2021 Alternative Investment Outlook
Alternatives strategies: Dennis Kim, CFA, Director of Custom Alternative Solutions; Lori Whiting, CFA, Alternatives Investment Director
Private equity insights: Matt Witheiler, Private Equity Principal and Sector Specialist
Private climate insights: AJ McGuire, CMT, Investment Director
Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.
Vicious liquidity cycles, volatility, and the role of alternative investments
As we wrote at mid-year, the pandemic and the resulting global economic shutdown brought bouts of market distress and dislocations that created investment challenges but also potential opportunities for alternative strategies. While we are certainly not yet on the other side of the pandemic and the related economic implications, we think it’s worth considering some of the other market and industry dynamics that are likely to impact the environment for alternative strategies in the months and years ahead.
In particular, we continue to see mounting evidence that risk assets are becoming more illiquid in risk-off environments — a trend that predates the pandemic, is likely with us for the longer term, and may have a number of potential implications for alternative strategies.
“Walking with soup”
The COVID-driven market sell-off was just the latest in a long line of events that have highlighted the lack of liquidity in the market when it was needed most and the impact this can have on market behavior. In recent years, we’ve seen market sell-offs accelerate into more severe market downturns — in February 2018 (“Volmageddon”), the fourth quarter of 2018 (initiated by Federal Reserve rate hikes), and May 2019 (US/China trade tensions), to cite a few examples.
Figure 1, from our Global Derivatives Group, illustrates the changing relationship between the volatility environment (proxied by the VIX) and liquidity (based on the average level of futures liquidity). We see that for a given level of volatility, the average level of futures liquidity was significantly lower in the second half of the past decade than in the first half; the effect is particularly pronounced at higher levels of volatility.
The liquidity challenges can be traced to a number of profound changes in capital market structure and the asset management/trading ecosystem. Following the global financial crisis, regulatory action forced broker-dealers to greatly curtail their market-making activity. Gradually, we saw the emergence of the market-making role with certain systematically oriented trading firms, who have smaller amounts of capital behind them and, as a result, are programmed to be highly risk-averse, withdrawing liquidity when volatility rises to avoid “catching too many falling knives.” At the same time, we’ve seen a proliferation of strategies (CTA, volatility targeting, volatility managed) that have a propensity to demand liquidity when volatility is rising.
When volatility is low, there is no problem, but it doesn’t take much for higher volatility to drive down the supply of liquidity and simultaneously drive up demand for it. This results in larger-than-warranted moves to the downside, which in turn produce more need to sell/de-risk and so on. As our colleague Gordy Lawrence, director of Global Derivatives, put it, “If you’ve ever tried walking with a hot bowl of soup, everything is fine as long as your gait remains stable, but once you hit a bump and the soup starts sloshing back and forth, it’s pretty hard to get it to stop before it spills over the edge.”
What it means for markets and the role of alternatives
As trading continues to become more concentrated and algorithmically driven, we would expect the potential for sharp drawdowns to grow. We would also expect correlations to trend up over time, driving potentially larger dislocations.
Another consequence of these market-plumbing issues may be less efficient market pricing. Over the short and medium term, pricing increasingly seems to be a reflection not of fundamentals but of liquidity.
Against this backdrop, we think investors may want to consider several ideas for their alternatives portfolios:
- Given the potential for more drawdowns, risk-mitigating strategies may become increasingly important, including market-neutral strategies and/or strategies that aren’t correlated to risk markets. Investors may also see a growing role for tail-risk-protection strategies.
- There may be a growing role for specialized strategies that can exploit these broader trends. This may include fundamental long/short stock-picking strategies that can distinguish between winners and losers amid liquidity-driven price dislocations. In addition, while the market volatility spurred by the trends discussed above may create challenges for risk-asset performance broadly, we would also expect it to lead to greater dispersion across and within sectors, potentially making for a more fruitful environment for bottom-up stock picking by long/short managers.
- When liquidity is constrained across market subsectors, some credit relative-value strategies may benefit by serving as liquidity providers without assuming directional exposure to the market overall. These managers may be able to identify disconnects between market prices of dislocated securities driven by liquidity considerations and what they consider sensible clearing prices for those securities based on fundamentals.
PRIVATE EQUITY INSIGHTS
Cautious optimism in private equity markets
In the wake of broad market declines in the first quarter of 2020, we saw the private equity market gradually gain momentum in the second and third quarters, fueled by a sentiment of cautious optimism: Late-stage companies found a renewed confidence about their businesses (the optimism) but still had reasons to worry about the macro environment (the caution). Here I’ll offer a few thoughts on this landscape as we approach the start of a new year.
Uncertainty about events like the US presidential election, a potential second wave of COVID-19, or further deterioration in US-China relations can weigh heavily on private companies. A public company’s stock price may fall if the market goes down, but the repercussions can be much more dramatic on the private side. A collapse in the public market could seize up funding on the private side and, if a private company is not yet cash-flow-positive, that’s a scary proposition. Thus, private companies would rather give up an incremental 50 or 100 basis points of dilution at a lower valuation than potentially risk being unable to raise capital and going out of business. That risk is what keeps private-company CEOs awake at night, and we believe it’s also the reason valuations have remained reasonable in the private space — in what otherwise could have been an incredibly frothy time, considering the strong public market rebound.
The IPO market
In a year full of the unexpected, we think one of the biggest surprises for markets was the high level of IPO activity, especially in the second and third quarters. As the public markets rebounded beginning in the second quarter, we saw many companies seek to take advantage of the attractive environment by accelerating their IPO plans. As of October 31, there had been more than 180 IPOs in 2020, totaling more than US$60 billion — the highest level of IPO activity since 2014.1 This was unimaginable in March, as COVID-19 hit and the thought of having an open IPO window, let alone performing ahead of plan, seemed inconceivable.
We believe the second biggest surprise of this year is the rise of special purpose acquisition company (SPAC) IPO activity. There had been more than 185 SPAC IPO issuances with over US$65 billion raised as of November 15, the highest level in history.2 While previously considered a less attractive path to liquidity, SPACs have become more institutionalized and may offer certain benefits, such as more certainty to close, which can be attractive in volatile market environments.
Through the third quarter of 2020, late-stage deal volumes had outpaced the last three years on a quarterly basis.3 We believe deal activity has remained robust throughout the pandemic for two reasons. First, certain sectors have realized newfound growth due to COVID-19 and are looking to capitalize on this growth by raising capital. Second, other sectors have seen disruption to growth and have needed to raise unplanned rounds for “insurance” purposes.
The pandemic’s continued impact
It is worth noting that cautious optimism isn’t the rule for all private companies. There remain companies that are still meaningfully impacted by the virus and therefore not so optimistic. That said, there are also companies that are throwing caution to the wind and raising “nosebleed” valuations. This issue appears to be especially acute among companies doing earlier rounds of financing.
One final note on a category of company we’ve found increasingly common in the past few months: the “COVID questionable” company. These are companies that have seen massive positive transformations thanks to effects of the pandemic and the economic shutdown but face an open question about whether those effects will last. For example, will a household products company that has seen increased demand and lower customer acquisition costs in 2020 continue to perform well once COVID-19 is out of the equation? We’ll be watching this trend and others described here as the new year gets underway.
1Renaissance Capital. Includes US-listed IPOs with a market cap of at least US$50 million and excludes closed-end funds and SPACs (special purpose acquisition companies). Data is as of 31 October 2020. | 2SPACResearch.com. Data is as of 15 November 2020. | 3PitchBook. Includes all US late-stage venture capital deals, defined as any rounds of financing taking place Series C or later. Data is as of 30 September 2020.
PRIVATE CLIMATE INSIGHTS
On a mission: The disruptive force of private companies seeking climate-change solutions
Representing almost 6%1 of total venture capital investing in 2019, companies focused on addressing climate change represent what we believe is one of the most innovative sectors within private equity. Mission-oriented entrepreneurs, investors, and consumers widely accept climate change as a defining existential challenge of our time and are rallying around the need for dramatic change. At the same time, decades of infrastructure investment and the steep reduction in the cost curve of alternative sources of energy have created a conducive environment for scalable, solutions-focused businesses.
A confluence of secular trends
We sense growing optimism and belief in the potential for innovation in the venture capital community as it joins with governments, scientists, consumers, and companies to find real solutions to climate change. We think several secular trends are supportive of disruptive climate-focused entrepreneurs:
- Global coordination and continued infrastructure spend — The 2015 Paris Agreement was the first truly global accord focused on the need for a lower-carbon world. Over 100 countries have committed to become “net zero” by 2050, the latest being Japan in October 2020. With these commitments should come continued high levels of global infrastructure spend, creating a foundation for innovative, asset-light companies to build on.
- Consumer, investor, and corporate demand — Consumers are demanding transparency and choices that match their values, and companies are in search of technologies necessary to be competitive in the future. According to a recent NYU Stern Center for Sustainable Business report, since 2015, sustainability-marketed products have grown 7.1x faster than products not marked as sustainable, accounting for 54.7% of market growth, despite representing only a 16.1% market share.2
- New and cheaper technologies — The economics of sustainable energy are becoming more competitive (Figure 1). As the cost curve has continued to fall, companies providing scalable solutions with business models more suitable for venture capital are being created. While the combination of long lead times and unproven technologies has historically restrained VC investment in this area, there is growing interest in innovation in areas such as data analytics, advanced computing, and agriculture technology, where companies are rethinking business models to address large markets beyond the energy sector, such as logistics, manufacturing, and food.
A broad transformation across sectors
According to the US Environmental Protection Agency, the largest producers of greenhouse gas (GHG) emissions are in five economic sectors: transportation, electricity, industry, commercial & residential, and agriculture. Within each sector, we believe there are compelling opportunities for private companies to mitigate GHG emissions (e.g., alternative energy producers and battery manufacturers) and help businesses and consumers adapt to and alleviate physical risk factors such as heat and drought (e.g., providers of data analytics/risk modeling).
As outlined by the 2015 UN Paris Agreement, in order to have a chance of limiting global warming to 1.5 degrees Celsius above pre-industrial levels, global carbon emissions must decline by nearly half by 2030 and become “net zero” by 2050. The economic transformation that needs to occur will influence all areas of the economy, not just the energy sector, and companies focused on finding innovative solutions will need partners to help them develop and grow. As the world rallies to this extraordinary challenge, we believe there will be a growing opportunity for private companies looking to align their businesses with these goals.
1Crunchbase News, 2019 Global VC Report, 8 January 2020 | 2NYU Stern Center for Sustainable Business, Sustainable Business Index, 16 July 2020
about the authors
Dennis Kim, CFA, NFA
Director of Custom Alternative Solutions, Boston
Dennis is the director of custom alternative solutions for Wellington Alternative Investments (WAI), which is responsible for the business and investment oversight of certain alternative investment strategies managed by Wellington Management. He serves as the portfolio manager for global multi-strategy and diversified long/short equity approaches, and is responsible for developing alternative solutions for clients, including strategic allocation decisions, portfolio construction, risk oversight, and portfolio hedging.
Lori Whiting, CFA
Investment Director, Boston
Lori is an investment director in Wellington Alternative Investments (WAI). WAI oversees certain Wellington-managed fund vehicles that pursue alternative investment strategies. The WAI team serves as fund sponsor for several alternative funds, overseeing fund governance, product development, marketing, and operations, and servicing fund investors. Lori works closely with investment teams to help ensure the integrity of their investment approaches and represents the funds both internally and externally.
Private Equity Principal and Sector Specialist, Boston
As a private equity principal, Matt helps manage the firm’s private company investment activity across the technology sector. He works closely with portfolio managers, global industry analysts, and other global research resources within the firm to identify and pursue investments in private companies.
A.J. McGuire, CMT
Investment Director, Boston
A.J. is an investment director in Wellington Alternative Investments (WAI), which is responsible for the business and investment oversight of certain alternative investment strategies managed by Wellington Management. WAI oversees all aspects of these funds, including fund governance, product development, risk management, marketing, operations, and servicing of fund investors. WAI also coordinates the strategy and message around the firm’s full range of alternative investment capabilities. A.J. supports our distribution and private equity businesses, representing funds both internally and externally.
ACTIONABLE IDEAS 2021
This is an excerpt from our 2021 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come.