Jonathan Forsgren:

Hello and welcome to this Asset TV Alternative Investments masterclass. Alternative investments in private markets have been gaining interest from private wealth investors over the last decade and recently the persistent market volatility, high inflation and rising rate environment have made alts even more interesting to investors. Joining me to discuss how alts are performing in the current environment, the outlook for the investment type and how to access and include alts in private wealth portfolios are Anastasia Amoroso, managing director and chief investment strategist at iCapital, Brendan McCurdy, managing director and co-head of the Financial Advisor Solutions team at Ares Wealth Management Solutions. Sean Connor, president of Global Private Wealth at Blue Owl Capital, and Steve Nesbitt, chief executive officer and chief investment officer at Cliffwater. Thank you all for joining. So I'd like to start by having each of you give a high level overview of your firms and how they fit into the alts ecosystem. So Anastasia, can we start with you?

Anastasia Amoroso:

Sure. Well, good to be with you. And iCapital is a global alternatives platform and we're a financial technology company and we really focus on enabling access, efficiency and also education to alternative investments for private wealth clients. Because as you know, Jonathan, historically, alternatives has been very much an institutional domain, but our mission, our goal in life so to speak, is to make sure that private clients also have access to alternatives. And of course, again, it takes access, efficiency and education to do so. So that's where we're focused on at iCapital.

Jonathan Forsgren:

And Brendan?

Brendan McCurdy:

Yeah, thank you. Good to be here as well. So Ares is a $350 billion AUM private market investment manager. We focus on the four major private market asset classes, so private equity, private credit, private real estate and private infrastructure. And we just celebrated our 25th anniversary and while we largely had an institutional client base over many of those 25 years, we've had many private wealth investors that have known us for our funds and public companies most notably are publicly traded BDC ARCC, so long tenured private market investor who today is very focused on the wealth management space.

Jonathan Forsgren:

Sean?

Sean Connor:

Great. Well thank you for having me as well and look forward to the discussion. So Sean Connor, I'm the president of private wealth globally for Blue Owl Blue. We are a publicly traded asset manager focused on the private markets. We have about 140 billion invested under management and we do it through our really flavors where we're providing capital to that private market infrastructure and ecosystem. We do it through our direct lending business where we're providing credit directly to companies. We do it through our GP stakes business where we're providing capital to private markets manager selves, and then we do it through our real estate business, which is a little bit different. It's more of a real estate finance solution through the triple net lease.

And so as we think about it, we have a financing solution for private markets participants really at every level, the manager and the portfolio company level, and we offer that to both institutional and individual investors. The individual investors has been sort of a huge part of our business from the beginning. It's around 35, 40% of our capital and it's something we've offered side by side with our institutions since we got the firm going.

Jonathan Forsgren:

And Steve?

Steve Nesbitt:

Hey, thanks Jon for having me here today. I'm, as you mentioned, CEO of Cliffwater. We're a firm that was founded about 20 years ago dedicated to helping investors with alternative investments, really across the spectrum. Really over the last 10 years we've been focused on direct lending private debt and that represents most of our 15 billion in assets under management today. We've also been very interested in developing a research basis for investing in private debt, particularly for individual investors. We created about a dozen years ago, the Cliffwater Direct Lending Index is now the, I think, standard benchmark for private debt. In addition, we've done significant research on different aspects of private debt that culminated in two books I wrote the most recent one just published about a month ago called Private Debt. And then finally about four years ago we talked the talk. So we finally walked the walk and we launched a interval fund which demonstrated to our investors, primarily individual investors that they too can participate alongside institutions and private debt. That fund is now about $11 billion.

Jonathan Forsgren:

Well Steve, I'm going to start with you then here. Alternative strategies have been a staple of institutional portfolios for a long time, but recently we've seen increased interest from private wealth investors. What is drawing individuals to private markets?

Steve Nesbitt:

Well, I think two things. One is convenience. I think historically investing in private markets has been very complicated. A lot of paperwork, capital calls, unexpected distributions and I think there have been solutions offered over the last five years that make it much more convenient for individual investors to invest in the asset class. Many products offered and services offered by my peers on this call today. I think secondly, this really represents the second wave of alternatives for individual investors. About a dozen years ago there's a lot of talk about liquid alternatives. I think the second wave is about private alter alternatives and I think the fulcrum asset class there has been direct lending or private debt. Really the motivation there is higher yields. I mean basically with liquid debt, publicly traded debt yields have been between one and 3% where his private debt has been more on the order of eight to 10%. It didn't take long for individual investors, RAs to catch on to that. And so this second wave has started.

Brendan McCurdy:

And Steve, I agree with everything that you're saying and maybe I'd just add one more, which is opportunity set. So if you look back over the last couple of decades, so back around the turn of the century, there are about 8,100 publicly traded companies on US stock exchanges. Today that number is down closer to 4,000. So we have half as many publicly traded companies in the US today as we did not that long ago. Whereas we have many tens of thousands of privately held companies. And so the opportunity set I think is also much larger and I think individual investors are starting to realize that.

Anastasia Amoroso:

I think that's right, Brendan. Individual investors are definitely focused on opportunities in private markets because you look at something like artificial intelligence and as buzzy as it is in public markets right now, there's so many more opportunities in private markets. But I just wanted to add on to what Steven said about access. And historically you need it to have millions of dollars to be able to allocate to alternative investments if you were an individual client. But what we're focused on at iCapital is being able to bring down some of those minimums and now individuals may be able to allocate as little as $25,000 to alternative investments. So that's been a game changer I would say, Jonathan.

And then the whole efficiency that I was mentioning in the beginning is when you think about the legacy subscription process to alternative investments, it's stacks of paperwork this high, it's lots of inefficiencies. And again, what we're focused on at iCapital is making sure it's a digital end-to-end process and where we manage the whole life cycle of an alternative investment from the subscription to the capital calls to the distributions and so forth. So together with that access and efficiency and everything else, as Steven and Brendan mentioned. I think that's why we're seeing this rise in alts to private wealth.

Jonathan Forsgren:

But Sean, could you give us a sense of context in today's market environment, why investors should really be considering investing in private markets via alternative investments?

Sean Connor:

Yeah, I think I would classify it really with one word, which is uncertainty, right? There is a tremendous amount of uncertainty, whether that's in rates, whether that's in the economic outlook, and usually uncertainty or volatility creates opportunity and a lot of that opportunity can be captured through alternative investments and or you can dampen a lot of that volatility in your portfolio through alternative investments. And so the last 10, 15 years have really been somewhat straight line driven by very, very low rates. We're in a fundamentally different environment today and that really, really begets the opportunity set for kind of this next wave of alternative investments, which is people are looking at uncertain environment, uncertain rate environment, and alternatives historically have added incremental returns, premium to the public markets with a fraction of the volatility.

And especially today when you think about what's happened just in your own personal accounts, there's been a lot of volatility. It's been hard to generate returns historically over the last 10 or 15 years. Alternative investments can add a tremendous amount of value in the face of that and they can take advantage of those opportunities because it tends to be more patient capital. It's long term, long vision, buy and hold type investments that are really able to generate that outsize return for the risk.

Jonathan Forsgren:

And Brendan, Sean just touched on rising rates. Can you dig a little further into how the rising rate environment has impacted private markets and with the likelihood that the Fed is going to raise rates even more than previously expected, how might that affect private markets going forward here?

Brendan McCurdy:

Yeah, well there are really all kinds of potential interconnected effects, but perhaps I could give you a few specific examples. So one very obvious one is in private real estate and private infrastructure rising rates, the Fed is raising rates of course because of the inflation issues in the higher inflation environment that we've been in. Well in real estate, private real estate and in particular in multi-family and industrial private real estate, if you look back over the past many decades, so actually going back to the late seventies, private real estate again, industrial and multi-family in particular have had roughly two times the return in high inflation environments versus low inflation environments. And since rising rates often comes in the wake or chasing that inflation, you're seeing those two things move together.

Separately then just in the last few weeks and the banking system and the liquidity issues that we've seen, rising rates that are making it so tough for banks to repair their balance sheets, that's likely to reduce a lot of the lending that those banks can do to small and mid-size businesses as well as to commercial real estate. And so that type of lending we expect will need to come more and more from the private lenders and in fact, that's where we're seeing many of the best opportunities today.

Jonathan Forsgren:

And then sticking with the Fed and rates. Anastasia, what is your outlook? It looks like the Fed's probably going to raise rates maybe a little bit more, but how long do you see them holding it? Where do you see the terminal rates? Could you dig in a little bit more into your expectations for what the Fed does with rates this year?

Anastasia Amoroso:

Sure. Well, I think raising them a little bit more, maybe that's all we get. Whether you call it a pause today where they call it defacto pause, if they raise just 25 more basis points, I do think the stopping point is somewhere around five to five and a quarter percent. And the reason I say that is because we kind of heard that loud and clear from Fed Chair Powell's press conference last month where first of all, the FOMC participants penciled in that terminal rate goes to 5.1% and stays there. And then there's the statement that Chair Powell made, which is we may raise rates a little bit more maybe.

To me that sounds like a whole lot of maybes and what Brendan was talking about with the whole pullback in regional banks and the lending that they're likely to do this is a deflationary setup I would say, and this is why the Fed might be able to say, we've done the heavy lifting, we're now kind of handing the baton over to the banking sector and the economy and to the lag defect for them to play out and for them to eventually kick in and bring down inflation. So for all those reasons, I think we might actually pause around five, five and a quarter percent.

Now the markets are discounting more than that. The markets are saying that it's not just going to five and five and a quarter and staying there, but they're discounting depending on the day between three or four rate cuts into the back half of the year. And I don't necessarily think that a lot of participants believe that. I think what that tells you is that the demand wave is shifting and investors are increasingly looking to bonds as a safe haven and miss all the uncertainty that we're talking about. And as flows go back into the bond market, that's what kind of mechanically pushes down the yield. So I don't know necessarily that's because the participants really believe that the Fed is going to cut three or four, three or four rate cuts.

So having said that, Jonathan, this obviously impacts different parts of the advisor's portfolio and let's just think about, we're looking at cash bonds and equities. And if the hurdle rate on cash is 5%, that means A, you can park your money there, you can get paid while you wait, but it also means that if you're going to add anything else to the portfolio, it has to at least beat that 5% hurdle rate. So that kind of changes the advisor calculus of what else you might add to the portfolio. The second impact, of course is on the bond market and I would say with cash rates being at 5%, with the economy clearly going through some sort of slowdown here, the long end of the curve doesn't look as bad as it once did. And again, that's why the money has been going back into the bond market.

And if you think about what is one of the better hedges against potential recession, it's the long end of the curve. So I suspect that part of the portfolio will continue to experience flows. And then the last thing is the equity piece. We've had a major reset in equity valuations when the Fed went from zero to 500 basis points, but I think a lot of the valuation reset has now been behind us. And that's a good thing. And you might look at the markets and say, well, 17 or 18 times earnings, that's expensive. But if for the time being we have the economy that is not yet in a recession and we have a Fed that is nearing a pause, that actually may mean that the markets may be sustainable around these current levels and around these valuations.

Jonathan Forsgren:

I'm going to bring it back to liquidity and when we just touched on issues with the bank liquidity that's led to the crisis. Steve, can you dig a little further into how the banking crisis and bank liquidity has impacted private markets?

Steve Nesbitt:

Short term it's created some uncertainty, so spreads have widened, but that may be short-lived. Long term I think it's a big benefit for those of us on this call that are interested in investing in or underwriting direct loans or PR private loans because the world's going to move to alternative lending as opposed to commercial lending. And this just plays into this, into our investment thesis. So I expect long term this to be a real help to alternative lending. And just if I could just, Jon, just go back to Anastasia's comment just quickly on interest rates here. So from my point of view, I don't know what the Fed's going to do. I don't know where interest rates are go going, I'm pretty agnostic on that. One thing I do know is over the last dozen years, the Fed has really supported bonds, the Fed put they call it or the anchor to winward.

And basically that's all changed. And so in my mind, 2022 and the increase in inflation and the Fed's reaction to it has basically said, Hey, that game is over. And I've been cautioning our investors not to take duration risk and all of a sudden bonds are risky. It's a risk on asset. And even today with long treasuries at three and a half, I don't know where inflation's going to be, but I'm taking the over on that. I view traditional bonds as very risky. And one thing we like about private debt is its generally floating rate. So you don't have that interest rate, you have credit risk, and the people on this call are expert at credit risk, and I just view floating rate middle market debt as a substitute now as being a risk-off asset vis-a-vis traditional publicly traded bond.

Sean Connor:

Maybe just at the risk of belaboring this point, I actually wanted to make a comment about this too. Said a slightly different way, but what Anastasia just walked through and what Steve's highlighting is if you're buying traditional fixed income, you are betting against the Fed. And historically, if you surveyed lots of people and ask, is it a good idea or a bad idea to go against the Fed, most would say it's a bad idea and people are being compelled in this environment to do that. Doesn't mean they may be right or wrong, but it is risky and for a lot of reasons, that's why a lot of the asset classes that we manage on this call should be looked at anything particularly floating rate or positively leveraged to rising rates. Because anything fixed income, for the most part, you are betting against the Fed and that has been a notoriously bad idea over many, many decades.

Anastasia Amoroso:

Yeah, I mean that's hard to disagree with, but to just kind of come back to this debate between the long end of the treasury curve versus the floating rate exposure. First of all, I agree that the markets have sort of extrapolated rate cuts that may not happen. And so to your point, Sean, that we probably shouldn't bet against the Fed, and if the Fed tells us they're going to get to 5.1% and stay there, maybe we should take them at their word. So that does mean that the opportunity is still very much there in terms of let's say direct lending that is tied to a floating rate, interest rate. So the Fed stays at 5%, maybe they go a little bit higher, that's a great opportunity to earn that rate and then a spread in something like leverage loan or direct lending. But at the same time, if this is going to be an economy that is growing much slower than it has in 2020, 2022 rather, then chances are the long end of the curve is not going to rise quite as much as maybe some participants expect.

Steve Nesbitt:

Well, I would just one more, and I probably beat this to death here, but basically we're underwriting middle market direct loans at about 11%. Okay. That's very attractive. Or I could go long bonds, fixed bonds at, I don't know, three and a half, 4%. I just think you have to have a pretty good crystal ball to do the latter trade.

Jonathan Forsgren:

Sean, private market assets under management more than tripled since 2010 to over 10 trillion today. What have been the drivers for that growth and how do you see the drying liquidity impacting that growth?

Sean Connor:

Sure. I think the drivers of the growth that there's a lot of variables, so it's hard to pin one, but I would say maybe just to pick two, I think one is opportunity set and I think [inaudible] which is many [inaudible] are finding it better to be in the private markets, whether that's private market ownership, private market lending, private market solutions with real estate because it is more patient capital, it allows you to do things with a longer vision. And you see that in the numbers, for example, in publicly traded companies. So I think part of it is there is real value for management teams to be out of the public eye for a variety of reasons, but principally it allows you to be a long-term manager of your business. I think second is it's also worked, right? Investors are allocating to it because the returns have been superior to what they could otherwise get in the public markets, whether it's higher return, less volatility, or the combination thereof.

And so as long as those two pieces exist together, which I foresee that they will, I think it will continue to grow. And you can see that both in the institutions that we cover, they are, obviously fundraising is down in a difficult environment, but they're still allocating and most are indicating that they are allocating more. Maybe they're shifting where that is in the capital structure, but many are continuing to allocate because it's work for them. And in addition, specific to this conversation, there's a whole host of people out there who are very underallocated or have no allocation that could really benefit from that, particularly in this environment. And so the individual investors adoption, which is started, it's growing but still has a lot of white space, I think we'll continue to drive that growth.

Jonathan Forsgren:

Anastasia, what is your outlook for alternatives for the rest of the year?

Anastasia Amoroso:

Yeah, I mean there's a definitely different time horizons, but first of all, I do want to highlight that alternatives have really showed a strong record of outperformance over the last one year, three year, five year time horizon. And just to put some numbers around it, I mean over the last five years, for example, the S&P returned accumulatively 5%. And if you look at private equity indices for example, they returned close to 123%. If you look at venture, the returns have been closer to 157% compared again to that 55% for the S&P. So that's a historical look back. But if you think about the forward-looking assumptions for alternatives, they continue to remain strong. I mean, first of all, I will say that given the recent evaluations in the public markets, we are looking at somewhat better returns going forward for public markets.

But private equity, for example, is still expected to outperform public equity by at least 250 percentage points. Private credit is still expected to outperform public fixed income by 300, 350 basis points. And I'm sure Steven, you might have some even better numbers from the work that you do. So the forward-looking return expectations are still very much in favor of alternatives. And again, with the risk that tends to be lower than what you see in the public markets. If you ask me what is the outlook for the more immediate future and the next year, I would say it is divergent kind of depending on where you look in the alternative space. And if you think about, for example, buyout private equity, that's the space that I think is very well positioned because valuations are in the process of resetting, and at the same time, there's so much dry powder that's out there for private equity firms.

So the opportunity to take advantage of the reset in valuations of private companies is very significant. And historically, investors benefited if they invested in private equity in downturn years. So that's definitely a favorable near term outlook for me. Private credit, as I'm sure many will say on this call, I think is a very constructive outlook given the Fed funds rate to 5%, given the pullback in bank lending that we're seeing elsewhere and investors want to get paid while we wait out this volatility. So what better way to do that than in private credit earning 10 or 11%. And then we think get a little bit more mixed is of course commercial real estate. And while I do think that the bulk of the, so the repricing due to rising rates may be behind us, there is the issue of the wall of maturities of commercial real estate loans and what happens if some of those loans come due and there's not a willing bank to refight those loans.

So I think the expectations should be for higher defaults in the commercial real estate space. So near term that raises a risk, but for investors who are willing to look through that, through the lens of opportunity, I think over the course of the next year, we will find interesting opportunities and opportunistic real estate, meaning not just focusing on core assets with cash flows, but what is the opportunity for the upside in some of these dislocated properties?

Jonathan Forsgren:

Brendan, which private market asset classes are you liking most right now?

Brendan McCurdy:

Yeah, so there's a few that stick out to us at Ares. First off, it is private lending and in particular first lien loans. So the higher part of the capital structure, higher quality and first lien in particular means you're first in line if anything happens to go wrong with the underlying company, we do like those first lien loans because you are getting that 10 to 11% yield with a little bit of moderate leverage, you're up into mid-teens type of yield. And the really nice bit is not only have those had very low defaults and very low losses over decades, but we get really good collateral on those loans. And so we've got really good, we've got really good equity in front of us and really good assets that actually help to protect us in those loans. And the loans that we're making today have very good lender protections in them. So we like first lien lending.

I would agree with Anastasia that we like PE buyout, but I'd get even a little bit more specific and say we like to access that private equity buyout through the access point of secondaries. So the secondary market allows us to go in right now and be a provider of liquidity in a pretty illiquid market. It allows for many institutional investors, for instance, that need to bring down their allocations because either they had too much or they do need to access part of their portfolios. And by investing in secondaries, we get to be that provider of liquidity and get into many very attractive buyout underlying holdings and buyout managers, but at a discount. And we're seeing discounts on very good assets in oftentimes a 15 to 20% range right now. So we like that portion of PE buyout in particular. And then a bonus, one asset class that I'd give is private real estate lending right now.

So I'd agree with Anastasia that if you're looking to get into a portfolio of long existing loans, there could be real trouble, particularly from office borrowers, but in industrial real estate, in a multi-family real estate, which we both still both those asset classes right now, right now is a very good time to be making loans. And we're making loans in often the high single digits in terms of yield and again, with very good protection, very good collateral on properties that we very much like and wouldn't mind owning anyways, and about 70% loans to value. So again, a lot of really good equity ahead of us in those loans that we're making. And with the banks pulling back as much as they are right now, we'd expect to see a lot more commercial real estate lending opportunities there. So that's my two and a bonus.

Jonathan Forsgren:

Steve, you've been known to refer to private debt as an all-weather asset class. What characteristics about the asset class do you think contribute to this moniker and did that hold true in the very volatile year we saw in 2022?

Steve Nesbitt:

There have been a lot of asset classes that, and investments that said to be all-weather, I guess the only true all-weather asset class is cash, but unfortunately that over the long term that returns 0% on a real basis and a nominal basis. It's been until recently close to zero. So the question becomes, hey, is there an asset class that provides an attractive return above cash, above inflation that performs well during basically most market environments? And I've pointed to direct lending, senior secured loans, which Brendan referenced as really I think a good applicant for that title. So this year that just passed, 2022. Basically that strategy, at least if you look at our index and well-managed funds like Brendan's and Sean's produce positive returns and at about five to 6% in a year when stocks and bonds were down 20%, I consider that all-weather.

If you go back to COVID during 2000, there again, if you look at our index or well-managed products, basically direct lending produced a 5% handle during 2000. If you go back to the oil crisis, you could remember back to 2015 again, a problematic high vol year. Again, a 5% handle on direct lending, on private debt. With the long-term average being between eight and 10 and 10%, having a 5% downside, doesn't look bad. The real, just add the real stress test, the worst case is always 2008, that three Sigma event, as many people referred to it as, and basically middle market loans according to our index were down 6%. Anybody would've been jumped for joy with a minus 6% return in 2008.

Jonathan Forsgren:

Sean, earlier we touched on the high profile bank failures we've seen in the last few weeks. What is the difference about the direct lending model that makes it less susceptible to similar asset liability mismatches?

Sean Connor:

What's interesting is the type of direct lending that we do, which is at the larger end of the market, 100, 200, $250 million EBITDA businesses, a common question we would get is, well, why don't these very high quality businesses just work with the banks? And the banking model is they don't actually make those loans, they arrange them and they sell them into the market. And so that's the banking model within the direct lending space is they are an arranger to distribute model, which obviously is very different than what we do. What we do is we have long-dated capital, what we call permanent capital. It's 90, 95% of what we manage and that is perfectly aligned with the duration of these loans. We are buy and hold investors. And so when you think about what we do, we are providing predictability and reliability of capital. Because we have the capital, we underwrite the loans for the duration of those loans and we want to own them for the duration of those loans. It's a fundamentally different business model than what the banks do within our space.

Now, what happened to Silicon Valley Bank and Signature Bank and the like had really nothing to do with leverage finance, it was an asset liability mismatch. But I just want to highlight that normally we compete against those banks, big firms like ours and other direct lenders, and the value proposition is we are going to provide you a premium product, we're going to charge you more. We're going to have a document that is tighter, which is better for us as a lender. Of course, worse for you as a borrower, but you're going to have a reliable, predictable partner over the entirety of your loan. And when you see what just happens in the banking system, that reliability has really been called into question, not for reasons related to direct lending, but just generally speaking people are saying, well, is my financing provider reliably?

The banks had daily deposits, so they had the opposite of our business model. 90 to 95% of their money could leave every day instantly. Then they lent long on fixed income, long-dated, and they got that trade wrong. And we have the opposite business model, long-dated capital buy and hold investors that and know what they're buying and what they're holding onto. And the value of that has just gone up because of what happened in the banking system. So I think Steve mentioned it earlier, I think in the near to long term, this is a benefit for direct lending. People will look at the providers of capital, how are they set up? Will they be there for the long haul? And direct lending has proven time and time again that all-weather asset class. It's also been an all-weather support for the borrowers, which has helped it take market share.

Jonathan Forsgren:

Brendan, with many banks reluctant to commit to new financing in today's market, what does the opportunity set look like for direct lending now?

Brendan McCurdy:

Maybe I'll just mention that this has actually been a multi-decade change in trend that's that's already been in process. So actually if you go back to the early 1990s, you started to see a big wave of bank consolidation. I'm from the Chicago area originally, and so I think about a lot of the classic Chicago bank names from back in the day. So Continental Illinois, Alisal Bank, those are both part of Bank of America Merrill Lynch today. First Chicago, Bank One, those are both part of JP Morgan Chase today. And in fact, from that period on, we've seen the number of banks in the US decline. So there are about half as many banks today as there were a couple, few decades ago. And those banks then, now that they're part of much larger entities, it just doesn't move the needle for them to loan to the same small and mid-size regional and manufacturing companies that they used to lend to.

And in fact, if you look at commercial industrial loans today as a percentage of bank holdings, they've declined dramatically. And so this change has already been happening where banks have been stepping back from lending to companies, but with what's just happened in the last few weeks, we think that'll continue to accelerate the trend. And that's been true for a long time now on the kind of smaller and in mid-size of companies across the US, but now we're actually seeing that even in larger and larger deals. So many of the viewers will have seen the news that came out a couple of weeks ago that broke where potentially a $5.5 billion direct loan that Carlisle is trying to organize with a group of private lenders to fund its purchase of a stake in a healthcare company, a deal that large would've been quite unexpected and perhaps even unthinkable just a few years ago. And so we're seeing this retreat happen in real time, but we do think it's absolutely speeding up right now.

Jonathan Forsgren:

Anastasia, I'm going to come to you next here. With the continued economic uncertainty, do you think there's going to be an increased default risk here in private credit?

Anastasia Amoroso:

Yeah, Jonathan, I think it's obviously the right question to ask. I do suspect there's going to be an uptick in defaults in direct lending as well because after all, these are smaller middle market companies and probably some of them are more economically sensitive. Having said that, when you look at the defaults, for example, during the peak of the pandemic for direct lending, they were on par to the defaults that we saw in leverage loads partially because of some of the measures that were taken. So if we can have this expectations of those default rates being on par, on par with leverage loans, what we expect in the lev loan markets are default rates today of around 2.2%. That likely goes to three, 3.5% over the coming year and likely goes to 4% in 2024. So it's definitely an uptick and perhaps the direct lending will follow a similar trajectory, but we're not talking about double-digit default rates.

Sean Connor:

Maybe just to extend that last thought, Jonathan, I think one of the things that's important to understand is a default is not a loss. Those are two very different things. So just think about it on your house, if you default on your mortgage, the bank doesn't say darn it, and then walks away, they take your house and they sell it, right? They try to get their money back and recover it. They only lose money if the house is worth less than the loan. And so this is where direct lending is particularly valuable because if done correctly, you understand the house better because you've done, in the case of the company lots and lots of private side diligence, you have connectivity with the management teams. You shouldn't have many surprises because you're talking to them and can anticipate where they have challenges. And then the loan document, the mortgage should give you the opportunity through covenants and other protections to step in before that house or that company is worth less than your loan.

And so not only, so really defaults are one thing, but losses are really what drive returns in the private markets. And again, it comes back to the prior question. If you have the capital that's able to navigate and the team of course navigate through those challenges and maximize recoveries, default is really an equity problem first. And if a loan is at say, 40% loan to value, which is generally where our loans are, equity loses 60% first, then you start eating into an impairment on the loans. So defaults are really an inequity problem before they're a lender's problem, which again is why when you think about the uncertain environment being that senior piece in the capital structure, and Brendan mentioned this as well, is quite an important piece to consider.

Jonathan Forsgren:

And sticking with risk and private debt. Steve, according to your index, private debt has outperformed other common fixed income indices over other years. Does private debt provide more return because it's riskier? Is that just tied to it more a higher risk or what drives the difference in returns here?

Steve Nesbitt:

Well, it's in academia they call it the liquidity premium. So that's number one. So why does private equity outperform public equity? Why does private debt outperform public debt? Why does private real estate outperform public real estate? And that's because of the liquidity premium. You can't trade in and out of it. And so basically investors demand a higher return for investing in the private version of the asset class. Across all those asset classes, whether it's private equity, real estate or private debt, generally it's been measured to be somewhere between two and 3% premium over time. And if you want liquidity, that's great, go to the leverage loan market and you'll, all of the things being equal where you get a two to 3% lower yield, you can buy and sell it, but your yields not going to be as high. And basically though, if you're going to go to the private mar markets, you got to because you're holding these loans arguably to maturity, as Sean was talking about, you got to pay more attention to the manager who's underwriting the loan, the lender.

So consequently, there's more work to be done when, you just can't invest in private debt to a Bloomberg. You got to know who the lender is, what their track record is and so forth. I would also add that in addition to that liquidity premium, there's probably an additional one, maybe 2% additional return from picking the right lender versus the wrong lender. So not everybody's the same, and congratulations on picking two other panelists who represent outstanding firms at doing this. So anyway.

Jonathan Forsgren:

And Steve, how-

Brendan McCurdy:

Real quickly, Jonathan.

Jonathan Forsgren:

Okay, good.

Brendan McCurdy:

I appreciate that comment from you, Steve. And I'll maybe just add one note to that is when we're actually underwriting a new loan, there's actually three components that we think about that make up the yield. The first is just the risk-free rate, and there's no difference between the risk-free rate that private loan will have versus more public leverage loan. The second component is the credit spread. So the risk we, or the return that we get for the risk that we take on. And as Sean mentioned earlier, that's often, that spreads often a little bit higher in the private lending space, so you have a little bit of extra yield there. And then there's a third component, which is an underwriting fee. Right now we're seeing underwriting fees in the kind of one and a half to 3% range.

In the leverage loan space. They're also underwriting fees, but the banks that are organizing those leverage loans, they eat that one and a half to 3% generally. Whereas private lenders like ourselves, like Steve, like Sean's firm, we pass that on to our underlying investors. And so that's a big part of where the extra return comes from our perspective from, I think Steve is absolutely right from his perspective, from the underwriting perspective, that's the building blocks that we see.

Jonathan Forsgren:

So that kind of leads into the next question. I had this one for Steve. Steve, how much alpha exists in direct lending and how is it generated? And then some of that might've just been stated.

Steve Nesbitt:

Yeah, so I think there's an important point here. So you invest in venture capital or private equity, even publicly traded stocks for the upside, okay? It's always glass half full and you're looking for upside optionality and you're willing to concentrate your portfolio because you don't want to dilute that upside optionality. Fixed income, except for treasuries only bad things happen. Okay. So it's downside optionality. So to me, what the value of a lender is, one, being able to underwrite deals, not everybody can do that. And so there's value in that, but secondly, underwrite good deals. In other words, I would be willing to pay for an underwriter that has zero losses. And so how much value is that? Now, arguably according to our data, it's between one and 2%. So the average loss rate for our index of middle market loans averages is a little over over 1%.

Problem is with a bad manager, you can have 3% losses or higher. So to me, that's the framework. Zero loss is the best result. Average is one. If you pick a bad manager, it can be a lot more than that. And I think you want to reward a manager for having a lower loss rate. Generally we've been over the last five years, kind of a quiet period, losses haven't been that great. Going forward, that's even more important. So I think that's the alpha, not the highest yield portfolio, but the one that produces the lowest level of losses.

Jonathan Forsgren:

Okay. Anastasia, we're going to transition from private debt here to real estate. So what do you see as the best opportunities in commercial real estate right now?

Anastasia Amoroso:

Sure. Well, first of all, I think it's good to be talking about not just the risk but opportunities that are associated with commercial real estate. Because you see some of the headlines, for example, that commercial real estate just had the worst quarterly return since the global financial crisis. And if you look at the values of commercial properties, according to some indices, they're down 15% from the peak. If you look at office for example, it's down close to 25% from the peak. So when you see numbers like that, I think it's right to be starting to think about those opportunities, but also important for investors to consider that these opportunities may not be one and done here and now in the next month, but this may sort of extend throughout the course of the year as we experience this correction in real estate. But as you experience this correction, as you focus on opportunities, things that I would point to is multi-family, residential housing continues to be a top opportunity in my mind because mortgage rates are still elevated, home prices have started to correct, they're still elevated.

But as a result, a home buyer affordability is still at some of the worst levels that we have seen in many, many years. So multi-family housing, renting versus buying is still an attractive proposition. So yes, we might give up a little bit of the net operating income growth, but I think it may actually remain in positive territory. And given the low vacancies of apartments, I see that sector as being supported. So that's the near term one. The longer term one, as the correction really fully plays out in office, I do believe there's going to be bargains, there will be dislocation, and obviously working with the right manager to take advantage of those dislocations will be key.

Jonathan Forsgren:

Sean, Blue Owl's approach to real estate is a bit different from traditional commercial real estate investors. Can you talk us through what a triple net lease is and how does your strategy different from many other competitors that might exist in real estate?

Sean Connor:

Yeah, sure. So you're dead on, we play real estate and invest in real estate a little bit differently, and it's actually more a kin almost to credit where we're not going to buy an office building and apartment building and fix it up, operate it, and kind of work our way through tenants. It's much more of a financing solution. So what we do is we focus on what's called a triple net lease. So we're typically working with predominantly investment grade or other large corporates. We're buying their mission-critical real estate that they want to keep, but we're using our capital as a financing solution. They're selling it to us and they're leasing it back 15, 17, 20, 25 years, but they want to maintain control of it for their own benefit. And also we want them to maintain control of it for our risk, so they lease it on triple net lease.

What that means principally is they deal with all the expenses. So that's one of the challenges in real estate right now is expenses are going up, maintenance, taxes, insurance, all of that gets born by the tenant, then they pay us rent, and then there's typically an escalator on top of it. So what we get is typically a really high quality real estate, a very long-dated cash flow insulation from expenses, and just as long as that credit's good enough to continue to pay the rent, we have a high degree of predictability on a revenue stream. So very different than say, buying an apartment building and managing it through that challenge.

Jonathan Forsgren:

Brendan, with the volatility in fixed income markets, are you seeing an increased interest in infrastructure investment as a replacement for fixed income vehicles?

Brendan McCurdy:

It's an interesting question. So with regards to infrastructure, we are seeing some replacement both within fixed income and also within equity. So infrastructure can be both low and high risk. You can have more core infrastructure that's cash flow generating low risk, and some folks use that as more of a fixed income replacement. And then you can have much more equity-like infrastructure where you're going in, you're building out a platform of, it could be solar panels, it could be wind, it could be battery, it could be natural gas plants, but those are very long term and much more riskier equity type investments. So we see infrastructure being allocated to out of both equity and fixed income.

Now, I'd say more recently, the short end of the curve has been very attractive for six month treasury. When you're able to get four, four and a half percent, there's not as much attractiveness to going to the cashflow that you'd get from infrastructure. But as the short end of the curve, that real high short end of the curve starts to fade a bit more, we would expect to see a bit more of that replacement. But of course, the number one reason that most investors allocate to infrastructure is for the diversification benefits, for the interactive revenue for some of those automatic inflation adjusters that come with it. So it's really for the diversification benefits that we see more of the infrastructure allocation.

Jonathan Forsgren:

Anastasia, how has accessing private markets changed and what role should alternatives play for advisors in client portfolios? And how should financial advisors be thinking about an alt strategy in the context of individual investors?

Anastasia Amoroso:

Sure, Jonathan. Well, I think there's three reasons why investors should think about adding alts to the portfolio. The first is a potential for higher returns. So in a world where public equities have sort of been range-bound recently, may continue to be, you'll want to look for opportunities, they can get you an extra source of return, and that's private equity, that's venture capital. That over time has proven to deliver that extra potential upside. The second reason why you should think about adding alts to the portfolio is if it can enhance the income in the portfolio that you can be getting. And that's why we looked at direct lending versus just, for example, looking to high yield markets. And then the third reason why you should think about adding alternatives to the portfolio is if it can give you a diversification benefit. And I want to be clear that if you are investing in private equity, it's not really that much different of a risk that you're taking when you're taking with public equity markets.

So public equity is not really a diversifier, but if you are investing in hedge funds, for example, and depending on the type of hedge fund, let's say it's multi-strat or let's say it's macro hedge funds, they do have a low correlation historically had to other parts of your portfolio so they can be a true diversifier. And case in point is last year when everything across the board pretty much was selling off macro hedge funds, multi-strat have managed to deliver positive performance. So potential return enhancer, potential income enhancer and portfolio diversifier, are the ways that I would think about adding ALT to the portfolio.

Jonathan Forsgren:

And Sean, with interest rates pushing yields higher across the credit space, how do an investors benefit from allocating to alternatives as opposed to more liquid instruments from public markets?

Sean Connor:

Yeah, I think you benefit from a number of things specifically to direct lending relative to public fixed income, which is many of it is fixed rate, which we've talked about. You are taking interest rate risk there being in direct lending, principally a floating rate investment, you take that risk off the table in large part. In addition, if you just think about direct lending, the asset class today, and it was hit on earlier, it's generating 11, 12, 13% in some cases for senior secured floating rate loan.

Just to point out the last 14, 15 years, I think the equity markets have generated right around that level of return. So for being more senior in the capital structure in a floating rate instrument, getting your return paid poorly rather than waiting to get your return by selling your asset, you do end up adding quite a bit of value, I think to your portfolio and really just underscoring everything Anastasia just said. And so I think just generally speaking, within the credit space, as rates have gone up, the value of direct lending has gone up, not just because the base rate, but also the spread widening that's happened in this environment and it's among the most attractive that we've seen since we got Blue Owl outgoing.

Jonathan Forsgren:

Steve, coming to you, what message would you have for retail investors who are looking to add private debt to their portfolios?

Steve Nesbitt:

Well, if you look at the group of funds that have the longest track record investing in private funds, those that would be endowments, corporate pension plans, public pension plans, generally their allocation as a percent of their total portfolios is 30 to 50%. So I would not recommend those levels for individual investors, no, the generally their liquidity needs are perhaps higher and more uncertain. Also, the level of understanding is probably not as great. So generally I recommend somewhere between 15 and 25% allocation to alternatives. And that may seem high for a lot of individual investors.

But I think of it this way, generally you can earn, whether it's the lower risk direct lending or the higher risk private equity or the highest risk venture capital, generally you should expect three, an additional three to 5% on top of what you would earn with public bonds or public equity. So three to 5%, let's take 4%. Let's say you're allocating 20% of your portfolio to alternatives, keeping the risk the same. That's 20% of 40%, of 4%. That's close to an additional 1% return at about the same level of risk. And I consider that pretty significant over a long period of time. And that's what we generally recommend for individual investors.

Jonathan Forsgren:

And how are investors being rewarded for concentrating capital with specific lenders versus diversifying?

Steve Nesbitt:

Well, I think this is something very important. It goes to portfolio construction so there are some outstanding, two outstanding managers on this panel, but I would never put a hundred percent of my money with any single lender or single private equity GP. I think there's some level of diversification that makes sense, and I would diversify at least across three different funds and probably more, maybe five to six funds maximum. And it obviously it depends on the asset class, but diversification is important here and it's particularly important in private debt where it's, as I talked about downside optionalities.

Jonathan Forsgren:

Anastasia, earlier you talked about a reset in valuations. How can advisors take advantage of this reset in valuations in the private markets?

Anastasia Amoroso:

I think the best thing advisors can do right now to take advantage of it is to commit now to invest capital over the coming quarters or maybe coming year or two. And the reason I say that, if you commit to, let's say to invest in private equity, that capital is going to be called over the next three or four years. But of course the managers may have the discretion to deploy that sooner rather than later if they see a dislocation that's playing out right here, right now. So we're not out of the woods yet when it comes to the economic environment. We may still have a recessionary event, but the valuations having reset already. Chances are, if you're methodical, if you are deliberate, if you commit capital and you deploy that over the coming quarters, chances are you'll pick up some pretty good valuations along the way.

And once again, if you invest in private equity, for example, during the downturn years, the net IRS for those downturn year vintages were certainly higher than what we saw just prior to those down years. So chances are 2023 is going to be a much better vintage for private equity than 2021 was. I think the same probably goes for private credit and certainly commercial real estate. This notion of dollar-cost averaging into it as assets go through as correction cycle is also the right one to me.

Steve Nesbitt:

I would just add, hey Jon, if I could just butt in here. One thing that I've never, particularly for individual investors like this private fund structure where you make commitments and then you're investing over long, they're calling your capital over three to five years and you get your money back. I find individual investors, even institutional investors, very frustrated, Hey, I want to invest in private equity or private debt. Now I got to wait three years, three years down the line I finally get my capital calls and I don't know what the market conditions are going to be in three years. I don't know what my personal condition is. Financial condition is going to be in three years.

I really like what's happening in the market today. We're doing it. My two other panelists, their firms are doing it, creating vehicles that allow investors instant exposure to the asset class they want to invest in. So the investor controls their liquidity. They decide when they're in and when they're not, and on exit providing the maximum amount of liquidity possible for the asset class. I think that is the revolution. It is structuring the new structures being introduced. I think that's the innovation that's going to change this market.

Jonathan Forsgren:

Brendan, if a retail investor is thinking and wants to get into investing in alternatives, where should those retail investors be considering reallocating funds from to invest in those private market opportunities?

Brendan McCurdy:

Yeah, I'll try and keep it as simple as possible. If the investors are looking at private equity, even though private equity is shows much lower volatility than public equity, it is still equity. So we would allocate to private equity out of public equities. We'd allocate to private credit primarily out of fixed income, and we'd allocate to private real assets, both real estate and infrastructure out of a blend or a mix of equity and fixed income, depending upon where the investors looking for more diversification as well as whether the investors targeting more returns or more lower volume. So that's the simplest answer.

I think the other way to slice this question is thinking about it from an advisor's perspective, maybe they've built up some cash over the last six to 12 months, and if they have cash and they're thinking about how to start integrating that back into the portfolio, starting to put that back to work again, we'd look at what is the long-term target that you want to have, whether it's 70/30, a 60/40, a 50/50 portfolio, and we'd allocate potentially from cash as long as it won't put you above where those long-term equity fixed income mixes would be.

Jonathan Forsgren:

Well, thank you all so much for your insights on alternative investments. Before we end, I'd like to get a conclusive sentence or two, closing thoughts from each of you that our viewers can take away with them when they leave here. So Brendan, why don't you start us off?

Brendan McCurdy:

Sure. Well, I'll start by saying really appreciate, Jonathan, you having me on. Big thank you to my fellow panelists for the good discussion. And my final thought, as everyone knows, we're in a real strange market right now, but downturns like this, what's set up the next three to five years of returns in private markets. And so that's very well worth all advisors and investors keeping in mind.`

Jonathan Forsgren:

Anastasia?

Anastasia Amoroso:

I'm going to have to echo what Brendan said, which is downturns don't [inaudible] often, but we are in the process of evaluation, reset across many different asset classes, including within alternatives. So it's the right time for investors to be taking advantage of. And the second thought is a lot of private investors are not yet allocated to alternatives, or if they are, that allocation is very small. So why not take advantage of the recent valuations that we're seeing and increase those allocations at this opportune time?

Steve Nesbitt:

Yeah, I would just say for most of you who have basically stuck with the 60/40 mix, on a go forward basis, again, no crystal ball, but you're probably looking at a mid-single digit return over the long period of time with volatility of plus or minus 20%. So if mid-single digits sounds good to you with a lot of volatility, stay with what you're doing, the benefit of alternatives is probably an additional 5%. So those alternatives, getting to 10% plus a much less volatility, plus or minus 10% rather than 20%. Do your homework. That's very important in alternatives and good luck, hire good professionals.

Jonathan Forsgren:

And now to our closer, Sean.

Sean Connor:

All right. No pressure. Well, maybe just to the point about do your homework and know who you're working with, maybe just to start there. Blue Owl, we actually are partnered with everybody on this panel in one way or another, and actually in many ways. And so, one, thank you for having us, and two, if you find yourself talking to anybody at the firms on this panel, you've done a good job doing your homework. So that, I think that's an important consideration across the board. And I'll just end where really echoing what everybody said, I'm a big believer that volatility and chaos creates opportunity. You need to know who you're working with. You need to have a long-dated and the right capital structure to take advantage of that. And as we spend a lot of time talking about, there's a lot of options out there with good quality managers that are well set up to do that and hopefully add real value to clients' portfolios.

Jonathan Forsgren:

Well, thank you for those and thank you for being part of the panel.

Steve Nesbitt:

Thanks, Jon.

Sean Connor:

Thank you.

Anastasia Amoroso:

Thank you.