Buy the Rumor, Buy the News: Evaluating the Unshakable Interest in Real Estate

While investing in sanguine times has been an oft-held motto of contrarianism, what happens when even bad times are good times? Following up on last month’s analysis, we continue our analysis of the real estate market.

Long viewed as one of the safest markets, real estate has also seen dramatic increases in interest from both retail and commercial investors over the past decade. As such, we’re looking at real estate investor contribution and distribution values compared to the overall market change for a public real estate index, the DJ Global Select Real Estate Securities Index (RESI).

Key Takeaways

While our data on pre-2010 cash flows is sparser, readers who remember the events of 2008 might recoil at the idea of an invulnerable real estate market. As shown above, while the cash flows do not tell much, the index is very clear that real estate contributions were quite tepid coming out of the great financial crisis given shaken investor confidence.

This tepidity quickly waned, however, and the market was progressively built up with more investor interest and steady contributions through 2020.

Now in 2024, we see the same curiosity play out as it did in 2008, but for different reasons. The index dived in reaction to the pandemic, and the cash flows remained relatively fixed. This cannot be blamed on low data volume, but instead a perseverance of investor interest throughout the economic shock.

The confidence appears to have paid off, with distributions peaking in late 2021 alongside a peak in new contributions. This reaffirmed a desire to collect profits and reinvest the earnings in the real estate space—even amidst the real estate market lag of 2022 and 2023.

Looking Ahead

A second fallacy in the invulnerability argument is the bubble. One need only glance at a chart of US home prices to get a little concerned about the sustainability of this trend. The US is trying to ramp up new construction to stem the housing shortfall, and the open question of return to office looms over the commercial sector.

As we look forward into the rest of this decade, we expect some shakeups in real estate performance. It could be driven by either or both sector’s challenges and perceived overvaluation. However, whether the bubble bursts or local and national efforts to address supply and demand reign in the values, there will always be intrinsic value in the real estate sector.

Perfectly Hedged? Questioning the Tether Between Private Credit and the Federal Funds Rate 

Akin to Steve Eisman’s critique of how a firm can lose money in every interest rate environment, our analysis this month poses the question: How has the private credit market endeavored to make money in nearly every interest rate environment?   

To investigate this, we pulled the private credit market return over the past few decades from Cobalt’s Market Data to see how these funds responded to changes in the federal rate, and to examine how they may have pivoted to remain profitable. 

Key Takeaways

First, we can identify points of alignment between the two charts. The trough and peak in North American private credit returns between Q2 2008 and Q3 2009 clearly align with the 2008 recession and accompanying sharp drop in the Federal Funds Rate. We surmise that existing funds were gutted by portfolio company defaults, while new funds were used to acquire the distressed assets that became available.    

Looking ahead, we see a smaller version of this event in 2020 that coincides with the COVID-19 pandemic drawdown. The lag times in both charts, however, are not consistent, indicating that the interest rate is not a strong predictor (or even a lagging indicator) of the private credit market performance.  

By comparison, the private credit market is relatively agnostic to the Federal Funds Rate during the other periods. There appears to be no meaningful effect from the dot-com bubble and the subsequent rise in interest rates—or any strong effects from the rock-bottom rates of the “everything rally” of the 2010s.  

However, on closer inspection, we can see a predictable increase in private credit volatility about three years after a recession, coupled with slight downward performance as the Funds Rate increases. The volatility was likely due to distressed purchases during downturns that began torealize their value or failure. The performance likely emerged from higher borrowing costs that cut into a private firm’s ability to increase financing to their portfolio.

Looking Ahead

Moving past the 2020 drawdown, we can apply our findings and predict a period of slightly higher credit volatility in the coming quarters. Additionally, as the Federal Reserve appears to be pausing its rapidly ascending rate hikes, we are left at a potential crossroads for the private markets. 

 On one hand, the pause could prolong economic health and sustain a high funds rate for longer, potentially eating into private credit returns. On the other hand, if a more recessionary event is close, then there may be ample cheap opportunities for distressed investors to buy. 

The (Bar)Bell Curve: Looking at the Dispersion of PME Alpha by Private Market Funds

In past charts, we’ve discussed our PME (public market equivalent) engine and how it can be used to analyze a fund or group of private market funds against the public markets. The chart below encompasses our entire population of funds with cash flows and examines the most common outcomes of performance. Using the Cobalt PME methodology to compare our Market Data Funds against the MSCI ACWI, we generate a PME Alpha metric for funds with cash flows, and the dispersion of this alpha is reflected in the chart below.

Key Takeaways

Perhaps unsurprisingly, the largest group of funds are those with alpha over 14%, with over a quarter of funds reaching that threshold. A bit more surprising may be that second most common range is alpha less than -7%, with just over one-eighth of funds falling here. Between these two extremes we see a more typical distribution between -7% and 14% performance.

This creates a unique distribution where the most likely outcome is extreme over-or-under performance, with the next most likely result falling closer to 0%. The ranges reflecting slight overperformance and slight underperformance are the least common, signifying a market where private market investors are looking for big swings, and living with the big misses they may create.

Extending to include all funds with negative alpha, we see that 28% of funds have underperformed in comparison to the public markets. This likely skews towards newer funds, which often take a few quarters or years to start returning distributions and outperforming public equities. Still, this lines up with the idea that alternatives offer the chance to have outsize returns versus other markets, but the investments do come with more downside risk.

Looking Ahead

As this sample looks back on 20 years of data, it should be enough of a track record to give us a solid idea that the dispersion pattern moving forward will hold. There may be some slight variances, especially as funds raised in the volatile times of the pandemic begin to make their first distributions over the next few years but overall, we still expect the most common outcomes for funds to be higher outperformance or lower underperformance compared to the public markets.

For more information on PME and how Cobalt leverages it, download our white paper: Measuring Performance in Private Equity: The PME Cheat Sheet.

Playing the Long Game: Comparing VC & Buyouts Across Different Time Horizons

Within private markets, there’s often a focus on core metrics such as internal rates of return, multiples, and public market equivalents. However, Cobalt’s dataset collects cash flow information that enables users to derive metrics such as the time-weighted rate of return (TWRR) for a group of funds.

To highlight this metric, the chart below illustrates TWRR for the North American, Global, and Western Europe markets to compare the regions’ buyout and venture capital (VC) funds across different time horizons.

Key Takeaways

At first glance when comparing the two charts, the different patterns the VC and buyout funds take across each time horizon stand out most. The VC curve shows a slow decrease year-over-year, while buyout returns increase from the 10-year horizon, peaking at the 3-year horizon with a large increase. This spike can most likely be attributed to the timing of the chart, with a 3-year horizon starting in March 2020 (the bottom of the markets during the pandemic).

Another time period that jumps out is the negative venture capital returns at the 1-year horizon. We’ve covered many of the macro factors (including our analysis of first quarter 2023), but increasing interest rates and bank scares at the beginning of 2023 (SVB in particular) created a tough environment for VC on the 1-year timeframe.

A closer comparison of the two charts shows an emerging trend: VC generated higher performance on the 4-, 5-, and 10-year horizons, while Buyouts outperformed over the past 3 years. While VC had the stronger run throughout the relatively stable 2010s, it seems Buyouts are better suited for the uncertain financial climate and volatility that has defined the beginning of the 2020s.

Looking Ahead

Given this current trend, you might expect buyout funds to be a stronger investment in coming quarters. While each investment style has a higher rate of return for 3 horizons, venture capital’s outperformance lasted over 6 years. If this trend holds, Buyout investments still have a few more years remaining as the top performer. However, with so many unknowns and looming issues in the macro environment, it would not be surprising to see a quicker reversal of fortune.

More BRICS in the Wall: Analyzing the Effect of Currency Choice on Fund Performance

In light of the recent BRICS summit and the group’s goal of de-dollarization, we explored the effects of currency choice on global private market investing via two representative portfolios:

• USD funds investing outside of the US 
• Non-USD funds investing across the globe

We then compared each to the S&P 500 to see how they perform relative to the American public market equivalent (PME). 

Key Takeaways

Looking at the charts, the two portfolios display largely similar characteristics overall. Both progressions peaked in 2000 and cratered shortly after, reflecting the crash following the dot–com bubble. Then, we see positive progression again through the mid–2000s until a crash during the financial crisis of 2007-2008. Finally, investors received a calm tailwind to finish the 2010s with a safe and consistent outperformance of the S&P 500 at around 10%. 

The non-USD portfolio generated a much higher average level of returns than the USD sample for the bulk of the 2000s, and then leveled to the USD group around the Great Recession. But what caused non-USD funds to outperform their dollar-denominated counterparts throughout the mid 2000s?  

The performance of the Euro may be one factor. Euro-denominated funds make up a large portion of the non-USD portfolio, and that currency exhibited strengthening compared to the USD over that period. Another explanation may be European market outperformance during that period. Indices, including the FTSE 350, expanded close to 2x from trough to peak progression in the mid-2000s, while the S&P 500 only expanded around 1.5x during the same period.  

Looking Ahead

It will be important to keep in mind U.K.’s continued struggles with inflation when observing the next trends in Western Europe. Most other major economies have reduced or muted the effects of inflation at this point, while the U.K. may still be mired in a macro climate that’s less friendly to alternative returns. 

With a more volatile environment, it will be interesting to see if the unexpected observations in the venture capital and buyout lower quartile returns revert back to the average benchmark moving forward. 

Down and to the Right: Assessing Western Europe Alternatives by Investment Style

After a recent portfolio monitoring client win in Spain, we decided to review Western Europe for this month’s analysis on alternative fund performance. In the chart below, the Q4 benchmark for each investment style illustrates how a Limited Partner (LP) may assess their portfolio weightings in the region.  

Key Takeaways

Unsurprisingly, venture capital and buyout funds have the highest first quartile returns. However, the roles are reversed on the downside: Venture capital remains completely above a 0% return, while buyout funds have more risk of not returning an investment. This highlights that ingrained trends often appear in the aggregate, but focusing in on a specific region may expose deviations from the norm.  

The largest investment styles in the alternative fund space (venture and buyout) offer the highest returns, but they are joined by growth equity and real estate, two other styles that have the highest upper fences of the benchmark. It’s important to note that co-investments are just behind real estate in this regard, having a higher first quartile floor. 

The investment styles with lower fence bounds (credit, infrastructure, fund-of-funds) do offer the benefit of tighter overall benchmarks, meaning an LP may have a better idea of their overall return when investing in these styles. Fund-of-funds exemplifies this best, with only a 6% difference between the upper and lower-fence of the benchmark. 

Looking Ahead

It will be important to keep in mind U.K.’s continued struggles with inflation when observing the next trends in Western Europe. Most other major economies have reduced or muted the effects of inflation at this point, while the U.K. may still be mired in a macro climate that’s less friendly to alternative returns. 

With a more volatile environment, it will be interesting to see if the unexpected observations in the venture capital and buyout lower quartile returns revert back to the average benchmark moving forward. 

Alternate Current: Studying the Early Divergence in Energy Market NAV vs. Dry Powder 1995-2022 

The energy market is consistently prone to violent price swings in reaction to global news. As a result, it’s a difficult style to invest in safely and steadily, despite its ever-growing demand. As follow-up to our June analysis, we‘re looking at more investment styles that deviate from overall trends. As shown in the chart below, Energy varies from other private market trends by splitting the tether between NAV (net asset value) and dry powder at an earlier date and higher rate—more than any other style. 

Key Takeaways

Let’s look at the difference in dates. The main market divergences between NAV and dry powder were in 2009 and 2020. These were significant investment inflection points, and in both cases, NAV began to rise beyond dry powder levels as investors spent down the latter to invest into these distressed markets. We can see this reflected in the chart above as well; NAV briefly exceeds dry powder levels from 2010 to 2015 and then accelerated in 2020. 

However, between 2015 and 2020, there is a massive rise in NAVs as investors spent down dry powder amid a globally declining energy investment period and historic drops in oil prices. One explanation for the rise was the push for renewable energy sources, such as solar, that began to grow in 2016. In addition, cost-saving measures pushed renewable costs closer to and then below parity with fossil fuels. (Take a look at the Energy Infrastructure Funds raised.) Those opportunities may have attracted the remarkable investment. And as the demand for new or divested energy is constant, so too is the appetite for additional investment in this space. The environment at the time could have signaled investors to go all in and spend down their dry powder. 

Looking Ahead

As we alluded, even with the steady march of technological progress, the energy space is subject to strong macro fluctuations. Economic downturns or another pandemic could easily sideline energy demand and pricing in the medium term. Despite the risks and the tribulations of 2020, appetite for this investment style has persisted and strengthened. This gives credence to the sustainability of this wave of investment—as long as dry powder reserves remain. 

Q4 Crunch Time: Revisiting 2022 Returns at Year-end 

Before we publish Q4 2022 benchmark in Cobalt Market Data, let’s revisit our February analysis of 2022 H1 distribution pacing by vintage year.  

As a refresher, our distribution pace analysis calculates distributions as a percent of net asset value of private market funds. Now we’re able to include H2 (Q3 & Q4) in our analysis to measure how 2022 returns stack up to historical trends and to assess how accurate our predictions were back in February.  

Key Takeaways

In Q3 2022, the average distribution pace of 3.1% was slightly below the 4% in Q2 2022. This tracks with the downturn across public markets in the same quarter (3Q22); the S&P 500 saw a 6.3% decline from July 1 to September 30.  Additionally, this was the lowest third-quarter pace since 2008 to 2010, a stretch of time with sub-3.5% quarters each year.  

Historically, the third quarter distribution pace is typically stronger than the first or second quarter. However, 2022 bucked the trend as the pace increased as the year progressed, with Q1 being the highest and subsequent quarters slowing. 

Q4 finished above Q3 at a 3.7% pace, but it was still lower than the first two quarters of 2022. It was also the lowest Q4 rate since 2010 as there was a distribution rate of at least 5% throughout that timespan.  

Overall, 2022’s average distribution pace of 14.9% is well below the previous 10-year average of 24.8%. The change in annual rate, along with the change in the typical quarter-to-quarter patterns in the market, shows that private equity was not immune to the economic uncertainty and volatility in the macro climate throughout that year. 

Looking Ahead

It’s tough to draw a direct correlation, but the last two analyses reveal that public markets can signify the distribution pacing patterns in the private markets. Based on the S&P 500, there was a 7.5% increase in the public markets during the first quarter of 2023. This could signal an increase in private markets distribution pacing for 2023, although several factors could counteract this. In addition, the collapse of Silicon Valley Bank may weigh on distributions in the alternatives space, namely venture and growth verticals. 

We will publish the Cobalt Q4 benchmark data in the coming weeks, at which point we can dig deeper into the overall trends of private markets in 2023. 

The Bridesmaid: Secondary Liquidity Investment Trends from 1999-2022 

Wedding season is in full swing, and as many are searching for cheap suits and flights, we’ve looked at an always–invested–in but–never–obsessed over style: Secondaries. To gauge investor interest and cyclicality, we used Cobalt market data to compile the distributions and contributions in the secondary fund universe against buyout funds (which we feel is representative of the overall private market trend). This analysis gives a size–agnostic sense of how investors pay in, and how they are paid out for their choices. 

Key Takeaways

To start, let’s dive into buyout fund liquidity over time. This is representative of the general liquidity cycle of private markets over the past 20 years. Most mainstream strategies (excluding Secondaries, Infrastructure, and Natural Resources) follow the pattern in the chart above. The overall private market investment cycle is characterized by higher contributions during and following recessionary events (2000-2003, 2007-2010) and higher distributions immediately after the recovery (2004-2005, 2011-2018). This implies a cyclical approach to private market investments. Investor interest is counter-cyclical, with investment surges resulting in payoff surges about five years later when the funds begin distributing. 

So, why and how do secondary funds break the overall private market trend? As seen in the chart, Secondaries roughly follow the same pattern of investing during economic downturns (with more distributions coming out of these downturns), but the scale of distributions is heavily muted compared to the benchmark.  

One explanation for this is the scope of secondary investing trending upwards, with NAVs increasing since 2006. Total secondary fundraising in the 2000s was only $85B, compared to $335B in the 2010s. As a result, the significance of $2B excess contributions is much greater in 2008 when total contributions and distributions are around $3B. Conversely, in 2013 $2B excess distributions are compared to more than $12B total. The result is the diminution of the liquidity ratios following the 2008 recession seen in the chart above. 

Looking Ahead

It’s clear that secondary funds have been a popular investment strategy amidst the Covid-era drawdown. This is in line with the broader market, but combined with rising NAVs proportionate to contributions we could anticipate another disruption of the cyclical pop as distributions will be paid out in the coming years. This will likely be overshadowed by the volume of investment, yielding a “surprisingly” subdued liquidity ratio. 

However, apart from appearances, this does not reflect the investment style performance and the ability to generate returns, as the increasing popularity is reflective of Secondary’s relatively similar performance to the rest of the private markets. 

Through the Grapevine: A Hypothesis in North American Infrastructure Trends Q1 2006-Q4 2015

Infrastructure is a vertical we often analyze as it exists in a middle ground between mundanity and innovation. And the motivations for its investors can vary within that middle ground. We investigated infrastructure fundraising in 2021 and have had a nagging curiosity about the lone peak in 2008 fundraising ever since. The Great Financial Crisis tends to explain many trends around that time, but we looked deeper and charted the rate of return against the total net asset value (NAV) in North American Infrastructure investment to see if performance could be a driving component of the 2008 peak. 

Key Takeaways

First, let’s look at the total value plot. We see an inflection point in Q2 2008 when the nearly flat curve of total NAV begins to increase at a rate that is sustained throughout the next decade. Indeed, our prior analysis confirmed this and showed sustained growth in infrastructure fundraising in the 2010s. The chart above gives us the “switch flip” moment to reveal how this upward trend changed rather quickly. Given this occurred in 2008, there is a myriad of possible explanations: a flight from credit and real estate to safer investments, an assumption that post-recession investment could consist of higher national infrastructure spending (both civil and energy), for example. 

Secondly, let’s examine the rate of return plot. The returns are consistent and generally positive from 2006 to 2015. However, there are noticeably larger, positive returns in the lead–up to the inflection point in 2008. In 2006, the chart shows some large returns relative to the average, culminating in a massive return spike in 2007. Now, these are almost certainly products of sample size: single funds delivering outsized returns relative to a smaller population of funds in our database at that time. Regardless, the correlation is quite striking, and tempts one to postulate if fund managers at the time heard of the high individual returns and tried to pile into the space to capture excess return. This would inflate the NAV but flatten the returns as average performance decreased. Of course, the answer is likely a far more complex combination of factors. 

Looking Ahead

While this chart analysis ends in 2015, it gives us insight into the potential direction of future investments. Today, infrastructure is still an expanding investment style, as energy diversification alone continues to pull more and more interest.  And as infrastructure begets maintenance, investment can be a self-spending prophecy the more it increases. 

From a performance perspective, we no longer see wildly outsized infrastructure returns like in the chart above. However, we still see strong and safe average performance from this style, implying the suppressed performance in the wake of the Great Financial Crisis may have been an anomaly.