While interest rate cuts create generally supportive conditions for alternatives, the direction of interest rates should not be the only reason to invest.
The Federal Reserve in September cut interest rates by a quarter percentage point, and signaled the resumption of an interest rate cutting cycle that has been on pause since last December. Markets are expecting four more cuts to short-term rates over the next year. What does this mean for investors in alternatives?
Lower interest rates tend to be positive for risk assets, as investors are incentivized to move out of lower-yielding assets like cash. But each asset class has a different relationship to rates.
It's also important to recognize that while short-term rates are declining, long-term rates may not follow the same path. The long end of the yield curve is driven by factors that include concerns over rising inflation and the ever-increasing national debt. Many alternative strategies utilize a mixture of short and long-term financing, making their interest rate correlations more nuanced. In this context, the portfolio benefit of lower correlation to public markets that alternatives have is particularly valuable.
For private equity, cheaper financing can create a meaningful boost, particularly when combined with a business environment that remains firmly in growth mode. Lower borrowing costs allow buyout funds to employ more (and cheaper) leverage in their acquisitions, potentially enhancing returns. This environment encourages increased deal flow and M&A.
Venture capital also benefits from lower rates, though indirectly. Lower short-term rates can stimulate demand across the economy, supporting the overall growth prospects of VC-backed companies. Should longer-term rates also decline, venture investments — which are valued based on discounted cash flows extending far into the future — can become more valuable.
Private credit, consisting predominantly of floating-rate debt, faces direct sensitivity to rate cuts. Absent a deterioration in the economic backdrop, yields could move lower alongside policy rates. However private credit offers premiums over public debt, so on a relative value basis remains attractive. The other side of the coin is that borrowers gain breathing room, lowering default risks.
Real assets, characterized by long-duration and stable cash flows, are less sensitive to short-term rates. However, real estate and infrastructure offer an additional benefit in this environment: inflation hedging. Lower interest rates and stimulatory fiscal policies have the potential to provoke inflation. Property rents and income from infrastructure can grow in line with inflation. This ability of real assets to provide protection against purchasing power erosion, as well as lower correlation to public markets, is valuable in an environment of slower growth and higher inflation. If long term rates also trend downward, that could provide further support to real estate, coupled with ongoing supply constraints in the market as construction volumes have declined.
Hedge funds have a more nuanced interplay with interest rates. The volatility inherent in an uncertain rate-cutting cycle creates enhanced opportunities for alpha generation. Skilled managers can capitalize on arbitrage opportunities across markets. Cheaper financing can help some strategies, but the benefit may be offset by lower interest on cash posted as margin or on short-sale proceeds.
While interest rate cuts create generally supportive conditions for alternatives, the direction of interest rates should not be the only reason to invest. Investors should maintain focus on fundamental factors such as manager selection, strategy differentiation and the goals they are looking to achieve.