking into renewables and datacenters as key areas of focus.

The private equity (PE) industry continues to adjust to the macroeconomic environment of elevated interest rates. Data for the first quarter of 2024, however, indicate a turning point is nearing. PE valuations seem to have found a bottom. Transaction activity, while down in dollar value, is picking up in deal count. Deal realizations have yet to build more momentum, but we think conditions are there for an acceleration in the coming quarters.

• A return to normality in the PE space will likely take a few more quarters, but we think this is a good time to allocate to the asset class. Entry valuations for new portfolio companies are back to pre-COVID averages (unlike public equities), offering an opportunity to acquire assets at a reasonable price. Funding costs remain elevated, but we expect them to fall in the second half. Overall, we believe investors should stay in the market while being selective about new investments.
• We prefer general partners with a strong track record in value creation, a particular focus on growing margins and revenues, and ability to secure lower entry multiples. We see opportunities in those buyout strategies with a value bias that can seize opportunities in the middle market, as well as in more complex situations such as carveouts, spinoffs, and divestitures where valuations and the potential for value creation are particularly attractive.
• We think secondaries continue to present solid fundamentals, driven by limited partner and general partner needs for liquidity, while also still offering attractive net asset value discounts to investors.
• For investors with a thematic lens, we like exposure to quality growth in areas such as software, health, and climate- related solutions.

Direct lending delivered positive returns in 2023, driven by high current income and only moderate realized losses. Anecdotal evidence suggests a continuation of this trend in the first quarter of 2024, with around 2–3% returns for the quarter.

• A key change in the loan market, however, entering 2024 has been the return of banks to originating loans to PE borrowers. Increased competition could put pressure on spreads and loan documents in the coming quarters. Lagged effects of higher interest rates may also start to exert a heavier toll in certain segments of the market. Industry level statistics on financial stress suggest that risks are contained and manageable. But increasingly, we see a differentiated market and one subject to increased dispersion across loan size, sector, and seniority.
• We believe return prospects for the asset class remain attractive and anticipate high-single to low-double-digit returns for 2024. But some of the trends described above underscore the importance of selectivity when investing in the private credit market today.
• We recommend focusing on areas benefiting from strong fundamentals. Our preference goes to senior, upper middle market, and sponsor-backed loans. This approach, coupled with a focus on newer loan vintages and sectors less susceptible to cyclical downturns, should mitigate risks and take advantage of appealing prospective returns.
• In distressed and special situations, opportunities are likely to arise in certain parts of the economy, for instance in the commercial real estate sector. The significant amount of corporate debt likely to mature in the coming years should also provide a steady source of deal flow.

We estimate that including a 20% allocation of alternatives in a balanced portfolio could increase expected annual returns by about 50 basis points per annum over the long term, for an equivalent level of portfolio volatility. Investors should note that alternatives come with a unique set of risks, including lower liquidity and lower transparency.

The current conditions look ideal for active management, in our view, as the outlook for rates, AI, and elections around the world is likely to lead to market dislocations. In addition, in a market where stocks and bonds could periodically move together amid rates and inflation volatility, we think hedge funds can be a good portfolio diversifier.

In the current environment, we favor the following hedge fund strategies:

• We think low net equity L/S strategies can benefit from market dispersion, mitigate market directionality, and abrupt selloffs while complementing traditional equity positions.
• We also recommend investors to look into strategies that can take advantage of current macroeconomic shifts and imbalances. Historically, macro funds have been able to take advantage of monetary policy errors and higher volatility across curve/rates trading, inflation trading, and commodities trading.
• And lastly, multi-strategy funds, with their flexible approach to shifting between different investment strategies based on evolving market dynamics, can offer a comprehensive solution for managing risk and seeking returns across various scenarios.