Today’s alternatives landscape through a portfolio-construction lens

On the eve of the COVID-19 pandemic, valuations were rich across most alternative asset classes. As discussed in Private markets 2020,  building an outcome-oriented private markets portfolio required even more selectivity and discipline than usual.

The extreme market turbulence since then has underscored the value of thoughtful, risk-managed portfolio construction in safeguarding desired outcomes such as capital growth, enhanced income or stable income. The importance of understanding market factors within private exposures and the benefits of truly idiosyncratic and diversifying sources of return have become even clearer.

In our recent webcast, Comparing private market opportunities, Pam Chan, CIO and Global Head of BlackRock’s Alternatives Solutions Group, applied this portfolio construction lens to the task of assessing opportunities across a greatly changed alternatives landscape. Following are excerpts from her discussion with Mark Everitt, Head of Investment Research and Strategy for BlackRock Alternative Investors.

From a pan-alternatives perspective, how does this crisis resemble previous ones, and how is it different?

I’ll start with a major difference. Private markets have grown significantly since the global financial crisis and will play a larger role this time around, over the course of a recovery that could take several years.

The private markets have tripled in size from US$2.5 trillion in December 2007 to US$7.7 trillion today, increasing from 4% to 11% of public market size, figures from Preqin and MSCI show. So private markets will provide a much larger quantum of flexible and bespoke capital that can be used to finance rescues or long-term secular opportunities that public markets may not be suited for, or where public avenues may not be available. At the same time, given the depth of private markets, we may also see dislocations specific to them, perhaps with ramifications reaching beyond that private asset class itself.

Also, the GFC educated investors on potential private market returns available during dislocations. We expect to see assets in the coming months available at very attractive prices as compared to recent history, but the question is whether those prices are attractive enough to compensate investors for the elevated levels of risk. We must underwrite investments in the context of anticipated structural shifts in the global economy.

I’ll also point to the way opportunities tend to develop on different timelines in different asset classes. By looking at how returns played out post-GFC, investors can gain insights that will be useful this time around. Using data from Preqin, we’ve looked across asset classes to understand the sequencing of opportunities post-crisis and the speed of return degradation. Here’s what we observed:

1. Distressed debt fund performance peaked with the 2008 vintage and compressed most rapidly.
2. Opportunities in turnaround equity developed more slowly, as entry valuations took longer to adjust. Valuations were most attractive in 2009 and 2010 vintages, when EV/EBITDA multiples compressed by two times from their peak, according to S&P LCD.
3. Finally, distressed real estate saw the greatest returns in 2010 and 2011 vintages, and those opportunities persisted for a few years bolstered by the impact of the Fed’s TALF program on CMBS and RMBS. This is in line with what our colleagues are describing today as well – i.e., it may take a little longer to see buying opportunities in real estate, but they will likely have a longer window.

How should investors think about the resilience of private markets and their contribution to the whole portfolio?

Private markets tend to exhibit less accounting volatility than public markets given valuations are less frequent and are not exposed to market sentiment. Most importantly, however, private assets are generally not subject to forced selling. Also, given that each private transaction is manufactured for a specific situation, investments may benefit from structural features that limit downside or insulate cash flows from exposure to broad market factors. Moreover, there are certain asset classes that may be inherently orthogonal or otherwise have less correlation to market factors.

As one example, a structured payout arrangement on an oil and gas overriding royalty interest may allow an investor to trade capital impairment risk for extension risk amidst the energy market selloff.

Then there are what we call “alternative alternative” (alt-alt) asset classes. Music royalties are one good example—consumer listening habits don’t change with movements in the S&P 500. Other examples include wetland mitigation credits and other forms of content IP. These niche assets make up only around 5% of the private market today but we believe they will play an increasingly important role in bolstering portfolio resilience to market turmoil. Preqin estimates that investors will allocate approximately 10% of their portfolios to a variety of niche / diversifying investments by 2023.

In addition to deal-level or asset class attributes, portfolio construction and risk management are critical for building resilience for the overall portfolio – hence we spend a lot of time understanding each investment’s bottom-up risk factor exposure in order to avoid unintended concentrations of risk across what may on the surface appear to be diversifying investments (see The core role of private markets in modern portfolios).

What opportunities are you seeing? 

We divide these into two categories: those that arise from negative catalysts—usually liquidity needs—and those that are driven by secular trends that may be accelerated by COVID.

In terms of those driven by negative catalysts, we are beginning to see stressed and distressed opportunities. An example in rescue finance that we’ve been reviewing is a preferred equity investment with an asymmetric return profile – financing a large, high-quality, privately owned, financial institution. The company hedges their rates exposure and faced a significant margin call due to repricing. Aside from these temporal issues with their cash position, the business is otherwise robust and their need for execution certainty garners a premium.

On the other hand, we see several sectors that are well positioned given existing secular trends and new COVID-related tailwinds. For example, the increased need for remote services will potentially benefit information technology companies in software solutions, cloud computing, online education, media content and e-commerce, among other subsectors. The question here is how to access these companies, since the tailwind, paired with the relatively low capital intensity of the businesses, mean they are less likely to need additional capital for survival.

One way to gain exposure is through structured growth equity. We have observed that growth equity seems to be one of the more resilient strategies within private equity in terms of deal flow. Since 2000 growth equity has only made up 5.6% of buyout deal flow, according to Preqin. However, in a four-week period ending in late April, it made up nearly 20% of deal flow. A similar phenomenon occurred in the fourth quarter of 2008 after Lehman crashed. Growth equity made up nearly 24% of deal flow during this time.

Qualitatively we believe this might be true because growth equity is less reliant on debt financing than traditional buyouts. Along the same lines, growth equity is more reliant on increased output and improved business cash flows rather than optimizing capital structure through leverage. This lowers the overall beta to the market—the risk you are underwriting here is more company specific and idiosyncratic in nature.

One current example is with an upstart online bank. We believe the company is well-positioned to succeed given its purely online business model. The dislocation could make it possible to structure downside protection while retaining much of the upside convexity of a typical growth investment.

Any concluding thoughts?

First, we believe there will be ample opportunity to buy well across private markets, which had been highly valued prior to this dislocation. Again, I’d underscore amidst all the uncertainty, the size and nature of the private markets today will give them a greater role in the recovery from this crisis than any one prior.

Second, the key will be flexibility - investors will need to act quickly as opportunities arise and before returns diminish. Investors may benefit by being outcome-oriented and asset class agnostic as opportunities can be expected to shift across strategies and time, and may dissipate quickly as capital flows in.

Third, portfolio resilience requires re-underwriting existing and carefully assessing new investments through a lens of market risk exposure. Constructing one’s portfolios in a risk-diversified manner is critical and, where possible, incorporating more orthogonal or alt-alt investments to capture non-market drivers of return can help.