Happy summer, everyone! Let’s turn our attention to markets and the economy.
Back to markets: Gratification delayed but not denied
The U.S. economy continues to defy pessimists’ predictions (I continue to maintain that if you’re betting against the mighty U.S. service-based consumption economy—in the midst of one of the greatest investment booms of all time—you haven’t been paying attention for the past three years). The consumer is in solid shape, business fixed investment is hanging in there despite ongoing trade friction, the Tax Cuts and Jobs Act (TCJA) was just extended with some extra goodies thrown in … I guess all of those “60% probability of recession, no, 70% probability of recession, no gosh darn it, 80% probability of recession” forecasts were sort of wrong, huh?
The hard data (most importantly, the labor market and U.S. consumption power) appear as if there never was a trade war and even business fixed investment has barely slowed from historic growth rates. However, clearly there has been some impact because what once could have been one of the greatest business fixed investments booms in recent generations (AI + everyone else pumped about deregulation and lower tax certainty) has reverted to more pedestrian levels, and the consumer almost certainly has become a bit more cautious (hey, nonstop gloom-and-doom headlines can at least marginally impact consumption).
That being said, the best way of thinking about this is the same way I think about the borderline inevitable (I say borderline because, as always, nothing is guaranteed) multiple re-expansion of middle market private equity valuations in our evergreen and drawdown strategies: Gratification delayed but not denied.
As sure as the sun rises in the east and sets in the west, the brief slowdown in Q2 consumption will lead to even greater future growth, and businesses are slowly but surely getting their arms around optimizing for the new onshoring trend. And by the way, this does not even get into the incremental investment dollars being rerouted to the U.S. for domestic production.
U.S. equity markets: Less upside/more downside
When we turn our attention to U.S. equity markets—as supportive as I’ve been on the technical and fundamental strength of large U.S. multinational corporations (despite the clear threat from the trade war on margins)—we are getting a little extended now with:
- Unprofitable tech surging again
- Nasdaq back to 29.6X price to earnings ratio (P/E), S&P back to 22.5X
- The Russell 2000 despite comical, unachievable forward growth projection of 20% the next 12 months at an unbelievable 27.4 (the definition of an adverse selection bias index if ever there has been one)
So, be careful about adding any more equity beta here.
Additionally, there is still a lot of room for the yield curve to steepen as relentless Treasury supply continues and the Fed gradually takes the front end to 3% ... the economy’s resilience continues to work against longer duration1 fixed income. The only scenario where you have upside in long duration fixed income is in an economic collapse, which, fortunately (for those of us who care about the labor market) is not likely to happen any time soon.
So, the biggest issue for equities, now that we have round-tripped on valuations, is materially less upside than two, three or six weeks ago (not to mention two years ago), but if anything goes wrong, materially more downside. Clearly the most obvious risk is Chairman Powell being removed, causing the yield curve to go bananas and viciously steepen, which in turn leads to short-term multiple compression.2 After that, it would be the trade war cracks margins enough to significantly reduce next 12 months’ earnings growth assumptions (10% is pretty healthy after all in a slower nominal gross domestic product (GDP) growth environment).
Just to be clear, the most likely path is a grind higher, but equity markets are just far less positively convex (more upside than downside) in the nearer term than the recent past.
How to complement large and mega cap equities?
So, if you are full up on large and mega cap growth, the question is: What do you complement that with? International, emerging markets, U.S. small/mid cap or middle market private equity?
Well, small cap listed equities are ridiculously expensive, with historically and potentially forward-looking poor growth, and I know the small to mid-cap rotation has been a favorite long-only thesis this year, but U.S. mid cap unsurprisingly is just marginally better than small cap. Recent international outperformance has really just been a flow/currency trade, and international economies are in general plagued by unimpressive economic growth at best, and a paucity of world leading companies with impressive growth (although let’s give Taiwan Semiconductor Manufacturing Company (TSMC) a little bit of credit).
In contrast, middle market private equity fortunately provides Nasdaq-like revenue growth (high single digits to low teens, or 1.5X¬–2.5X U.S. nominal GDP growth) and is about 35% cheaper than the Russell 2000, which makes it the definition of growth at a reasonable price (GARP). Additionally, unlike public markets, where valuations are extended, there has been no material increase in middle market private equity valuations after they contracted by 23% from end of 2020 through end of last year. Whenever you have growth at rock bottom valuations, you have less downside and more upside almost by definition.
Credit: Taking cash off the sidelines
In credit, spreads have tightened back in, and fundamentals are still relatively solid. So, if you are looking for higher yields with less downside in the event that something unforeseen happens, you can potentially pick up several percentage points more income (between 1%–3%) in private credit, whether it be middle market corporate loans (upper, lower, sponsored and non-sponsored), senior commercial real estate loans or other types of asset-based lending (ABL).
Additionally, one of the biggest challenges for investors remains the “what to do with massive cash hoards that have built up the past four years” in order to increase income or total return without taking uncomfortable levels of risk. This is a mission alternatives and private markets are made for, as long as you can tolerate the reduced liquidity and modest levels of volatility.
What we're paying attention to
Let’s now turn our attention to some of the most compelling trends and their continued evolutions.
- Equity: Some of the themes we are paying attention to are tied to the AI/data center infrastructure mega investment theme, as well as the more nascent trend of robotics, and the established trend of robotic surgery; but also less glamorous themes like HVAC and lawn care improvement roll-up/consolidation themes. The goal, as always, in middle market private equity is to find growth at a reasonable price. Middle market PE deal flow has picked back up after a post-Liberation Day slowdown, which bucks the trend in large and mega cap private equity of “please, oh please, can the IPO market reopen ASAP."
- Credit: Business and professional services continue to be an area of interest given the sustained growth rates of EBITDA, cash flow and downside resilience; software loans are looking attractive again and receivable financing for companies that are seeking a liquidity boost continue to shine. That being said, we are seeing compelling opportunities areas of asset-based finance—like auto lending and aviation leasing—at equal to greater yields than upper middle market/large/mega cap cash flow–based loans, and with less downside risk. In sponsored lower middle market junior debt and non-sponsored lower middle market senior, we are still seeing opportunities 200bps¬–500bps wider than large and mega cap.
- Real estate: Multifamily and industrial continue to be sectors we are paying attention to. We have remained constructive on hospitality while being well aware of the cyclicality of the industry and are about to finance our first office loan as that sector continues to recover (in real estate lending, patience can be a virtue). Leaning into and out of sectors as they transition from fundamental uncertainty to transparently solid fundamentals has been a compelling approach since the pandemic: Whether it was ramping up lodging and retail in 2021, fading industrial around the same time as lending terms became untenable (a polite way of saying coo-coo-caroo) and leaning back into industrial once lending terms became attractive again. In the case of office, we have been extremely patient but there are starting to be opportunities that match conservative risk profiles while offering wider spreads and lower loan-to-value (LTVs) ratios than other sectors.
- Liquid markets: In hedge fund strategies, there continues to be potential opportunity in taking advantage of the secular slowdown in refinance activity in the mortgage market driven by sustained higher interest rates. Furthermore, if there is ever any materially significant home price depreciation on a more national level (like what is occurring in certain boom states like Florida), it will further depress refinance activity. Additionally, two other strategies that are fairly timely include merger arbitrage and convertible bond arbitrage. Merger arbitrage, with a subcategory of community and regional bank consolidation, is positioned for a much less hostile merger environment compared to the last several periods when realized deal break risk was at, or close to, record highs. Convertible bond arbitrage performance was taking advantage of recent market volatility and, as volatility has now receded, the strategy should now be driven more by new issuance discounts over the next several quarters.
Be selective
With the proliferation of more and more alternative/private market strategies, an investor just has to be more selective. So if you can, go with structurally advantageous beta + alpha as opposed to less attractive beta. Or put another way, let’s all strive to provide the most alpha-centric differentiated performance possible to our investors!
Hope to see you soon on the road, or on our first official Future Standard webinar where we will explore the macro and private credit opportunities more broadly. Additionally, I will be joined by my partners, Head of Junior Credit Chuck Harper, Head of Global Credit Andrew Beckman and Head of Real Estate Credit Rob Lawrence, who will articulate their particular areas of expertise within private credit.
New brand. Same drive.
At Future Standard, we are all very excited about our new name, so I want to close out by succinctly sharing our motivation behind the change.
- Our transformational combination with Portfolio Advisors greatly enhanced our platform’s ability to deliver performance, access and specialization for our clients.
- Future Standard allows us to meet the market with a unified brand to better articulate our mission to serve our institutional and individual investors.
Our mission is to deliver differentiated performance, primarily by investing across the capital structure of private middle market corporations, which are a key driver of growth in the U.S. economy, as well as commercial real estate (but please don’t sleep on our liquid multi-asset platform as we have come a long way the past four years in terms of expanded capabilities).
As we all know, differentiated performance, particularly when there is sustained alpha, can go a long way to improving the efficiency of portfolios. One of my favorite expressions is that “performance sells, but nothing sells like differentiated performance.” Future Standard is an aspirational brand in that we are not saying “we are now the Future Standard of alternative asset management,” but instead, we’re signaling a higher bar for what investors should expect in terms of performance, access, specialization and client service. Our brand is about anticipating and addressing what’s next for clients. One recent example of that is the combination with Portfolio Advisors. And we have a long history of innovative moves: From being the first to launch a private business development company (BDC), to launching and ramping the largest non-traded credit REIT (when the rest of the marketplace was focused on real estate equity).
We look forward to a bright future. Till next month, “the time for the right alts is still now!”
Investor considerations
Investing in alternatives is different than investing in traditional investments such as stocks and bonds. Alternatives tend to be illiquid and highly specialized. In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investments made in alternatives may be less liquid and harder to value than investments made in large, publicly traded corporations. When building a portfolio that includes alternative investments, financial professionals and their investors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined.