Perspectives

In the current market environment with few reliable sources of return, many investors are turning to private markets to supplement their investments in public markets. Altera believes that within this space, smaller opportunities present the greatest potential upside for investors.

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Predicting the future in financial markets is like trying to pick the winner of the Super Bowl in the preseason, unless maybe you have a copy of Gray’s Sports Almanac from Back to the Future. Surely, the confluence of issues relating to global supply chains, COVID-19, monetary policy, and fiscal stimulus, along with the current geopolitical landscape have stirred capital markets. With that, market participants have cause for concern across many things, especially inflation, overheating equity valuations, and the looming possibility of a recession.

With no shortage of issues to navigate, there are two questions that remain top of mind for investors:

  • Where can opportunities with favorable expected risk-adjusted return profiles be found?
  • Are there options that provide a yield and preserve the purchasing power of financial assets?

While answers to these questions have a dependency on point in time and relative market fundamentals, as it turns out, we feel private credit investments are well positioned to deliver both strong risk-adjusted returns and a meaningful yield.

Fundamentally, private credit is a form of fixed income, but in many ways it’s markedly different from public fixed income. Even before interest rates began their current upward mobility (the 10-year treasury is approaching 3.00% for the 3rd time in the last 10 years1) and the effects of inflation began to reverberate through consumer wallets and corporate coffers, the case for private credit was strong. Now it is even stronger.

Private credit is typically structured as floating rate debt (generally in the form of loans) and very often includes extensive protective covenants for lenders, which present key advantages to investors. As highlighted in Altera’s recent perspective “IS PRIVATE CREDIT THE ANTIDOTE FOR WHAT AILS FIXED INCOME?, private credit can deliver both yield and capital preservation. Effectively, investors are getting the benefit of a more favorable interest rate profile relative to higher-quality, fixed-rate public debt, and a more favorable risk profile relative to floating rate public debt.

These differences were two of the primary drivers behind Altera’s launching of a private credit offering in the current market environment. Further, we selected a sponsor with an extensive track record, experienced team, and thorough investment process. This sponsor is conservative in how they underwrite the businesses they lend to, has the ability to structure loans to provide attractive income with capital preservation, and also adds the possibility of capital appreciation through equity in their investments.

On a risk-adjusted basis, we believe private credit is poised to perform well relative to other assets beyond just fixed income. The combination of structured yield, downside protection, and ability to capitalize on equity upside makes for an “all-weather” strategy. We continue to operate without a crystal ball to predict the future, but we also see the role of private credit in investment portfolios becoming more and more of a benefit. I wonder what Marty McFly is seeing in the Almanac…


[1] Board of Governors of the Federal Reserve System (US); www.fred.stlouisfed.org/series/DGS10.

We believe asset allocation and a disciplined evaluation of risk and return are hallmarks of an effective investment process and critical within the current environment. Read how adding a diversified sleeve of alternative investments to investors’ portfolios can reduce expected volatility and increase expected returns.

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With tax season now in full swing, we wanted to remind you to file an extension on your taxes due to delayed reporting with private investments. Extensions are very common when investing in private placements. The deadline for filing an extension is the standard tax deadline of April 18, 2022.

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The only thing we have to fear is… fear itself.

The first inauguration of Franklin D Roosevelt

Much is being written in 2021 about price inflation, debating its persistent or transient nature, and conveying a general worry over the impact of inflation on asset prices. With this note, we hope to explore the history of inflationary periods to determine how much inflation impacts fundamentals and how much market action is merely fear itself.

Investors with some age on them have been shaped by the period of elevated inflation in the 1970’s. As the graph below shows, most other inflationary periods have been associated with wars — with prices spiking from wartime shortages and then deflating when supply/demand conditions returned to balance. But the inflationary period of 1973-74 was different and not associated with wars but with monetary policy. Stock prices during this period declined by more than 45%, and bonds saw coupon interest undermined by declining principal value from rising rates.

Interestingly, the battle against inflation didn’t actually commence until after the Nixon Administration’s easy money policies had been abandoned and the Volcker Fed commenced a high interest rate regime to “break inflation’s back” in the early 1980’s.

Given the noise in the markets today, one would expect that this would have been a horrific period in which to be an investor. But despite persistent inflation during the ten years following the ’73-‘74 bear market, eight years were positive for equities. Bond returns were positive a similar percentage of the time. And shockingly, S&P500 returns (including dividends) averaged more than 15 percent per year during this decade. It would appear that inflation surprises are more important than inflation itself.

What does one make of this revelation, and how does it relate to private investments?

First, one must admit that market averages hide the volatility that affected many companies and sectors. Those bear market years were most difficult for high multiple growth stocks whose prices often declined by more than 80%. (Remember that Avon Products and Coca Cola were growth stocks of that era.)  Clearly, future earnings are worth far less in a high inflation environment. Similarly, lower quality names with high leverage were also decimated as the rising cost of leverage took its toll on free cash flow and solvency.

In the current era, the private equity industry has thrived in this period of lower cost leverage, allowing managers to widen their view of potential targets and buy at ever higher valuations. Assuming “real” rates of interest behave logically, then higher inflation would raise financing costs and put marginal deals out of reach. We would expect skilled managers to continue to succeed in such an environment, while those without an edge would eventually point their careers elsewhere. Investors without a coherent strategy may find this new paradigm less than accommodating.

The takeaway for private investments, therefore, is not that inflation is scary, or that it is benign. The observation is that low leverage strategies should endure. Skilled managers and sponsors in private equity can continue to add value. Enterprises with pricing power will better be able to navigate whatever environment exists. And certain real estate categories are clearly inflation hedges, with rents that adjust over short time periods. Conversely, highly leveraged strategies and overpaying for growth are risky endeavors when discount rates rise.

At Altera, we strive to identify strategies with real value-added as opposed to “prosperity through financial engineering”. We seek enterprises with pricing flexibility and modest leverage. We favor durable revenue streams, even at the expense of being a little dull. We are long term investors in long duration assets.

We can’t predict inflation rates, or whether or not the current spike will endure or prove to be transitory. But as history has shown (in the graph above), change IS the constant, and inflation rates are just as likely to surprise on the downside as the upside. This makes the entire inflation discussion (for long term investors in private securities, anyway) as much a media-driven phenomenon as it is a fundamental one.

Today’s investors are challenged to find yield in a low-rate environment and appreciation potential in a world of highly valued equities. They are increasingly looking to alternatives to meet their financial objectives. When investing in alternatives, however, some of the greatest challenges for an investor are determining the true level of risk being taken and assessing what is an acceptable rate of return for that level of risk.

In public securities, risk is often couched in terms of volatility. But for illiquid private investment vehicles, risk is more likely to be defined as the likelihood of a permanent loss of capital. Each definition can be applicable to a particular situation, but defining risk is more multi-faceted than this, and return targets surely aren’t all created equal.

As we will describe below, there are times when a seemingly mundane investment with a 12% target IRR is just what a portfolio needs.

Embracing Illiquidity Risk

In addition to bearing the risk of loss, investors in private securities face a lack of trading liquidity. The lack of a daily mark-to-market valuation can make private investments a stabilizing factor in a portfolio, at least over the short term. While surely not an indication of a lower risk level, this draws attention to the weakness of using volatility as a primary measure of risk. It also highlights how public securities can react strongly to market and economic factors, adding to portfolio volatility, while private valuations are much slower to change and are driven by operating fundamentals more than by short term views.

Private Real Estate has lower correlation with S&P500

Even if one assumes that illiquidity delivers a possible benefit to offset investor emotions, an investor should still be compensated for the lack of trading liquidity of any investment. In practice, it seems that we usually are. An example of private real estate investments versus publicly traded REITs shows a yield premium of more than one percent for private funds and a far lower correlation of returns with the S&P500 (shown at right).

Higher Sharpe Ratio for Private Real Estate

Likewise, a comparison (at left) of the Sharpe Ratio of public versus private real estate shows that the private investment has delivered more return for each unit of risk.

The concept of illiquidity risk circles back to the concern over volatility: Both are risks that an investor may have an unexpected need for funds (either from true need or emotional reaction) and may find it necessary to liquidate investments at the worst possible time. But the investor who can accurately forecast their liquidity requirements has an inherent advantage. Rather than being concerned over the illiquidity of a part of their portfolio, they can budget for the amount that needs to remain liquid (and subject to the volatility of the financial markets) with the remainder focused on the long term and earning an “illiquidity premium” and potentially higher returns.

In short, turning the liquidity question on its head could yield a portfolio with a more efficient risk/return tradeoff.

Reducing of Correlation Risk

While investors may be compensated for illiquidity, they are not usually compensated for incurring correlated risks (i.e., the risk that two investments behave in the same way at exactly the worst time.) When an investor expands their opportunity set by including private investments, they increase the likelihood that they can incorporate vehicles that have a lower correlation of returns.

In practice, correlation risk can and should be diversified away where possible, but this aspect of investing is often neglected when investors put on their “deal hat” and not their “portfolio hat”. When taking a portfolio perspective, it becomes clear that identical 12% target IRRs are NOT of equal value if one of them is highly correlated with existing positions. Adding true diversifiers with the same target return improves portfolio efficiency, again delivering more potential return for each unit of risk.

It is also important to view each investment’s target IRR as a central point amid a range of possible outcomes, some of which may be negative. And when the same risk factors (i.e., interest rates or economic growth) are the main drivers of returns for more than one investment, the investor may be multiplying their risks despite investing in what appear to be thematically different stories.

Portfolio management is therefore about trade-offs, and where possible, about upgrading portfolios to perform better over time for the risks that are being taken. Investments aren’t viewed in a vacuum, but rather in comparison with existing holdings and possible alternatives.

With stock returns having averaged 10% per annum over the past 50 years, an alternative investment fund with a 12% target IRR and no correlation to the S&P500 can look like a winner for an investor who can allocate to private alts. With US large cap equities at elevated valuations, the case for alternatives is even stronger.

Seeking “Alpha” and “Beta”

At Altera, we assess an investment’s return potential and its risks, looking at both the broad asset class and the specifics of the investment itself. Our process tends to produce eclectic investment vehicles where one of the largest risks factors is often manager execution. We focus not just on getting the “beta” (return of the asset class), but also on finding those independent sources of “alpha” that add value through execution in a specific segment at a particular point in time.

For example, “manager execution” might be delivered by improving the profitability of a self-storage facility after acquisition, increasing its yield and its market value. It might be in the selective acquisition of underperforming hotels or in a manager’s process of acquiring so-called “dull” companies at low valuations and providing capital to consolidate other competitors into a larger, more valuable entity.

In these examples, manager execution is about more than owning an asset and riding the wave of a market cycle or organic growth. It is about making more from what’s there, adding to the potential return of an investment, independently of the macro factors at work. When investors can earn alpha (from the value-add) and beta (from the asset class), their chances of earning returns that are less correlated with their other investments increases greatly.

The conclusion is that a portfolio mindset seeks diversification of certain types of risk, attempting to minimize some while embracing others. By specifically targeting different sources of alpha, this process could deliver a better outcome over the long term, even while incorporating the occasional 12% IRR fund.

1 Sources: Bloomberg, NCREIF, NAREIT 20 years ended 12/31/2017.

2 The Sharpe Ratio is a measure of excess return on an asset above a risk-free rate relative to the standard deviation of return of that asset.

3 JPMorgan 2021 | 25th Annual Edition — Long-Term Capital Market Assumptions