Alts managers search for opportunities

Alternative investment managers agree that very few scenarios anticipated at the dawn of the pandemic have come to pass, with even the trends that accelerated doing so in unexpected ways.

One of the biggest is that widespread distress — even in real estate — has yet to materialize due to government stimulus and open capital markets. Indeed, the distress window opened just a crack for a period of less than a month at the onset of the pandemic last March, but it was all on the public markets.

"When the world collapsed, our first inclination was that there's so much uncertainty but there is likely to be stress and distress in the system," said Nimisha Srivastava, Chicago-based global head of credit at Willis Towers Watson PLC.

Willis Towers Watson executives were not sure how or in what form the stress and distress would take, she said. Many of the opportunities were on the liquid side, Ms. Srivastava said.

"You didn't need to be a rocket scientist to buy high yield in March and April," Ms. Srivastava said.

Through its OCIO business, the firm added to high yield positions with fallen angels, liquid securities that had been investment-grade but were reduced to below-investment-grade bond status.

Industry executives also thought that commercial real estate debt was likely to present a "decent opportunity," she said. Again, no one knew what form the opportunity would take: direct real estate assets, rescue financing or commercial mortgage-backed securities investments, Ms. Srivastava said. That didn't happen either, she added.

The reasons were the growing amount of capital raised in distressed funds, increasing competition and the fiscal stimulus by governments, mitigating any real systemic stress, Ms. Srivastava said.

In 2020, 37 distressed investment funds raised a combined $46.7 billion, according to Preqin. Most of the capital was raised in the fourth quarter when 18 distressed funds held final closes on $35 billion, Preqin data show.

"It did not leave much opportunity for managers to play" in the stressed and distressed arena, she said.

Distressed debt assets under management for U.S. institutional, tax-exempt clients grew 42.6% to $13.7 billion in the year ended Dec. 31, results of Pensions & Investments' annual survey show. Assets of the largest distressed debt manager, Oaktree Capital Management LP, rose 36.2% to $10.7 billion. In April 2020, Oaktree announced its intention to raise the largest distressed debt fund in history, $15 billion for Oaktree Opportunities Fund XI, according to a Preqin report.

So far, the fund has raised $14.7 billion, with 50% invested or committed to public and private market investments, said Nicholas Goodman, managing partner and chief financial officer of Brookfield Asset Management, which owns a majority of Oaktree, on a May 13 Brookfield earnings call.

So far in 2021, as of May 21, nine distressed funds raised $3 billion, which is a fraction of the $11 billion in capital raised by 17 distressed funds in the first two quarters of 2020, according to Preqin.

However, not just specialist managers can make distressed investments. Credit funds that had broad mandates, allowing them to make a combination of liquid and illiquid credit investments, continued fundraising, Ms. Srivastava said.

The story was the same across real asset segments, managers said. The top money managers' real estate equity AUM for U.S. institutional, tax-exempt investors tumbled by 13.7% to $379.7 billion in 2020, infrastructure AUM was relatively flat at $39.9 billion and real estate investment trust AUM fell by 3% to $122.8 billion.

"There wasn't a significant sustained decline in valuations, apart from a few sectors in real assets," said Anne Valentine Andrews, New York-based managing director, global head of real assets at BlackRock Inc.

BlackRock had $7 billion in real estate AUM for U.S. institutional, tax-exempt investors as of Dec. 31, flat from the end of 2019, according to P&I data.

"If you asked back in March (2020), we might have expected more" valuation declines, she said.

Instead, the trends that existed before the COVID-19 crisis escalated much faster during the pandemic, including a "huge acceleration" of ESG-focused investments, she said.

Real asset strategies that are poised to do well include renewable energy, telecommunications, digitalization as well as investments to take advantage of demographic trends such as investing in senior living, Ms. Andrews said.

In 2020, BlackRock raised $12 billion, its biggest fundraising year ever in real assets, she said. However, transactions dropped in 2020, recovering in 2021, "given the dry powder and managers' deployment needs," she said.

What helped real asset sectors is that unlike during the Great Recession, the capital markets remained open, Ms. Andrews said.

"It was easy to get a bit of a runway for assets," she said.

Lenders were willing to make deals with borrowers to give them time to work out issues they had and there was capital available to tide investors over.

"Everyone was vying for time to see how (the pandemic) would all play out," she said.

Lenders weren't too worried if an asset had a short-term revenue hit, Ms. Andrews said.

For example, BlackRock has some airport and toll road investments, mostly in its debt portfolios, she said. The biggest question that nobody had the answer to was when would the traffic return, even though everyone thought the travelers would return eventually, she said.

"They just needed to ride out the storm — not that anybody prepared for zero revenue," she said.

One of the big surprises has been the divergence of performance within real estate sectors, said Lee Menifee, Los Angeles-based managing director and head of Americas investment research at PGIM Real Estate.

Prudential Financial was the top-ranked manager of real estate investment trusts for U.S. institutional, tax-exempt investors with $28.3 billion in AUM, flat from a year earlier, and 20th for equity real estate with $5.5 billion, up 13.7% from 2019, according to P&I data.

"We went into the downturn expecting a downturn in apartment demand and expecting it to play out like a typical recession with job losses and income losses," Mr. Menifee said.

Instead, urban apartments were negatively affected even more than anticipated, while suburban multifamily held up more than expected, with only a fairly short and minor recession, he said.

But PGIM executives do not expect this trend to last.

"What we really think, ultimately, is that it (the pandemic) will have more of a transitory effect on urban markets," Mr. Menifee said.

Suburban apartment markets behaved pretty consistently with a downturn that was very, very sharp with a lot of stimulus spending, he said.

"To us, with the benefit of hindsight, the sharpness of the urban apartment market downturn seems disproportionate to the underlying demand," Mr. Menifee said.

Rents have already hit the bottom in all urban markets and are on the way back up, he said.

"This is kind of remarkable because the office recovery hasn't really happened yet," Mr. Menifee said.

The return to urban apartments is happening in advance of offices being open, he said. "That tells us that housing, in general, remains very strong," Mr. Menifee said.

The biggest question mark is the office sector.

"Office, by far, is the biggest bogeyman in the room," said Michael Levy, Dallas-based CEO of real estate investment firm Crow Holdings.

"In the (start of the) pandemic people said that nobody will come back to the office again, (but) I am not so sure they are right," he said.

Still, most of the investment capital is favoring multifamily and industrial with little investment in office due to the "tremendous uncertainty," he said.

"Businesses will expect employees be back to work in the office in September when children are back in school," Mr. Levy said. "Society is lining itself up post-Labor Day to get on with things."

Government stimulus has buoyed many alternative investment strategies.

Stimulus by the governments around the world, especially in the U.S., "really saved corporate America," said Kristofer Kwait, Wilton, Conn.-based co-CIO of Commonfund Asset Management Co., the firm's OCIO business with $14.2 billion in AUM.

What remained were some distressed and stressed investment opportunities in structured securities, mostly residential mortgage-backed securities, he said.

Some alternative investment managers including hedge funds that were in the middle of fundraising just stopped due to the lack of distress that they had anticipated, Mr. Kwait said.

"I think in credit there are not that many players that have the ability to move quickly and to be able to look across the space. Those managers put money to work," he said.

Private lending last year also slowed down significantly, Mr. Kwait said. The reason was that the buyers and sellers could not agree on terms. The buyer wanted terms based on the current situation while the lenders wanted to use pre-COVID-19 terms. Most of the lending was in the form of rescue financing designed to get the borrower through a rough patch.

The big surprise in hedge funds was how poorly quantitative funds performed, he said. Managers that relied on computer models "were beaten up by stock pickers," he said.

Indeed, strategies designed to provide downside protection experienced significant drawdowns at the start of the pandemic, said Julia Bonafede, co-founder and head of investments at alternative money management firm Rosetta Analytics Inc., based in Minden, Nev.

"March and April 2020 proved the limitations of designer beta and leverage that underpins the majority of marketable alternative investment strategies," which are hedge funds that invest in public markets, liquid alternatives and liquid investment strategies, she said.

"The inability to identify and allocate persistent patterns in data because of the continued use of decades old investment frameworks will continue to manifest in underperformance, especially in times of market stress," she said.

Worldwide hedge fund assets declined 1.3% to $666 billion over the year, according to P&I data.

Another unexpected impact of the pandemic came in certain sectors of private equity, said Scott Sussman, partner at private equity firm Sole Source Capital LLC.

"There is a lot of technology that came to the forefront out of the pandemic," including in solutions such as automatic identification data capture technology used in warehouses and stores' stockrooms to manage inventory, he said.

"What was less expected is those solutions (automatic identification data capture technology) moving from the back of the store to the front of the store," as a result of contactless pickup at grocery and department stores, he said.

Sole Source is also investing in barcode and shipping labels, growing areas in light of the boom in e-commerce due to the pandemic.

Also unexpected was an increase in deal flow due to the pandemic's impact on people using the time to take stock of their personal priorities.

"Many founders accelerated retirements because of COVID, and they used COVID as a time to reflect and figure out what they want to do with the next 20 years," Mr. Sussman said. "We are seeing a lot of entrepreneurs making the decision to sell, creating a lot of deal flow."