DAN O’DONNELL, GLOBAL HEAD OF CITI INVESTMENT MANAGEMENT ALTERNATIVES
As economic and financial stress mounts, opportunities for high quality private equity, real estate, and hedge fund managers typically multiply. The best managers possess the discipline, deep knowledge, and ready cash to exploit them.
KEY MESSAGES
Over time, private equity, real estate, and hedge fund managers have achieved some of their strongest performances after crises
We know how investors feel. It is hard to commit to invest for five, seven or even ten years in the midst of intense economic difficulties. Looking at history, however, private equity, real estate, and hedge fund managers have achieved some of their strongest performances after crisis periods. Limited partners who invested boldly subsequently benefited from their skillful managers’ taking advantage of market dislocations. In 2001 and 2008, for example, average private equity vintage returns increased by 800 and 710 basis points respectively over the prior year’s level.1
The pandemic is likely to produce significant economic and financial stress for businesses and asset owners across many industries and asset classes. In sectors like leisure, private health care, education and retail, there will be numerous restructurings, recapitalizations, and bankruptcies, many more than in the 2008-09 period. We expect more favorable valuations due to purchase multiple contraction in private equity (PE) and capitalization rate expansion in real estate (RE). When these lower valuation metrics are applied to lower shortterm earnings expectations, entry prices for new money can become quite compelling. Amid this distress, certain fund managers should also be able to borrow cheaply.
1 Source: Cambridge Associates
Where patient money will be rewarded
While we are on the cusp of a unique and significant opportunity, we would emphasize that private market valuations typically lag those of public markets. The most attractive investment opportunities in private markets will likely present themselves over time, rather than all at once. It is our view that the best distressed opportunities will become available later this year and during 2021. In other words, we expect them to occur after the initial macro-level credit support from central banks is scaled back and the economy is actually in recovery.
Even as we see the number of “stressed company” opportunities begin to rise, we have not yet seen the spike in default rates and ratings downgrades that are likely to prompt further forced asset selling. In past cycles, there has been a multiyear period that allowed for managers to take advantage of stressed and distressed situations. We think this pattern will be repeated in this COVID-led recession. Many smaller and less well-capitalized PE firms will have problem companies in their portfolios. Companies with stressed balance sheets will need to unload assets to deleverage. And some companies will want to do strategic acquisitions that require external capital. All of these are opportunities for specialized and well capitalized managers that have the patience and requisite teams to capitalize on them.
Good companies needing capital will have to pay more for it
In private equity, specialists targeting growth and pre-IPO equity may benefit disproportionately. Some of the better growth companies will accept lower valuations as they bolster their balance sheets to enable their businesses’ further expansion in a recessionary landscape. Opportunistic and turnaround specialists will face an opportunity-rich landscape, where money and managerial talent will be rewarded. This is especially true of opportunities overseas. In hedge funds, the largest gains following dislocations have often accrued to liquid distressed debt and structured credit strategies.
In real estate, we favor managers with established track records over previous cycles of identifying fundamentally sound assets that have been repriced, overleveraged, and/or undercapitalized. We also believe that the repurposing of retail assets will be a major opportunity in the 2020-25 period.
Alternative investing in Unstoppable trends
Within our Unstoppable trends universe, the COVID-19 economic shutdown has highlighted certain special opportunities in healthcare and digital infrastructure. These areas have shown resilience, but also require additional capital investment over the coming years. Many well positioned companies will want to make strategic acquisitions and the cost of capital will benefit limited partners in a recessionary environment. Conversely, the hospitality sector and certain urban real estate have been hit hard by COVID-19 and will likely require fundamental restructuring, given pandemic-driven changes in consumer behavior and working patterns.
Certain hedge funds will see unusually good opportunities
In hedge funds, managers with the requisite fundamental and trading skills – or restructuring expertise in the case of corporate credit – should be well positioned for opportunities arising from liquidity strains and forced selling. In structured credit, the market has already witnessed heavy bouts of selling, ranging from daily liquidity funds to highly leveraged mortgage REITs. In the corporate credit markets, spreads on investment grade and better quality high yield debt have narrowed following the Fed’s intervention. However, the debt of middle market borrowers, overleveraged companies, and those in more vulnerable industries remains at distressed levels. As the Fed steps back in 2021 and beyond, we think additional opportunities are likely.
In these most unusual and trying times, investors should consider the benefits of longer duration investing. Potential returns over the coming decade – see Major changes to our Strategic Return Estimates – offer some of the reasons why. Our Alternatives research teams’ role is to identify the managers with the skills to capture the opportunities and execute upon them. Qualified investors’ role is to establish a core allocation in private equity, real estate, and hedge funds including late-stage venture capital (VC). This diversified set of investments can serve as a stabilizer in times of turmoil and an alpha generator when we look back on this period.
Stefan Backhus, Megan Malone, and Michael Yannell also contributed to this article.