Alts may face dry spell in 2022 after 10-year ride

Alternative investment managers rocked it last year, with assets under management soaring in most sectors — but that party is now over.

Direct lending AUM grew 580% in the year ended Dec. 31 to $15.8 billion; master limited partnerships grew 98%, albeit from a small basis, to $1.8 billion; mezzanine debt was up 48% to $7.3 billion; privately placed debt rose 35% to $116 billion; and private equity was up 26% to $42.8 billion, all according to data from Pensions & Investments’ 2022 survey of money managers.

Real asset AUM gains were also in the double digits in 2021, with real estate investment trusts up 23.8% to $163.1 billion, while infrastructure grew by 22% to $48.5 billion and equity real estate was up 14.1% to $436.4 billion.

That was oh so 2021, managers say.

As the champagne glasses were stowed away from New Year’s Eve celebrations, so too, it seemed, were the good times that have rolled on for a decade. Some managers are now wondering if public markets volatility and rising inflation and interest rates will result in their giving back some of the AUM gains they enjoyed last year. Making it an even more challenging investment environment is that nobody is certain, really, what to expect in the coming weeks or months — let alone the remainder of 2022.

While alternative investment return data has not yet been released, research firm PitchBook said in its first quarter 2022 private equity report that it expects returns for the larger funds to suffer the most because bigger, $1 billion-plus companies are more easily valued by using public company comparisons and are more likely to exit by going public. Meanwhile, market indicators aren’t pretty. Inflation is up to 8.3% for the 12 months ending April 30, a smaller increase than the 8.5% for the 12-month period ending at the end of March, according to the most recent release by the U.S. Bureau of Labor Statistics. By comparison, inflation was 7% in 2021 and 1.4% in 2020.

The challenge is that current market conditions can lead people to draw different conclusions, said Peter Hayes, a London-based managing director and global head of investment research at PGIM Real Estate.

A person could be “super bearish” or bullish, considering that market volatility and inflation are the result of shutting down the world’s economies and countries emerging out of a global pandemic, said Mr. Hayes, who earlier in his career was a U.K. economist at the Bank of England.

PGIM is the $1.3 trillion global investment management business of Prudential Financial Inc. Its real estate business, PGIM Real Estate, is in first place on P&I’s list of managers of real estate investment trusts, with $33.7 billion in U.S. institutional, tax-exempt REIT assets as of Dec. 31 — up 19% from $28.3 billion a year earlier, the results of P&I’s money manager survey shows. PGIM Real Estate reported $6.8 billion in equity real estate AUM as of Dec. 31, a 23.6% increase from $5.5 billion year-over-year, P&I’s 2022 manager report shows.

Managers across the alternative investment spectrum anticipate fundraising, transactions, valuations and exits will be slower this year than in 2021.

Said Michael Arougheti, New York-based co-founder, CEO and president of Ares Management Corp., “We see a slowdown in activity as private markets adjust to the new pricing environment.”

According to Preqin, 2,012 private equity deals worth a combined $185.4 billion and 201 private credit transactions totaling $54.8 billion closed worldwide in the first quarter. That’s down from 2,265 private equity transactions with a combined value of $200.5 billion and 400 private credit deals worth $63.3 billion in the quarter ended March 3, 2021.

“I would expect to see private market valuations start to come in, but not to the same severity of the public markets,” Mr. Arougheti said.

Returns vary based on the size of the fund. The 10-year internal rate of return was 19% for private equity funds with more than $1 billion or more in total capital commitments, 17% for funds with $500 million to $1 billion, 16% for funds $250 million to $500 million,12.4% for funds under $250 million as of Dec. 31, according to PitchBook Data.

Ares is in the second spot on P&I’s list of buyout managers in U.S. institutional, tax-exempt AUM with $7.7 billion as of Dec. 31, up 13% from $6.8 billion at the end of 2020. Ares is also in the second position for managers of U.S. tax-exempt assets in distressed debt, with $2.2 billion as of Dec. 31, up from $1.2 billion as of Dec. 31, 2020; and for managers of energy assets, although assets were down to $711 million as of Dec. 31, from $847 million in 2020.

Mr. Arougheti said he also expects fewer exits.

“Industrywide realizations across the entire private market are likely going to slow,” he said.

Even private debt, which had been building momentum with AUM up 51.3% over the five years ended Dec. 31, has been impacted by current market conditions.

“There’s been a slowdown in transaction activity,” said Kipp deVeer, a New York-based director and partner at Ares and head of the Ares credit group. “We have flexible capital and take a patient approach to new investment opportunities.”

However, Mr. deVeer said that market volatility has also provided investment opportunities for Ares’ credit business, making other debt providers such as banks more cautious.

Adding to their jitteriness, on May 4 Federal Reserve officials raised interest rates by a half-percentage point with the Federal Open Market Committee raising the target range for the federal funds rate to a range of 0.75% to 1%.

“We have been able to step into transactions with private capital that were originally syndicated bank deals that didn’t materialize,” said Mr. deVeer, who is also a director and CEO of Ares’ publicly traded business development company, Ares Capital Corp.

“Banks are more hesitant to syndicate loans right now,” he said. “We are largely a buy-and hold investor so we have no requirement to syndicate.”

A slowdown in transaction activity can provide investment opportunities for other parts of Ares’ business, Mr. deVeer said.

When there are fewer transactions and exits, “that’s when structured secondaries and opportunistic credit can come in as a source of liquidity,” Mr. Arougheti said.

However, alternative investments are resilient even in difficult markets, he said.

“One of the beauties of the private markets is that nobody is a forced seller,” Mr. Arougheti said. “If you own a good company, you just own it longer.”

In real estate, PGIM Real Estate’s Mr. Hayes does not expect to see a pause in transaction volume reflecting today’s economic environment until later in the year, when the lag in reporting numbers begins to show up. Then, if inflation comes down, transaction volume is likely to go up again, he said.

But measuring inflation is “complicated” even for the world’s central banks, Mr. Hayes said, with the pandemic impacting “how reliable the inflation numbers really are.”

That makes decisions as to whether to increase interest rates very tricky — and the knock-on effect for real estate and other alternative investment managers is that higher interest rates mean increased cost of capital, he said.

However, there are investment opportunities ahead for real estate managers, especially needs-based properties such as housing, warehouses and data centers, Mr. Hayes said. For apartments and logistics, metropolitan areas in the Sun Belt have outperformed in recent years but PGIM Real Estate executives say that coastal cities are now attractive due to rising employment and limited supply. What’s more, aging populations create a need for more senior housing.

Ronald Dickerman, New York-based founder and president of $8 billion real estate manager Madison International Realty, said his firm has tilted its portfolio away from retail and office and toward more growth assets such as tech-enabled, single-family rentals, life sciences and cold storage.

However, his view of the real estate market is less rosy. Mr. Dickerman said that managers including Madison International Realty already are pausing transactions amid a secular repricing of real estate assets. He said he’s seen a number of failed transactions and lenders changing debt quotes. And he thinks things will get worse and so is proceeding with caution, he said.

“It’s pretty remarkable. We’ve come out of the woods in COVID and then the woods catch on fire” with the war in Ukraine, among other issues, Mr. Dickerman said.

“We’d been living in this Goldilocks world. Super low interest rates had been the ultimate subsidy for real estate,” he said. Madison International did not participate in this year’s survey of money managers.

Higher interest rates make financing investments more expensive and finding fixed-rate debt critical.

In a recent study on the migration of people around the world and its impact on real estate, LaSalle Investment Management indicated that the pre-pandemic trend of people gravitating to cities will continue after the COVID-19 crisis is over. This return to cities would be positive for the multifamily and retail sectors, the report said.

In the U.S., the question is how much of the movement of people during the pandemic out of big cities like New York and San Francisco was the result of COVID-19, how much was for economic opportunities and how much was part of a structural shift of people moving to lower-cost states such as Arizona from higher-cost states such as California, Illinois and New York, said Jacques Gordon, Chicago-based global head of research and strategy at LaSalle Investment Management.

“There’s an unmistakable move to the Sun Belt,” Mr. Gordon said.

Indeed, a move to lower-density Sun Belt states in 2021 fueled apartment demand, LaSalle’s study showed. However, this trend is slowing. As pandemic restrictions recede, more people are moving back to cities such as Los Angeles and New York, even though the high costs of living in these cities could slow growth, the study said.

A decade ago, LaSalle looked at the cost structure of cities and states, determining that high costs could dampen growth if there were an economic slowdown, Mr. Gordon said.

“We’ve actually steered most investments to low-cost cities,” he said.

LaSalle’s worldwide assets under management across asset classes grew 9.73% in the year ended Dec. 31, to $77.8 billion. LaSalle’s AUM managed for U.S. institutional, tax-exempt investors rose by 26% to $18.7 billion, according to P&I survey data.