Author: cvernon

The DPI Lie?

There are multiple ways to gauge how private markets managers are performing, such as benchmarking returns relative to their peers within their respective vintage years. Net internal rate of return (“IRR”), total value to paid in capital (“TVPI”), and distributed to paid in capital (“DPI”) are measurements that are among the most common. DPI is calculated as a ratio of cash returned to cash paid by the investors and is the one metric of the three that cannot be manipulated via subjective valuations. This metric is also not impacted by time. In effect, DPI does not lie… Or does it?

In 2023, distributions from private equity funds as a percentage of portfolio NAV stood at 11.2%, which represents the lowest figure since 2009. Given the slow exit environment over the past 18 months and the quick deployment pace of 2021 and 2022, many general partners are using creative methods to return capital to investors in advance of their next fundraise (absent a true exit). These methods include net asset value (or NAV) loans and continuation vehicles. Alternative methods of liquidity like these will engineer a boost in DPI in the short term but may increase risk and dampen overall returns as net capital outstanding contracts.

While deal activity remains depressed relative to 2021 and 2022, 2023 marked a return to normalcy relative to long-term average levels. This could mean that the pace of exits isn’t far behind, and DPI will remain private equity’s most veracious performance metric.

Long and Variable Lags

The Federal Reserve has waged an aggressive campaign against elevated inflation in recent time, having raised its policy rate from near 0% to over 5% in just over one year. These actions represent the fastest pace of tightening in the history of the central bank. Since the Fed began hiking in the first half of 2022, readings of core CPI, which strips out more volatile components of the headline CPI calculation like food and energy prices, have retreated from a peak of over 6.5% to roughly 3.9% as of the time of this writing. While this moderation of core inflation has led to increased (and perhaps overly) positive sentiment on the part of many investors, it is important to remember that the battle against high price levels has not yet been won. The week’s chart attempts to underscore that point by highlighting the amount of time it has taken for peak inflation to reach more trough-like levels (i.e., those closer to the long-term median core CPI reading) over the last several decades. Readers may be somewhat disheartened to learn that it has taken an average of around two years for inflation to go from peak to trough, with the last two instances requiring roughly three years. For context, the peak figure from the current cycle came 17 months ago.

As it relates to the reason for these long-lasting campaigns against inflation, Fed Chair Jerome Powell has noted the “long and variable lags” with which monetary policy often acts. According to the Fed, one explanation of these lagged effects is that many economic transactions involve prices and quantities that are agreed upon months in advance by the buyer and seller. If these agreements occur in advance of significant changes in monetary policy, they will naturally not be influenced by new levels of interest rates. Additionally, the Fed has noted that lags may arise from the “inattentiveness” of business owners, who may set prices on an infrequent basis to avoid “menu costs,” or the costs associated with price updates. Such behavior would lead the current economic reality to be unreflective of the current monetary policy. Whatever the reasons for the lags detailed above, precedent clearly shows that it may take additional months for inflation to retreat closer to long-term average levels, which may lead to an environment of higher-for-longer interest rates.

Looking ahead, the CPI figure for February is scheduled to be released on March 12. This reading will likely prove informative as investors attempt to determine future actions of the Federal Reserve, which is currently expected to cut rates three to four times this year. Interestingly, market participants expected as many as six rate cuts in 2024 just a few months ago. Marquette will continue to monitor the macroeconomic landscape and provide updates to clients accordingly.

Show Some Maturity

As interest rates remain elevated, some market participants have questioned the extent to which the maturity wall in the below investment grade fixed income market is a sign of increased risk. On paper, concerns related to the maturity wall are understandable, as high yield and leveraged loan issuers face higher financing costs due to increased credit risk. Further, these companies could struggle to refinance debt as it matures and, as a result, incur much higher interest expenses in the future. These dynamics may lead to an eventual increase in default rates and create headwinds for fixed income performance.

In recent time, however, there have not been significant issues when it comes to below investment grade issuers refinancing debt and extending maturities. Since the beginning of 2023, the amount of high yield and leveraged loan debt maturing in 2024, 2025, and 2026 has been reduced by a combined $472 billion, which constitutes roughly 17% of the current market for outstanding high yield bonds and leveraged loans. Additionally, the pace of refinancings and the reduction in impending maturities has only accelerated over the more recent term, as issuers took advantage of lower interest rates in the fourth quarter of last year to term out debt. To that point, more than $54 billion of high yield and leveraged loans have been refinanced over the past three months alone. This is roughly double the pace of 2022, during which $28 billion was refinanced every three months, and nearly five times the $11 billion being refinanced every three months in 2021, during which the market for new issuance was almost non-existent.

Although refinancings abound in 2024, concerns related to impending maturities are not entirely unfounded. Over the next three years, over 21% of the below investment grade market is scheduled to mature. While this number is down slightly from year-end, it remains close to recent-term highs. However, this increased pace of refinancings is a welcome sign for fixed income markets broadly. Fundamentals remain resilient in the below investment grade space, and this resilience will likely allow companies to bear higher interest costs and continue to extend out maturities to time periods that may exhibit more rate favorability.

If the Treasury Curve Could Talk

While most of Marquette’s research is written in the third person, this edition of our Chart of the Week series endeavors to anthropomorphize a key feature of the financial system to provide a unique perspective on the current state of capital markets. The following is what readers might expect to hear from a sentient Treasury curve, which is currently suffering from a prolonged inversion.

I just want to feel “normal” again.

For most of my life, longer-dated bonds have provided higher yields than those with shorter maturities. This is often the case since investors expect increased compensation for the increased risks (e.g., higher duration, lower liquidity, etc.) associated with holding long-term bonds, and I am considered upward sloping and normal when these factors are at play. On certain occasions, however, I have been upended as a result of the reversal of those dynamics, though I have usually been able to snap out of those periods of inversion relatively quickly. To that point, the average length of my inversions was less than one year prior to my current funk, which began in July of 2022 and has yet to abate. During this painful time, the 2-Year Treasury yield has been higher than that of the 10-Year by an average of 54 basis points. Put simply, I feel stuck.

The last time my inversion was this prolonged or this extreme was during a period of roughly 20 months beginning in the late 1970s amid rampant stagflation. Led by Paul Volcker, the Federal Reserve began aggressively raising the federal funds rate in 1978 to combat elevated price levels, and these efforts led to an acute inversion of more than 200 basis points. I was offered a brief respite in May of 1980, but this period of normalization lasted only a few months before short-term rates started moving higher once again. You may remember this period as the “double-dip recession,” but I think the “double-dip inversion” is just as apt a descriptor given my behavior! I have inverted on a few occasions since that difficult time. Specifically, I became inverted again in the late 1980s after a lengthy peacetime expansion drove inflation higher and the federal funds rate increased as a result. Still, that inversion lasted less than a year, as then-Fed Chair Alan Greenspan was forced to cut rates to mitigate a recession that began in 1990. I next became inverted when the Fed increased rates in the early 2000s after the longest period of domestic economic growth to that point. This inversion lasted around seven months before Greenspan came to the rescue once again by cutting rates following the busting of the Dot-Com Bubble, a fall in business investing, and the September 11th attacks. When I became inverted in the lead-up to the Global Financial Crisis, it was Ben Bernanke who straightened me out after just six months.

As I mentioned earlier, my current inversion is particularly pronounced relative to my history, and I have spent the last several months asking myself the following question: How can I get out of this predicament? In theory, longer-dated yields could increase and restore my normalcy, however market participants have such strong demand for long-dated bonds at present that those yields may be range-bound. With that in mind, an appeal to Jerome Powell to lower the federal funds rate may be my only hope. This being the case, you can imagine my dismay at this week’s CPI reading, which came in hotter than expected at 3.1% on a year-over-year basis. Until we see inflation inch closer to the 2.0% target established by the Fed, I believe that Powell will likely hold short-term rates at their current levels and my inversion will continue.

A Primer on Alternative Credit

Alternative credit, also referred to as private credit or private debt, has emerged as an area of significant interest for investors in recent time, offering attractive returns and distinct advantages compared to liquid credit markets across an array of strategy offerings. Over the last decade, alternative credit managers have stepped in to play a critical role within lending markets as traditional lenders (i.e., banks) have retreated in the face of liquidity constraints, more stringent regulatory requirements, and higher borrowing costs. As bank retrenchment has intensified, non-traditional credit providers have gained further prominence by offering stable, efficient, and long-term sources of funding for borrowers while also generating attractive returns for investors. Indeed, the leveraged credit market has grown rapidly since the Global Financial Crisis, evolving into a return-enhancing asset class with diversification benefits relative to public fixed income. Given current trends related to supply and demand for capital, as well as the efficiency with which providers can supply favorable loans within corporate capital structures, we expect alternative credit strategies will continue to offer attractive opportunities for investors going forward. However, while the broad opportunity set is particularly attractive, it is important to note that there are many types of strategies that fall into the alternative credit category, and each of these strategies offers varied risk, return, and liquidity characteristics. As it relates to risk broadly, investors should understand how the economic cycle, illiquidity risks, default rates, and increasing competition for deal flow can impact the asset class.

While Marquette has been an active participant in alternative credit markets for many years, the proliferation of the asset class and the expansion of offerings available to investors of different profiles serve as an impetus to examine the space in further detail. The aim of this whitepaper is to provide a background on the alternative credit space, highlight some of the key drivers of return and risk across various alternative credit strategies, and outline the prospects of the asset class going forward.

Another (Down) Round

Venture-backed companies tend to be nascent and typically deploy investment capital in an effort to drive revenue expansion, often to a point at which they are losing money. Given this profile, these businesses must raise new capital every few years to fund future growth. In normal circumstances, each capital raise is conducted at a higher valuation, assuming the company remains financially viable. That said, there are occasionally instances in which the market’s perception of valuation has materially changed or the company is not achieving specific growth targets. Cases like these, which are referred to as down rounds, result in companies being forced to raise capital at lower valuations than the ones exhibited during the most recent fundraising period.

Many venture-backed companies raised capital in 2020 and 2021 at relatively high valuations. Since that time, a significant portion of those companies have seen cash levels depleted and are now returning to the market in order to fund operations for the next few years. However, today’s market environment looks quite different from those of 2020 and 2021, which means these companies are being confronted with much lower valuations as they attempt to raise capital. As displayed in this week’s chart, these dynamics have led to a steady increase in the number of down rounds over the last several quarters. To that point, down rounds (as a percentage of all fundraising rounds) hit a new high of nearly 27% in the third quarter, which is more than double the long-term average.

The trends depicted in the chart above are likely to lead to some disappointing returns for venture capital funds with vintages from 2018 through 2021, as these funds deployed significant amounts of capital during those years and now face a more challenged valuation landscape. On the bright side, these dynamics may present an opportunity for funds with more recent vintages and fresh capital to invest at more attractive valuation levels. Marquette will continue to monitor developments within the venture capital space and provide recommendations to clients related to existing exposures and future commitments.

A Tale of Two Emerging Markets

While Chinese equities have largely languished in recent time amid robust performance of Indian stocks, it is important to note that these dynamics were quite different just a few years ago. To that point, the MSCI China Index outperformed its Indian counterpart by roughly 45% on a cumulative total return basis between 2016 and 2020. During that period, global investors were optimistic about the growth prospects of many Chinese companies and benefitted from an expanded opportunity set given the addition of local market shares to the MSCI Emerging Markets Index. Chinese stocks grew to comprise nearly 40% of the benchmark at the end of 2020 as a result of these developments, which caused many market participants to wonder if China should still be considered an emerging country.

As most readers are likely aware, these trends have shifted dramatically in the last few years. Since the start of 2021, the MSCI China Index is down roughly 50%, as the country has presented investors with myriad headwinds including changes to the regulatory environment, increased government debt, a challenged property sector, heightened geopolitical tensions, and a weaker-than-expected post-pandemic economic recovery. In contrast, the MSCI India Index has returned more than 60% on a cumulative basis over the last four years. Market participants have been drawn to India due to its strong structural growth story which centers on favorable demographics, government reforms, and robust economic expansion. As a result of increased investor attention and equity market appreciation, the weight of Indian equities within the EM benchmark has roughly doubled since 2016. Going forward, continued growth may push Indian equities higher, though many investment managers are now becoming wary of current valuations. Many Chinese stocks, on the other hand, are trading at historically low multiples and facing extreme levels of negative sentiment. These dynamics could lead to a reversal of the trends outlined above in the near term.

As it relates to investing in emerging countries, it is important to highlight the need for patience and diversification given the variability of returns associated with the asset class when compared to most developed markets. Investors should also consider the use of actively managed strategies within the space due to return dispersion and the demonstrated ability of most managers to beat the MSCI Emerging Markets Index over long periods of time. Marquette will continue to source best-in-class managers within the asset class, monitor performance trends, and provide recommendations to clients accordingly.

2024 Market Preview Video

This video is a recording of a live webinar held January 25 by Marquette’s research team analyzing 2023 across the economy and various asset classes as well as what trends and themes we’ll be monitoring in the year ahead.

Our quarterly Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real assets, and private markets, with commentary by our research analysts and directors.

Sign up for research alerts to be invited to future webinars and notified when we publish new videos. If you have any questions, please send us an email.

2024 Market Preview: A 40 Degree Day

A former colleague once described his brother-in-law to me as a “40 degree day.” The puzzled look on my face revealed my unfamiliarity with the term, so he went on to ask me: “When does anyone get upset about a 40 degree day?” I laughed and shook my head — it was genius, the perfect way to describe something more forgettable than memorable…not especially good or bad, just average.

Given what markets have been through over the last four years — COVID, outsized returns both good and bad, record inflation, sky-rocketing interest rates, geopolitical conflict, and elevated volatility — I know I’m not alone in hoping that 2024 market returns will resemble a 40 degree day. Indeed, an “average” year of returns across markets will equate to positive portfolio performance for most asset allocations and allow investors to satisfy their risk and return goals.

Of course, there are potential stumbling blocks to a “normal” year. In particular, we will closely watch the Fed pivot and the disparity between expected and actual rate cuts, geopolitical conflicts, and the U.S. presidential election.

With that as background, we offer our annual outlook across asset classes, highlighting trends and themes for the year ahead. Happy reading and here’s to a year of normalcy!

Lost in Transaction

The 10-year Treasury yield notably displayed significant movements throughout 2023. Specifically, it was largely range-bound over the summer (between 3.5%–3.8%), then shot up to around 5.0% in October before falling back down to under 4.0% before year-end. It currently hovers slightly above 4.1%. Thanks in large part to these movements in yields, the real estate market seized up and very few transactions occurred in the fourth quarter of last year. As a result, the full calendar year of 2023 exhibited the lowest transaction volume in the last five years. Limited transactions in the market provide a hurdle for real estate managers and third-party appraisers to accurately determine asset values. As such, the pace of contraction for the private real estate index NCREIF-ODCE has been choppy, with the latest quarter responsible for nearly one-third of the benchmark’s gross return correction of -16.4% since late 2022.

Quarterly returns for the underlying index managers have been volatile in recent time as well. Based on a sample of 18 of the 25 ODCE index funds, the average spread of gross returns over the last five quarters has been nearly 6 percentage points. For context, the longer-term spread is closer to 4 percentage points. Additionally, each fund in that sample has underperformed the ODCE benchmark in at least one of the last six quarters. These figures underscore the notion that recent marks have displayed an elevated degree of dispersion and noise.

Even with the considerable drop in valuations, real estate fundamentals remain relatively healthy outside of the office space. Most do not believe assets are broken, and rent growth still exists within the multifamily, industrial, and self-storage sectors (albeit at lower levels than in prior years). As it relates to the road ahead, real estate investors should remain patient as market dynamics play out. To that point, it may take several quarters for buyers to come off the sidelines, after which more transactions can occur and ultimately be reflected in valuations. Marquette will continue to monitor the real estate landscape while emphasizing the importance of prudence and a long-term perspective.