Alternatives: Stabilizing in a shifting world

Like the broader economy, 2025 should be a year of normalization in alternatives. New norms are taking hold; the democratization of alternatives means they should play a key role in portfolio construction for both institutions and individuals, while emerging global themes and structurally higher interest rates could reshape asset demand. Moreover, easier monetary policy should allow activity in the most distorted markets to gradually normalize.

As the Federal Reserve cuts rates, exit activity in private equity could improve. Green shoots are apparent with exit values up ~51% y/y through 3Q24⁵, although this is due to sellers bringing their highest quality assets to market. On a count basis, exits have only modestly recovered. Still, lower rates and better access to debt financing should help buyers and sellers find a better balance. Moreover, a more business-friendly regulatory backdrop under the incoming administration should fuel a continued recovery in exits via M&A. As lower quality deals come to market, however, valuations may come under pressure, benefiting new fund vintages but creating challenges for legacy assets. With rates unlikely to return to 0%, we would favor small-to middle-market companies given their lower dependence on leverage for returns, while secondaries remain an attractive way to gain instant exposure to mature assets.

Dynamics in commercial real estate are improving but unevenly. Valuations across most sectors are stabilizing (Exhibit 1) and may continue to as monetary policy loosens. Fundamentally, office remains challenged while industrials and multifamily look attractive, although there are regional divergences. Nevertheless, managers with liquidity can seek quality assets at attractive prices as valuations turn the corner. Those well-positioned for shifting demand in a post-pandemic world, like data centers or logistics properties, are especially compelling. Moreover, opportunistic investors may look to deploy capital as assets are brought to market by existing owners reluctant to refinance at higher rates. All that said, the outlook for real estate is murkier after the election, and it remains unclear whether a more favorable regulatory backdrop can offset the impact of persistently higher mortgage rates.

Unlike real estate, private credit has yet to see a cyclical correction. Defaults have trended higher in recent quarters but remain low, although elevated amend-and-extend activity points to a building credit cycle (Exhibit 2). Moreover, increased bank lending, which could be further boosted by deregulation in the banking industry, could force direct lenders to focus on lower quality borrowers, pressuring default rates higher. That said, while returns may retreat alongside policy rates, investors searching for enhanced yields should continue to find them in private credit. 

As short-term interest rates settle at more normal elevated levels and as policy uncertainty increases, volatility across financial markets could remain elevated. Both dynamics should benefit hedge funds, which can provide diversification and the potential for enhanced returns. Meanwhile, investments in infrastructure and transportation can provide stability via steady income. Even as we usher in a new administration and policies, these assets should continue to benefit from long-term secular tailwinds such as supply chain shifts, AI infrastructure build-out and the energy transition (particularly increased electricity consumption).

Given rich public market valuations, lower bond yields and positive stock/bond correlation, investors should leverage alternatives to enhance portfolio return, income and diversification. Importantly, “alternatives” is one word used to describe asset classes with a variety of different characteristics. They can diversify not only public market exposure, but among themselves as well.

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