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  • December 2020

2020 Alternatives Outlook

  • Lori Whiting, CFA, Investment Director; Jason Horowitz, Investment Director; Matthe Witheiler, Private Equity Principal and Sector Specialist

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. FOR PROFESSIONAL OR INSTITUTIONAL INVESTORS ONLY

The changing alternatives landscape

Performance has stayed top of mind for alternatives investors amid traditional beta’s 10+ year bull market.

For some, this period has led to disappointment as hedge funds have on average been unable to keep pace with rising equity markets. But could increasing volatility change this trend?

In our 2020 outlook, we explore how episodic volatility could benefit alternatives strategies. In addition, we highlight a few insights on the changing alternatives landscape that asset owners may find helpful as they consider ways to optimize their alternatives allocations in the year to come.

Performance is still paramount

As asset owners evaluate alternatives managers’ recent performance relative to traditional betas, we believe it is important to consider whether the experience of the last ten years is likely to persist. Though traditional betas’ strong returns are well-understood, Figure 1 shows just how consistent this outperformance has been relative to hedge fund returns.

For investors that expect the beta-friendly environment to continue indefinitely, low-cost beta would be a logical allocation. Conversely, for investors that believe that there is a high probability of a recession in the near future, increasing cash balances would be an understandable change.

In our view, it is more likely that the increasingly volatile environment that began in Q1 2018 will continue. We believe alternatives are well-suited to weather such an uncertain market given their ability to create value through security selection and tactical changes to their net and gross exposures.

Figure 1

Will beta’s ten-year bull-run persist?

Figure 1

Source: HFR Global Hedge Fund Industry Report – Year end 2018 | PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

Harnessing volatility

The prolonged bull market for traditional betas noted above occurred as long-term volatility decreased for nearly a decade (Figure 2). We believe this environment put alternatives strategies at a structural disadvantage as many are designed to benefit from volatility and dislocations — and were likely to struggle without them.

Starting in Q1 2018, however, volatility has shown signs of reversing the trend. In our view, alternatives allocations can help asset owners exploit that reversal. In particular, we see a role for strategies that are diversifying and/or risk mitigating within the context of investors’ broader beta-heavy portfolios.

As we think long-term volatility is likely to continue rising, we believe the opportunity set is increasingly attractive for alternatives strategies.

Figure 2

Long-term volatility is cyclical

S&P 500 rolling 5-year volatility (%)
Figure 2

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS | Chart data: 31 December 1974 – 31 August 2019 | Sources: S&P, Wellington Management

In our view, there are several reasons to believe episodic volatility will persist in the period ahead. These include potentially-elevated equity valuations, market structure changes, the long-term withdrawal of central bank quantitative easing, and continued geopolitical uncertainty. We believe asset owners would benefit from considering whether their current allocations are aligned with their expectations for the market environment going forward. As we think long-term volatility is likely to continue rising, we believe the opportunity set is increasingly attractive for alternatives strategies.

Asset owners’ evolving needs

The early-adopters of hedge funds in the 1990s and early 2000s were often return-seeking high-net worth individuals, family offices, and endowments and foundations. In recent years, large pension plans, insurance companies, and sovereign wealth funds have entered and institutionalized the hedge fund market. It is important to consider how this shift has affected the alternatives landscape. Relative to the early-adopters, these investors may have different time horizons, increased cash-flow needs, more limited appetites for volatility and drawdown, and different oversight and governance structures.

In our work with investors, we have also noted many of the large asset owners are looking for ways to optimize their alternatives allocations, with goals that extend beyond performance and diversification.

In our work with investors, we have also noted many of the large asset owners are looking for ways to optimize their alternatives allocations, with goals that extend beyond performance and diversification. In many instances, investors are seeking strategic relationships with alternatives managers that have the potential to create value on a number of levels. We believe this trend is likely to continue.

Select goals of strategic relationships with alternatives managers

Do more with less

Many asset owners aim to have more allocations with fewer managers. This offers the opportunity to better leverage research economies of scale and potentially optimize fee budgets.

Custom solutions

Investors may also seek bespoke exposures or return profiles that can provide diversification within their overall portfolios, for example, via the combination of multiple independent alpha sources.

Avoid duplicating costly operational due diligence

By allocating to a familiar manager, asset owners can focus due diligence efforts on the investment approach, as opposed to the manager’s operational infrastructure.

Leverage knowledge sharing

From operational best practices to real-time insights into investment research, many investors want alternatives managers to share additional expertise.

In part due to these expectations – along with strong performance — large alternatives managers have taken the lion’s share of hedge fund allocations in recent years. 65% of hedge fund assets are now with managers with greater than $5 billion in AUM. Larger asset owners may also have more risk-averse investment boards that require extensive due diligence of managers — which we believe contributes to a preference for larger managers with more perceived organizational stability.

Lastly, increasingly stringent filing requirements, complex hedge fund regulations, and service provider fee pressure have disproportionally impacted firms with fewer resources. Larger managers may be better suited to manage these complexities because of their scale and resources, which could benefit asset owners. Efficiencies and cost-savings derived from large global trading and prime brokerage relationships, in-house treasury teams, and other shared infrastructure have the potential to add meaningfully to bottom-line returns for fund investors.

The future of the alternatives landscape

In our view, clients continue to see an important role for diversifying and risk-mitigating alternatives strategies in their overall portfolios despite potential displeasure with recent performance. Perhaps, like us, they believe the factors that drove returns for the last ten years are unlikely to persist.

We appear to be moving into a challenging market for traditional beta that we think may offer an attractive opportunity set for select alternatives strategies. We believe strategies that are designed to take advantage of volatility, dispersion, and dislocations are particularly well-suited and may provide returns that have low correlations to traditional betas.

As the alternatives’ landscape evolves, we think it is vital for asset owners to find specialist managers that are well-equipped to adapt to their changing needs. Though investment performance remains paramount, these also include leveraging economies of scale, breadth, the ability to customize, and potentially a willingness to share knowledge.

Myth vs data: A few thoughts on the private equity market

There has been a lot of hand-wringing about the state of the private equity market and the tech IPO public market recently, but I think the concerns are rooted in a number of myths that are worth dispelling.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. FOR PROFESSIONAL OR INSTITUTIONAL INVESTORS ONLY

Myth 1: Late-stage private companies are overvalued and performing poorly in the public markets.

What the data says: So far in 2019, there have been 16 venture-backed consumer/tech IPOs on US exchanges.1 Fourteen of the 16 are trading above the last private market financing round, and the group overall has averaged a 305% return from the last private round with a median return of 68%.

Myth 2: Venture-backed tech IPOs in 2019 have been a disaster.

What the data says: Of the 16 venture-backed consumer/tech companies that went public on US exchanges this year, 11 are trading above IPO price.1 The average difference from IPO price to current price for the group is 39% with a median of 11%. Plus, the five that are trading below IPO price are doing so for what we believe to be idiosyncratic reasons (e.g., competition, overly aggressive IPO pricing).

Myth 3: The IPO market is broken or weak.

What the data says: The chart below (Figure 1) doesn’t suggest to me that the IPO market is broken (2019 is first half only). The past three years have had around 150 IPOs a year, with proceeds of US$30 – US$50 billion. I believe that doesn’t look so different from the 2004 – 2007 or 2010 – 2013 eras.

1Data as of 11 October 2019 close. PAST RESULTS DO NOT NECESSARILY INDICATE FUTURE RESULTS. This includes “unicorns” in the consumer and technology sectors that IPO’d in 2019. This list was sourced from Crunchbase and originally included 27 IPOs. We excluded nine of the companies, which are in the health care sector or are based in Asia. The majority of the excluded IPOs were trading above their IPO price as of 11 October 2019. Unicorns are defined as private companies with a market capitalization of more than US$1 billion.

Figure 1

US IPO activity – Annually

Figure 1

Source: Renaissance Capital. Includes US-listed IPOs with a market cap of at least US$50 million since 2002 and excludes closed-end funds and SPACs (Special Purpose Acquisition Companies). Data is through 31 July 2019.

Myth 4: Companies are going to go public earlier.

What the data says: I see this as unlikely given the potential benefit of going through the hyper-growth phase of a company’s life in the private markets. The number of companies raising a late-stage round of financing has actually increased more rapidly than late-stage private capital has come into the market, bringing the years of dry powder on hand — a measure of how long uninvested capital committed to the space will last — from 2.5 years in 2016 to less than 2 years in 2018.

I believe many of these companies are remaining private longer because it allows them to think and act more strategically. Today, companies have more flexibility in choosing the right time to go public and may be in a much stronger financial position when they decide to list.

I believe many of these companies are remaining private longer because it allows them to think and act more strategically.
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