David Lebovitz:    Welcome to the Center For Investment Excellence, a production of JPMorgan Asset Management. The Center For Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.

Today's episode is entitled, macro pressures in private markets, and has been recorded for institutional and professional investors. I'm David Lebovitz, Global Market Strategist, and host of the Center For Investment Excellence. With me today is Jared Gross, Head of Institutional Portfolio Strategy for JPMorgan Asset Management. Welcome to the Center For Investment Excellence.

Jared Gross:    Thank you, David. It is a pleasure to be back again.

David Lebovitz:    Well, it's great to have you back today, Jared, to talk a little bit about macro pressures in private markets. So, with that, let's jump in. A lot of people think about private markets as being relatively insulated from the ebb and flow of economic and market volatility, but as you and I have been discussing, that is not entirely true.

And really, it's more about the lag between things that happened in the public markets, and that being reflected on the private side of the equation, particularly with respect to valuations, the bottom line being that eventually, private market valuations catch up to what we're seeing in the public markets in real time.

And so, I'm glad you're with us today. And what I'm hoping we can do over the next 15 or 20 minutes, is try to identify a number of pressure points that are going to impact private markets and private market investors, and try to clarify how and when these effects will become a little bit more visible, as up until this point, we're still patiently waiting for them to become visible.

Jared Gross:    Yes, you know, it's a really interesting time to observe that distinction between public and private markets. So, public markets have obviously adjusted pretty significantly this year. Fixed income, we've seen higher rates, wider spreads. Valuation is significantly lower, and therefore an attractive opportunity potentially for new capital to come in.

Equity is the same way. We've seen multiples decline significantly. Markets are off a lot. And if you have dry powder, obviously that's a great time to be an investor. Now, that's not to say we've hit the bottom, but certainly, in the public markets, that sort of price mechanism has adjusted fairly quickly in response to these economic conditions.

And as you said, in the private markets, it hasn't. Now, there's a couple of ways to think through that. One is that there's this really significant time shift that takes place between when capital is allocated and when the gains are realized.

And so, private investors who allocated capital several years ago, are probably going to be a little bit disappointed in that they're sort of harvesting those gains in a period that's much more challenging. But the flip side, of course, is that for money that's going into the markets today, they may find some really interesting opportunities.

We probably just have to be a little thoughtful about which sectors we look at, recognizing that it's a difficult operating environment. There's less favorable conditions in certain sectors, and financing costs, which are a huge part of private investing, are up significantly.

David Lebovitz:    Absolutely. And I think financing costs are something that, as I was thinking about this a little bit, are certainly a relatively pervasive risk across the private market landscape today. But before we dive in and talk about what's happening at the asset class level, I thought I might just provide a little bit of backdrop as to the way we're thinking about the outlook for the macroeconomy.

As we discussed a couple of weeks back, the monetary policy cycle is in full swing. We're seeing signs that the pace of economic activity is decelerating against the backdrop of inflation that has remained relatively sticky, and interest rates, which continue to move higher.

And the question that we keep on getting is really around peak inflation. What I would say is that inflation has peaked in the United States. Feels like it's in the process of peaking around the world, particularly in places like Europe, and the reality is that monetary policymakers, whether it be the Fed, the ECB, the Bank of England, so on and so forth, they continue to work quite hard to try to bring this inflation under control, and either maintain, or in some cases, restore their underlying credibility.

And so, when we think about the direction of travel here going forward, I think it's important to recognize that the inflation we're seeing is still young. I think it's premature to declare that we're embarking on a period similar to the 1970s, but we do recognize that it's going to take time for inflation to come back down to levels that are a bit more palatable for the Federal Reserve.

And we're most likely looking at, at a minimum, a slower growth environment in 2023, with the risk of recession continuing to rise here in the United States.

Jared Gross:    I think these macro questions are really interesting in their own right. But of course, ultimately, we're going to tie this back to how they will flow through into the private markets. On this issue of the Fed's response to inflation, I think it's really interesting.

You know, since Jackson Hole, obviously, there's been a significant shift in the market's perception of the Feds priorities. And it seems clear at this stage that inflation is the number one priority. Growth and jobs fall somewhere below that.

And certainly, protecting financial markets from price declines seems to be a distant memory at this stage. And I thought in the week of Jackson Hole, it was really interesting to hear Governor Mester speak, because I think she outlined what is probably the emerging consensus on where Fed policy is heading, which is, we're going to see higher Fed funds rate.

She articulated I think 4%, but it's probably going to be there for a while. So, maybe rather than a replay of say, the Volcker era, which was jack rates to the roof, crush the economy, and then quickly reduce them, we may be in for kind of a longer cycle.

And that's kind of an interesting question to sort of tease out, because how does that affect businesses and their health over a longer and more protracted Fed cycle?

David Lebovitz:    Exactly. It's almost like the Fed has been taking cues from the crypto world, you know, everybody talks about hold on for dear life. I think that's going to be very much the case when it comes to rates in 2023. Totally agree. The bar for cuts, extremely high.

It looks like they're going to get rates as high as they can, and then leave them there for as long as they can at the end of the day. And so, you mentioned earlier, the real question here is how this all links to investments and corporates and assets more broadly.

You know, a couple of things jump out at me. Clearly, there's a pass-through from slower growth into revenues. You mentioned the labor market. We're obviously seeing very robust wage growth there. That has an impact on margins.

We talked earlier about rates and the impact that that can have on financing costs. And the reality here is that some firms are going to be able to pass this along to the end consumer, but others, that may not necessarily be the case.

And so, with that said, maybe let's dive right in, and I'll kind of set the stage for the asset class, and then would love to get your perspective from more of an allocator's angle. You know, when we think about real assets in general, we still think that it makes sense to own real assets, even though inflation has peaked.

Yes, inflation is coming down, but it's still north of 8% here in the United States. And so, any asset that generates cash flows, which are relatively resilient to inflation, continues to make a lot of sense. From where we sit, we do recognize that slower economic growth in aggregate, probably means higher cap rates for real estate.

Higher interest rates obviously mean higher financing costs. But as we've seen over the course of the year thus far, the ability to pass along some of these higher costs to the end consumer, to the end user, is still a very effective way to offset inflation.

Jared Gross:    And I think real assets are a great place to start, and they've gotten a lot of attention over the last year or two as we anticipated a rise in inflation. And investors were, I think, reasonably thoughtful about adding to these asset classes for that reason.

But it's useful to kind of lift the hood a little bit and understand why they're resilient and what that means in terms of the investment thesis. So, there's basically two ways that real assets can generate cash flows that are resilient to inflation.

One is that you own contracted revenue streams that allow for pass-throughs of costs. Utilities are probably the most obvious example. Even defense contractors have some of this in their contracting. And while public firms can benefit from this, obviously you can buy stock and utilities and defense contractors and so forth. You get a lot of equity beta in the process.

And I think what makes this particularly attractive on the private side is that private infrastructure, and particularly infrastructure assets that are involved in power generation and distribution, are a real sweet spot here.

And almost echoing what you said earlier about the lag between public and private markets, the contracting process does not reset itself overnight. And so, while yes, inflation may have peaked in the near term from a macroeconomic data perspective, the ability of these assets to effectively capture that inflation spike and pass it through to investors who own them, is far from over.

And, you know, we can spend some more time on this perhaps in a little a bit, but when you think about private infrastructure, what you really want to own are operating businesses with scale, where you can link diversified generating assets, both traditional and renewable, into an established distribution channel. That's really what makes this work.

Owning a single wind turbine is a lot less interesting than owning a fleet of wind turbines that you can connect to a distribution network. And ultimately, we think that's really where the best gains are going to be found.

David Lebovitz:    I completely agree. I think the other thing that's interesting, and we talked a little bit about this on The Guide to Alternatives Web cast earlier in the week, but in private markets in general, you've kind of seen a movement away, within the investment community, a movement away from focusing on those trophy assets, focusing on those big-ticket items, and potentially overpaying for some of those assets, and focusing more on add-ons and platform creation, so on and so forth.

And I think, again, kind of that more nuanced approach to owning assets and bringing assets onto a platform, can generate benefits for investors over the course of time.

Jared Gross:    The other path - I mentioned the one with sort of these contracted revenue streams. The other way that real assets do this is by owning long-lived, capital-intensive assets that have long-term, high-quality leases. And of course, the trick there is, you have to have some scale.

You have to own enough of these assets that the pool of assets and the leases that they throw off, are resetting across time, because it's through that resetting process that you capture the upside from rising prices, and you insulate yourself from rising costs.

And you want to have visibility into the credit quality of the lessees, and you want to be to move in and out of individual assets and sectors across time to be able to optimize your portfolio. So, it's definitely a space where scale makes a lot of sense.

And I think, as opposed to infrastructure, here we're thinking a little more about say core real estate or even transportation assets, where it's not an explicit inflation pass-through in a contractual sense. It's leases that reset. And again, these broad attributes that we look for, scale, managing the portfolio across sectors and geographies, has enormous value. Flexibility to buy, to build, to own, to operate, and experience.

To be honest, when we're at these points in a market cycle, having managers who have been through previous market cycles, is enormously valuable, and it's been so long, not since we saw even just a downturn, because we can look back to the global financial crisis, but we saw an inflationary period.

There are very few managers out there who have lived and worked through a period of high inflation. And so, that skillset is critical.

David Lebovitz:    And I would actually take that one step further, and I think this is a great transition into a conversation around private equity. If you look at a lot of the private market data, it kind of best case, goes back to the early 2000s.

You know, you can get real estate further back. You can get private equity further back, but the more granular data doesn't certainly go back to the '70s or the '80s. It tends to cut a bit sooner. And so, a lot of these managers that people have become familiar with, have also been operating in a period characterized by a very low cost of capital, effectively zero, and that has made it very easy for them to make money by kind of throwing things at a wall because in a zero-rate environment, everything tends to stick.

And so, turning to private equity, again, from a macro perspective, and we've seen this on the public side to an extent as well, you know, higher inflation means that nominal revenues shouldn't collapse, but as we're seeing across the board, costs are key, and margins are getting squeezed on the public side.

Margins are going to be squeezed on the private side as well. It's important to remember that there's no forward-looking multiple or forward-looking earnings number in private markets. Everything is trailing. And so, a lot of the valuation that's done is based on what has happened, rather than what is going to happen. And I do think that you're going to begin to see reratings and valuations and write-downs here as we move into the end of 2022.

And then, obviously higher rates mean higher borrowing costs, both at the operating level, as well as at the fund level. And although cash flow has become the primary driver of returns over time, we do need to be cognizant of the fact that the backdrop overall, higher rates, higher wages, higher input costs, is going to be very different from the environment that we've been in over the past 10 years, which has been extremely friendly to private equity at large.

Jared Gross:    I think, starting with your first comment, that is, we're in a higher rate environment that we have not seen in a long time. The private equity industry has largely been built, at least in an environment of declining interest rates, and certainly for the last decade, in a period of extremely low interest rates.

And it's not clear exactly how that's going to ripple through the private equity landscape, but there's a few things we can say. First, large-cap LBO-style PE is going to be challenged here because, one, they rely more heavily on leverage to execute deals.

We've seen the trailing multiples of private equity deals at extremely high levels over the last couple of years, you know, north of 11 times EBITDA. And that's the warning sign. It also is interesting that the performance tends to correlate with BBB yields, which obviously are much higher right now, and certainly suggest lower performance going forward.

Some more internal stuff that will be interesting to watch, as financing gets more expensive, you probably expect to see a little bit less in the way of sort of subscription financing on the way in. That may ultimately accelerate capital costs, and investors will be putting money into these funds earlier.

At the back end, you expect slower exits because the multiples are lower. And until they recover, it's going to be harder for private equity sponsors to monetize their assets at an attractive level. That's going to lengthen the investment period.

That's going to reduce IRRs. So, I think we have to be mindful that while private equity an incredibly attractive asset class for a lot of fundamental reasons, some of the IRRs that we've become accustomed to reaping, are the result of this low-interest rate environment that we're no longer in.

And I'll certainly pass this back in a sec. I think the next place to take this is probably venture, where you're talking about the growthier end of the spectrum, the most distant cash flow streams that are going to be sensitive, if not directly to financing costs, since many venture companies aren't really borrowing a lot of money.

It's more of an equity investment, although it is interesting to observe that they are borrowing more than they have ever before. So, you know, interest rates are certainly not an irrelevant fact for them. But you can also just think about venture as sort of a portfolio of options.

I mean, these are a lot of call options you own. The option is way out of the money right now. And also, the concern is that sort of venture strategy of just owning a lot of different things and hoping for a couple of home runs, the correlation's going to be rising too.

And so, the diversification within that pool of venture assets is going to be much lower. And that's an interesting thing to contemplate as we put money to work. Now, again, right now, it's probably there are some interesting opportunities.

Companies may be weaker, may be more on the distressed side, but all of this kind of lagged effect of higher rates, is going to ripple through these private equity markets sequentially.

David Lebovitz:    Exactly. And I think at the end of the day, when the cost of capital is not zero, good business models can be differentiated from bad business models in a more precise way. And so, totally agree with those points on venture, and very much expect to see some weeding out, if you will, in terms of the ability of venture capitalists to focus on businesses that really have the potential, rather than, like you said, just kind of throwing a little bit of cash in everything and assuming that over time, it will work.

We've talked about the challenges from higher rates and higher financing costs, and what that means for multiples, so on and so forth. The flip side to that coin is that if you're a lender, higher rates can actually be your friend. And so, private credit to me is looking somewhat interesting in the current environment.

We've seen yields exhibit far more stability in the direct middle market space than we have in kind of the large corporate space over the course of the year thus far. We are hearing anecdotally that managers are less inclined to lend against cash flows, looking more to lend against physical assets, just kind of bringing in the risk in their portfolios.

But again, these higher rates certainly suggest that there's an emerging opportunity on the lending side of the equation. The one caveat to that is that inflation is north of 8%. And so, from a purchasing power perspective, or in real terms, obviously inflation is going to erode some of that yield that you're getting from a direct loan.

But what I would say in general is that it feels like you're getting a higher quality asset on the private side of the equation, than you are in the publicly-traded, broadly-syndicated finance markets today.

Jared Gross:    Yes, it's interesting. On the credit side, I think you have a much more direct comparison between what's available in the public markets, and what you can earn in the private markets. And for the last several years, when we saw very low interest rates and very tight credit spreads, the impetus for investors to go to the private credit market, was largely to generate higher levels of yield.

And while there are quality differentials, depending on which part of the public markets you're comparing yourself to, as we said at the beginning, public markets have adjusted right now. And so, when you look at high yield or IG credit and some of these other sectors, the relative yield benefit that you got a year or two years ago from going from public to private, is not as profound as it was.

And I think that doesn't make private investments bad. It probably - the margin makes them slightly less attractive relative to public, but it also means you have to be more selective about where in the private markets you go.

And I think you touched on this a lot. The smaller and mid-market size direct lending and private credit provisioning, is still really attractive. You're getting better yields. You're getting better credit metrics, and the presence of sort of cov-lite lending and sort of where the lender has far less protection, is less prevalent than it is as you move up in size.

And so, I think that the space that you really want to focus on, is in that sort of mid to smaller size direct lending, because that's where I think you are servicing a client base that doesn't have access to a public market equivalent.

You're getting a distinct asset class. It still is credit. It still has spread risk and duration risk, and other things, but to a much lower degree than you're getting in some of the other sectors that you talked about, and really differentiated from the public markets.

David Lebovitz:    Exactly. And, you know, the only other point I would make on private credit is, we did kick off today by talking about slower growth, then higher rates, and tighter policy. For the forward-looking investor, potentially there's an opportunity in the distressed space that's emerging here, and will continue to emerge as we look ahead to 2023.

But I want to bring it home with a conversation around hedge funds. One of the things that jumped out at me from our update to The Guide to Alternatives was that if you look at equity volatility, it's basically come back down in line with its long-run average, but if you look at interest rate and FX volatility, those are both nearly two standard deviations above their long-run average, reflecting, in my opinion, continued volatility within the macroeconomic variables, things like growth, inflation, so on and so forth.

And so, from my vantage point, I think macro vol is going to remain elevated. I think that that's going to keep interest rate volatility higher, and that's going to have knock-on effects across the capital markets. And the reality is, that we need to think about other ways of diversifying portfolios, rather than just owning, you know, stocks and bonds, and hoping that that negative correlation holds, which it certainly did not at the start of this year.

And so, we think hedge funds can help from a diversification perspective. We also think higher rates will improve the carry that hedge funds are earning on collateral. And so, really reaffirming our view that the clouds continue to break over the hedge fund universe, particularly things like macro strategies.

But Jared, from your vantage point, what else are you seeing in the hedge fund space that you think is relevant to our listeners?

Jared Gross:    So, I think I tend to bring a healthy dose of skepticism when it comes to hedge fund performance, but that's not to say that there aren't some bright spots. You know, I think what we've seen in the last couple of quarters, if not year or two, is that many strategies that characterize themselves as hedge funds, are essentially levered long stock pickers, and they tended to have a pretty pronounced growth bias, and that has come to ruin in many respects.

And that shouldn't be an indictment of the hedge fund space entirely. It's just an indictment of those particular strategies and sort of maybe labeling themselves as something that they weren't. I think you hit on the key issue, which is that what you get from a hedge fund strategy, or a more unconstrained investment strategy, particularly in a period of volatility, is the ability to go long and short and not just underweight within the construct of a benchmark.

And so, when you have high conviction ideas that you can express in either direction, to the upside, through a long position, through the downside, through a short position, the greater volatility, the greater dispersion that we're seeing in the markets right now, should be a very rich opportunity set.

From a style standpoint, macro-driven and long-short strategies, and I say that true long-short strategies, not pretend long-short strategies, should be very well positioned for this environment, and they should be able to provide attractive levels of alpha, certainly more so than we've seen in recent years.

And also, I think credit strategies, anything that involves capital structure arbitrage, the ability to move up and down the capital structure, again, using secured financing, senior debt, mezzanine debt, stressed debt, anything that has that level of flexibility up and down the capital structure, is going to be a really interesting place to play, because as we go into an environment, not just where rates are higher, and so the carry is better, but the impact of an economic recession and inflation is really going to differentiate the operating results of these individual companies and assets that we're looking at.

That's going to be a very rich sandbox for the hedge fund community to play in. And so, I think that's going to be the right approach. But again, as with almost all private asset classes, selection is critical. And I think nowhere more so in hedge funds where I think there tends to be a little bit of fattishness and sort of return chasing and really being disciplined about understanding the nature of the alpha that they're exploiting, and the persistence of the edge that they have, is really key.

David Lebovitz:    I think that that's a fantastic point and a great point to end on. So, Jared, as always, thank you for joining me today, and looking forward to having you back again soon.

Jared Gross:    David, thank you so much. Great conversation.

David Lebovitz:    Thank you for joining us today on JPMorgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Thank you. Recorded on September 16th, 2022.

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