Beyond potentially yielding superior returns, alternatives serve as effective tools for investors to mitigate inflationary risks and insulate performance from the movements of public markets. Amidst declining interest rates and the accelerating energy transition, alternatives are poised to claim a more substantial stake in investors' portfolios.

Accessing alternatives: partnership matters

While historically perceived as difficult, it’s getting easier for investors to access alternative assets. Certain barriers to entry remain such as lack of liquidity, sometimes longer hold periods as well as high degree of technical expertise amongst the sub sectors. With these unique attributes of alternatives, the importance for investors to partner with managers boasting a solid track record and on-the-ground expertise is crucial.

Indirect Real Estate – which covers both liquid instruments like REITs, units in dedicated real estate funds which can be both open and closed ended, as well as co-investments or joint ventures gain exposure the real estate sector without having to physically manage any land buildings. Indirect real estate also has the added benefit of empowering managers to make decisions not only on the assets owned by a given company, but also on economical and geopolitical concerns, market sentiments, as well as liquidity and momentum. Still, not all segments of the industry are equally attractive due to their cyclicality.

In the case of infrastructure, where demand is increasing thanks to the global embrace of energy transition, leveraging fund managers’ relationships, particularly those involved in M&A, can help gain exposure to good projects. However, if infrastructure has been shown to have the potential to deliver steady, long-term risk adjusted returns, navigating this asset class is not easy due to the limited number of attractive projects, their inherent complexity and their hefty capital requirements.

Concerning private debt, access is predicated on having the ability to translate its characteristics into features that can meet the specific constraints faced by each type of investor. For instance, an insurance company will care about regulatory capital metrics so getting a robust and accurate credit rating will go a long way in helping them meet their regulatory requirements. Both flexible and offering the potential of capturing an illiquidity premium compared to public credit, private debt is an illiquid asset class, a factor that investors should keep in mind.

How alternative asset classes adapt to the changing interest rates environment

As interest rates hit their peaks before trending down, alternative assets are bound to become more attractive. With lower interest rates leading to smaller debt servicing costs, valuations are likely to improve as pricing would be made more attractive.

In the infrastructure sector for example, where debt durations can stretch up to 40 years, capturing duration today can potentially deliver attractive returns given where we are in the interest rate cycle, The effect of lower rates is even more pronounced in real estate debt, where they not only improve debt service coverage but also typically result in an increase in the value of the underlying secured assets therefore improving leverage and credit quality overall. In addition, offering investors an illiquidity premium of 200 basis points on assets yielding seven or eight percent in today's market is very compelling, however applying this premium to assets yielding four to five percent makes the illiquidity premium effect on total returns even more substantial as interest rates go further down.

Furthermore, as private debt is fully customisable and can be structured as fixed or floating rate, secured or unsecured and short or longer duration. In fund financing, where deals are typically floating rate and shorter maturities (1-3 years) their high investment grade ratings and illiquidity pickups mean that investors are increasingly considering this asset class as part of their wider liquidity strategy.

Interest rates also wield considerable influence over the built environment, with lower rates poised to invigorate both the real estate sector and infrastructure. Beyond just boosting returns, lower rates can also spur wider economic growth, thereby intensifying the demand for development projects. Companies need to expand and require more space. Moreover, given revenues on new development projects are frequently linked to CPI or inflation through new leases or construction contracts, alternative investments can serve as a hedge against higher interest rates in the future.

Where are the deals?

While the entire alternative universe is generally attractive, there is a high demand for fund financing, particularly subscription financing. In this setup, the proceeds advanced by fund providers are secured against Limited Partners' (“LPs”) commitments, especially during the initial ramp-up phase when General Partners (“GPs”) prefer not to tap into LP’s commitments. With durations typically spanning one to three years supported by exceptionally high credit quality – often A or AA – fund financing offers compelling risk-weighted returns.

Meanwhile, major institutional investors are actively acquiring GPs at hefty valuations as they seek to secure both the specialist knowledge and industry access required to pursue large-scale greenfield infrastructure projects. As these ventures often entail navigating intricate regulatory frameworks, protracted procurement procedures, and intricate negotiations on decades-long agreements, expertise is key to make them work, hence the premiums paid.