Family offices with a new generation of leaders are proactively exploring alternative investments to grow and manage their wealth, most notably in Asia and Singapore.
They are revisiting their overall asset allocations to reassess the role that alternative investments will play in their portfolio now that the long-term outlook looks much brighter.
They have also been proactively exploring the broad spectrum of alternative investments to grow and manage their wealth, not just in private equity but also in private credit, direct lending, and infrastructure, to name a few.
This has led to a marked shift in family office investment strategies, as increased allocations are being made to alternatives as an asset class. One particular concept seems to be capturing the attention of family office principals — the additional potential return that less liquid investments offer versus traditional stocks and bonds.
In many cases, they are also applying a “liquidity lens”, through which they look for opportunities to capture this illiquidity premium by replacing traditional stocks and bonds with private equity, credit and real estate.
Global economy slowing but not stuttering
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Global equity markets are in a much better place than they were a year ago. With US equity markets exceeding the most optimistic assumptions this year, several private equity-backed companies have registered for initial public offerings — a positive sign for private equity investors.
Inflation is meaningfully lower from the 2022 highs in almost all major economies. The pace of interest rate increases has slowed in the US, while Europe is continuing to raise interest rates. The magnitude has decreased with increased certainty on where interest rates will stabilise.
Family offices are of the view that there does not appear to be something fundamentally broken in the broader economy. We do not have the same subprime-triggered crisis that we had in 2009, with the banking sector rocked and a major housing problem in the US.
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We are seeing good employment and consumer data in most major markets, while corporate earnings are holding steady.
Market conditions are ripe
Anecdotally, family offices feel that the private equity industry should get back to scaled deal-making at pace again by 4Q2023, while the vast majority expect the return to be in 2024.
To put things in perspective, global private equity (buyout) deal values in 1H2023 are down about 40% from the prior year (annualised). We have not seen such low deal-making activity in the past six to seven years.
It now appears that there could be a pickup after such a long pause in deal-making activity. The slower deal-making backdrop has reignited general partner (GP) fund innovations, as they steadily develop new types of fund structures across sub-asset classes, helping the industry become increasingly attractive to limited partners (LPs) with highly specific allocation and liquidity requirements.
If we take a subset such as buyout funds, they alone aggregate about US$2.8 trillion ($3.8 trillion) in un-exited assets, over four times the levels held during the global financial crisis. This has meant that over the past 20 months, very little capital has been returned to LPs to make new commitments.
Alternative asset managers are proactively trying to diversify their investor base, and are attempting to be less reliant on traditional endowments and pension funds. This has led to a specific focus on family offices and the broader wealth management segment.
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In the past decade, most of the value creation (performance) in buyout funds has been attributable to underlying investee businesses experiencing revenue growth and multiple expansion. When we look at the profit margin expansion of the underlying businesses, they have been a very small contributor to increases in valuations.
Moreover, revenue growth and multiple expansion have been significant enterprise value contributors at exit. In the current environment, family offices will want to look for fund managers who can put a company on a path to sustainable, profitable growth.
They would like to see managers who can focus on profit margins and revenues, especially businesses that can pass on any inflationary costs to their customers. This seems to be the key ingredient to success in an environment in which rates will be higher for longer.
Backdrop presents an opportunity
Family offices are increasingly keen to explore funds that are geared towards GP-led secondary transactions. In such a fund, the original GPs move assets from their existing funds into newly created “continuation vehicles”. The capital raised by the respective GP from the sale enables them to facilitate liquidity options to existing investors.
In some vintages, private equity continuation fund returns for top-quartile funds have exceeded 30% internal rate of return (IRR). This creates a win-win, as investors in the continuation vehicle have a much shorter J-curve, and original investors in a lower liquidity environment are more inclined to cash out in such a GP-led deal.
We have seen increasing interest in private credit and direct lending. Family offices are comfortable taking less liquidity and better covenants in return for higher yields.
They have shifted focus from emerging market high-yield debt into the middle markets predominantly in the US and Europe. The opportunity is mainly emerging from the gap in bank financing in middle markets.
Right time to enter?
Citi’s Strategic Return Estimates (forecast of returns over a 10-year time horizon) from private equity are 50% higher versus last year, illustrating that vintages after public-market selloffs historically have performed well.
Private equity has the highest Strategic Return Estimates across all asset classes, surpassing commodities, equities, fixed income, hedge funds and real estate. This presents an opportunity for investors to allocate capital.
Industry reports have shown that the overall investment portfolios among family offices with an average asset allocation of around a fifth to private equity saw that asset class contributing to a greater percentage share of overall returns.
Alternatives — whether via private equity or real estate funds, direct holdings of real estate, or equity or debt positions in private companies — continue to be a key priority for family offices over the next few years.
Diversification benefits
Citi’s flagship survey of family office clients this year showed that there was ongoing appetite for private equity but fewer than last year are planning to increase allocations. Growth equity and venture capital were the most popular fund categories. We expect this appetite for alternatives to remain strong.
Over time, a growing proportion of companies have shifted from being stock market-listed to becoming privately-owned.
This trend has meant that very few large companies dominate major equity indices, for example, the S&P 500 is being dominated by the large technology giants. More than two-thirds of the 2022 decline in public equities was attributable to the plunging values of tech-related stocks, most notably Microsoft, Apple, Alphabet, Meta, and Amazon, which together lost 43%.
Recall the saying “Don’t put all your eggs in one basket”? To gain exposure to the broader markets, a portfolio should have adequate exposure to private companies to ensure portfolio diversification.
Family offices are familiar with private markets, as for most that was their source of wealth. They are considering the alternative market developments discussed through this piece, by revisiting their traditional 60/40 asset allocations.
One may conclude that the role of alternative investments will be an important one for Family offices to get right in their portfolios. It will be interesting to see how this evolves over the coming years.
Prashant Dagur is Citi Private Bank’s investment counsellor team lead
