This article first appeared in Personal Wealth, The Edge Malaysia Weekly on February 17, 2020 - February 23, 2020

The global alternative assets industry saw its assets under management (AUM) reach a record US$10.31 trillion as at end-June last year, according to alternative asset data provider Preqin. This compares with US$9.56 trillion at end-2018 and US$6.43 trillion at end-2013, according to its press statement released in conjunction with the 2020 Preqin Global Alternatives Report.

The industry grew at an average annual rate of 8% between 2013 and 2018 and is well on its way to achieving US$14 trillion in AUM 2023, Preqin CEO Mark O’Hare says in the report. He notes that investors kept their faith in alternative assets in 2019 and plan to do so this year.

“Alternative assets have delivered a relatively good performance in both bull and bear markets. Recognising this, investors continue to put their faith in alternative assets,” says O’Hare.

The report says global private equity (PE) AUM hit a record US$4.11 trillion as at June last year. Capital flows into the asset class were robust in 2019 despite the world economy faltering. A growth in available capital, along with an 11% increase in unrealised value, boosted the segment’s AUM.

However, market conditions are becoming more difficult. The influx of investable capital and intensifying competition are driving up asset prices, says the report.

“Just over half (51%) of fund managers and over two-thirds of investors (69%) feel that PE portfolio company prices are higher than 12 months ago. This has had a dampening effect on deal flows. In 2018/19, the value of PE-backed buyout deals fell 21% to US$389 billion while venture capital deal values declined 18% to US$223 billion from US$271 billion.”

The difficult market conditions are not deterring investors, with 86% of limited partners (LPs) saying they intend to allocate as much or more capital to PE in 2020 as they did in 2019. “One reason is that most investors are satisfied with how their PE portfolios are performing. In fact, 87% of the LPs surveyed Preqin said returns in 2019 had either met or exceeded their expectations,” says the report.

The PE segment reflects not only the exciting opportunities ahead but also the challenges for the industry, it adds. “Fund managers have record amounts of capital to put to work — 58% expect to invest more in 2020 than they did in 2019. But investing is especially challenging when prices are high and competition is stiff.

“Market conditions could get tougher: 62% of fund managers (and 61% of investors) believe that we are currently at the peak of the cycle. If the cycle turns and managers are faced with a recession, the task of maintaining the kinds of returns that investors have come to expect from this asset class becomes even more difficult.”

Private debt AUM hit a record US$812 billion last year. It is now the third largest asset class in private capital, according to the report.

Some 151 private debt funds raised a total of US$104 billion last year, down from US$110 billion 210 funds in 2018. “The 10 largest funds closed in 2019 raised 36% of the total capital, an increase of seven percentage points compared with the previous year, highlighting the existence of capital consolidation as investors are increasingly drawn to larger, more established fund managers,” says the report.

It also says investors are upbeat about their private debt portfolios, with 91% of them saying they would either maintain or increase their allocation to this asset class over the longer term. “While investors may be seeking downside protection, private debt has not been tested through a full market cycle. This is where managers would want to provide more transparency around investment decisions, to convince stakeholders of the value the asset class can deliver, even if there

are difficult times ahead.”

Hedge funds saw a return of 11.45% last year, bouncing back from -3.06% recorded the year before. The asset class’ AUM increased 4.6% from the previous year to hit US$3.61 trillion as at November 2019.

However, 40% of hedge fund investors surveyed said the performance did not live up to their expectations. The report notes that 2019’s improved performance was only the second time the industry’s returns hit double digits in the past six years.

Last year was the worst for redemptions since 2016, with investors withdrawing a net US$82 billion from hedge funds in the year to November. Redemptions stood at US$110 billion in 2016.

The hedge fund industry keeps growing despite the difficult market conditions, with investors continuing to look to the asset class to diversify their portfolios and generate high, uncorrelated returns. “Delivering risk-adjusted returns with low volatility is a key benefit of a hedge fund allocation that extends beyond headline returns, and using a risk-free rate of 2%, the Sharpe ratio of hedge funds has been steady around the 2.5 mark for four years,” says the report.

Investors are looking at the industry in search of defensive strategies. The report says the demand for relative value strategies, which are designed to produce returns regardless of market direction, spiked in 2019. “Funds using relative value strategies made up 14% of all launches last year, the largest share achieved in more than five years.”

However, today’s market challenges are creating opportunities for fund managers to adapt, evolve and innovate, says the report. “Several funds that launched recently have eschewed the industry standard of a 2% management fee and a 20% performance fee in favour of more investor-friendly fee structures. For example, when Arizona-based Camkay Capital Management launched its Crisis Alpha Intraday CTA fund last year, the firm offered a 0% and 30% fee model with a high water mark.”

The report notes that fund managers are increasingly applying artificial intelligence and machine learning (AIML) techniques to improve operational efficiencies and boost returns. “After all, AIML funds have outperformed the wider hedge fund market and other systematically traded hedge funds on a three- and five-year annualised basis. Nearly a quarter (23%) of systematic hedge funds launched in 2019 use AIML, which is more than double the proportion that did so in 2016.”

According to the report, more than three-quarters (79%) of surveyed investors said they planned to allocate the same amount of capital or more to hedge funds over the next 12 months. “If the market cycle turns and conditions get even tougher, star managers will have a golden opportunity to demonstrate their value.”

Even as the global economy weakened last year, private real estate continued to grow. The report says investors seeking the asset class’ steady cash flows poured more capital into the segment, driving the total amount to an all-time high of US$151 billion. The increase in dry powder — along with a 5.3% rise in unrealised value — boosted the segment’s AUM to a record US$992 billion as at June 2019.

Aggregate capital raised opportunistic funds surged 38% to almost US$70 billion last year while the amount raised distressed funds rose more than eight times to US$8.4 billion, says the report. As competition intensified, fund managers went on the prowl for promising new niches such as property technology (proptech).

“These days, more real estate companies are looking to improve operational efficiencies with the help of new technologies. This has bolstered demand for the products and services offered businesses in the proptech space,” says the report.

There were some cautionary indicators, the first of which was that fewer vehicles reached a final close in 2019. “The number that did close fell to 295, the lowest total in a decade. In 2009, during the global financial crisis, only 229 funds closed,” says the report.

Capital consolidation in the industry has deepened. The report says 44% of the total capital raised last year was amassed the 10 largest funds. Two funds dominated the entire fundraising landscape — Blackstone Real Estate Partners IX, which secured US$20.5 billion, and Brookfield Strategic Real Estate Partners III, which brought in US$15 billion.

Deal volume and values fell amid concerns of rising valuations. The report highlights that three-quarters of the real estate fund managers surveyed in November 2019 said asset prices were higher than they were 12 months ago. And rather than pay too much for targets they perceived to be overvalued, some general partners stayed on the sidelines.

“As a result, the total number of PE real estate deals slid 4.7% compared with the year before, while aggregate deal values slumped more than 10%. Even as market conditions became more challenging, fund managers with massive amounts of financial firepower continued to put capital to work,” says the report.

Fund managers are well aware of the potential. Last year, there were 209 real estate technology-focused buyout and venture capital deals, amounting to US$13 billion in total value, almost double the figure recorded in 2018.

The report says there are 918 funds on the road, targeting an aggregate US$281 billion, an all-time high for both figures. Investor appetite remains healthy, with 93% of investors surveyed planning to either maintain or increase their allocation to real estate beyond 2020.

“This is not a surprise, given that 87% of investors expressed satisfaction with the performance of their real estate portfolios over the past 12 months. For fund managers, the challenge will be maintaining that performance even if market conditions worsen.”

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.