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In a speech at a banking conference last month, Jamie Dimon expressed concerns about the rapidly growing private credit market, which has surpassed $1.7 trillion in assets globally. He cautioned that while there are many “brilliant” people in the industry, not all players are “good”, and problems could arise from weaker firms making mistakes.
“There may be problems here. I do not think it is systemic, but I do expect there to be problems.”
His words, not mine.
In a recent interview with David Rubenstein at the Economic Club of Washington, D.C., Marc Rowan, CEO of Apollo Global Management, warned that the private equity industry may be facing a reckoning due to the rapid rise in interest rates and economic uncertainty.
Again, his words, not mine.
“But what are your words, Harms?”
Well, I’m glad you asked!
According to the Federal Reserve Bank of Cleveland’s model, as of May 2024, the probability of the U.S. economy entering a recession within the next year is 54.6%. So, slightly better than a coin flip, basically.
Bottom line? Historically, when the proverbial excrement hits the whirling blades, your clients typically worry about two things: 1) How am I doing against the S&P? and 2) Can I get to my money?
You know I love a good cliché, and there’s something in here about buying insurance after the flood, or that there is a reason why they’re called Hedge Funds, or something about trying to find life jackets after the ship has already hit the iceberg. I’ll just leave it at that for this month.
Hope everyone has a great summer! 🙂
Best,
Dan
Alternative Talking Points
We review the latest monthly reports and industry analyses across the private markets, boiling them down into a few easily digestible points to share with your clients. Contact us if you’d like more depth.
Hedge Funds: Hedge funds ended with strong performance in May, led by Equity Hedge and Event-Driven strategies.
➕ Equity Hedge Gains: The HFRI Equity Hedge (Total) Index surged by +2.5% in May, marking its fifth gain in the past seven months and its strongest monthly return since February.
➕ Sector Performance: Energy and Technology sub-strategies led the gains, with the HFRI EH: Sector-Energy Index up +3.6% and the HFRI EH: Sector-Technology Index up +3.2%.
➕ Event-Driven Strategies: Event-Driven strategies also advanced, with the HFRI Event-Driven (Total) Index gaining +1.6%, driven by Multi-Strategy and Distressed exposures.
➕ Relative Value and Macro: Relative Value Arbitrage strategies posted modest gains, while Macro strategies saw mixed performance with the HFRI Macro (Total) Index falling -0.65%. Active trading strategies outperformed systematic approaches within macro strategies.
➕ Geopolitical Risk Adaptation: Hedge funds are shifting focus from macroeconomic to geopolitical risks, adjusting portfolios for potential conflicts and policy changes.
Sources: HFR
Private Equity: Cautious GP optimism amid improving market conditions and deal activity, but with continued challenges and a need for adaptation.
➕ Many top private equity leveraged buyout funds have barely beaten the stock market in recent years, as they struggle to exit investments and liquidate portfolio companies.
➕ Scott Kleinman, co-president of Apollo, warned that private equity firms did not take substantial markdowns during the recent rate hike period. This means investors will have to absorb the decrease in valuations that is currently “in the pipeline”, leading to “fewer realizations and lower returns” for the industry.
➕ Higher leverage used in PE buyouts increases bankruptcy risk for portfolio companies, requiring much higher returns than public markets to compensate for the opacity and illiquidity. However, the ability to generate those higher returns is now in question.
➕ Exit drought, coupled with higher financing costs, has severely impacted PE dealmaking and fundraising. While opportunities remain, top firms are adapting their strategies in 2024, but are nonetheless currently sitting on >$1 Trillion of dry powder.
➕ To maintain returns in a higher-rate environment, top PE firms need to rely more on operational improvements and margin growth than on multiple expansion.
Sources: Institutional Investor, Bloomberg, Bain
Private Credit: Private credit funds are facing increasing challenges due to rising interest rates, tighter lending standards, and economic uncertainty, making it tougher for them to generate attractive returns.
➕ Jamie Dimon warned of potential risks in the private credit market, stating “there could be hell to pay” if cracks start appearing, drawing parallels to past issues with mortgage-backed securities.
➕ Over one-third of private credit borrowers now have interest costs exceeding earnings due to rising rates, increasing default risks.
➕ Rising concerns about competition from banks on larger deals and pressure to deploy capital is leading to weaker underwriting standards and looser covenants in private credit lending, raising future credit loss risks.
➕ While private credit fund leverage appears low, there are multiple layers of hidden leverage and interconnectedness within the private credit ecosystem that could amplify shocks, given the lack of transparency.
Sources: IMF, Euromoney, Business Insider
Commercial Real Estate: Characterized by continued uncertainty and transition, with strength in multifamily and industrial sectors, struggles in the office market, resilience in retail, and overall economic concerns impacting performance.
➕ Multifamily properties continue to perform well, with stable rents and low vacancies, except for some concessions in the luxury apartment segment.
➕ The retail sector remains resilient, succeeding alongside e-commerce and fueling demand for industrial properties. However, the future of office space is uncertain as central business district vacancies climb.
➕ Real estate investment trusts (REITs) are getting creative with deals, such as Blackstone dangling low-rate debt to make a student housing portfolio more attractive to buyers amid high borrowing costs and redemption pressures.
➕ Higher interest rates, geopolitical concerns, and the upcoming presidential election could negatively impact the economy and commercial real estate.
Sources: JPMorgan, InvestmentNews, NYT, AEI
Worth your time
Our monthly recommendation of books, articles, research, and announcements we found interesting, important, or just plain entertaining enough to share. Sometimes we’ll have a lot. Other times, not so much. The objective is to share things that are useful, not filler.
➕ Asset Allocation 201: Sortino Ratio, Positive Skew, and Near-Zero Correlation to Public Markets: Third Wire Insights. This 201-level educational article is a little drier and matter-of-fact than our typical introductory 101 articles, but that’s by design. Still insightful, maybe less entertaining for some, 201s are meant to go a little deeper into the specifics of what we think about when helping you select alternative investments with your clients.
➕ Private equity firms have amassed $1tn in ‘carry’ fees as taxation debate mounts: Financial Times. I just want to say one word to you. Just one word. Yes, sir. Are you listening? Yes, I am. “Carried Interest” Exactly how do you mean? There’s a great future in carried interest. Think about it. Will you think about it? Yes, I will. Shhh, nuff said. That’s a deal. Oh, uh wait, carried interest is two words. You get the ‘The Graduate’ reference, though, right? 🙂
➕ The US and Korean CHIPS Acts are spurring investment but at a high cost: Peterson Institute for International Economics. CHIPS Ahoy! The U.S. and South Korea are diving headfirst into the semiconductor race with their respective CHIPS Acts, spurring massive investments to secure supply chains and reduce dependency on foreign producers.
➕ Pursuing investment goals with private markets: Blue Owl. I don’t even know where to begin. The sub-heading for this paper from Blue Owl is “Your clients are more like institutions than you think they are.” Are any of you really picking up what they’re putting down here? We think it’s an odd sleight-of-hand to talk about institutional investors and their approach to alternatives while seemingly marginalizing hedge funds and pushing your own products. Hedge funds were a core allocation of Swenson’s ‘Yale Model’—you know the institutional model they all point to for why your clients should be allocated to their Private Markets funds.
Can somebody please tell us, if Private Markets is the term everyone is using for Alternative Investments now, what are hedge funds considered?
Disclosure:
This newsletter is for informational purposes only and does not constitute investment advice. All investments, including those in equity, debt, and alternative assets, carry certain risks, notably potential liquidity and transparency issues associated with many private investments. These risks should be considered in the context of an individual investor’s objectives and risk tolerance.
The views expressed are those of Third Wire as of the date of publication and are subject to change. The information has been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed.
Past performance is not indicative of future results. Investors are advised to consult with qualified financial, legal, or tax advisors before making any investment decisions. Third Wire does not accept liability for any loss or damage arising from the use of this newsletter.
By subscribing to this newsletter, you agree and acknowledge that Third Wire is not liable for any decisions made based on the information provided herein.
