Private fund spring

October 2024 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

October 2024 Issue

With the advent of high interest rates, institutional investors have gravitated toward a bevy of credit products, taking advantage of perceived lower risk profiles and relatively strong returns. This has siphoned capital away from the private fund markets generally, and alternative investments, specifically.

However, as interest rates decline (thus making the return profile on credit products less desirable) and headwinds buffet the global economy (thus increasing the potential for credit defaults), investors are likely to give alternative investments, including litigation finance, a closer look.

Beginning with the 2008 credit crisis and continuing through the coronavirus (COVID-19) pandemic and associated economic impacts of recent years, interest rates had been kept artificially low by central banks (including the US Federal Reserve) in an effort to stimulate the global economy. These policies had the effect of creating an entire generation of consumers and finance professionals who had been raised in an era of, effectively, free credit. Borrowing costs remained low as the returns on equities and alternative assets continually hit new highs.

As a result, institutional investors with capital to deploy often looked for higher return assets, typically offered by private funds, as traditional credit products languished. Moreover, traders without dry powder could engage in an arbitrage strategy by borrowing at low rates and deploying the borrowed cash into higher return assets.

This strategy was most evident recently in the so-called yen carry trade where private (usually hedge) funds borrowed yen at a depressed level set by the Bank of Japan and then used the borrowed cash to invest in higher return assets elsewhere. As with most financial stratagems, these schemes worked until they did not.

As inflationary pressures increased during the post-pandemic recovery, central banks had no choice but to raise interest rates in order to combat the greater evil of inflation at the expense of economic growth. This came at a time when governments were still trying to bolster industries that could have disappeared as a result of COVID-19 and its aftermath, which included debt guarantees for some sectors of the economy. Within a short period of time, credit products breathed new life as investors realised that credit provided reasonable returns, via increased interest rates, with relatively low risk, due to strong economic indicators and governmental assurances. Capital began to be siphoned away from alternative assets into both the bond and structured credit markets.

This shift was most notable in the private funds space. Ask any fund manager and they will tell you, anecdotally, that sources of capital had dried up. This spawned a new vocabulary in the private equity (PE) space, for example, with monikers such as ‘biotech winter’ becoming commonplace. For the uninitiated, biotech winter refers, among other things, to the pullback of venture capital (VC) and PE funds’ investments in the life sciences space in favour of other (e.g., credit) opportunities.

The combination of high interest rates and a booming economy in the US meant that private and public debt offerings were deemed ‘safe’ and offered good returns vis-à-vis the general market. The flow of capital into credit products became so pervasive that some alternative investment managers began to offer ‘credit-like’ returns by over-insuring their non-credit assets to mitigate risk, while also dampening the overall return profile, to satisfy investor demand.

Like pendula, finance markets tend to swing after reaching their apogee. To utilise the example from above, the Bank of Japan announced a rise in interest rates at the end of July of this year. Normally, this may have minimally impacted Japanese borrowers and assets. Instead, within days, the move created a global shockwave in the equities markets as arbitrage traders engaging in the yen carry trade suddenly realised that their investments were underwater.

Even small rises in interest rates meant that this financial strategy could fail and triggered automatic selloffs. Initially, there had appeared to be little reason for the drastic downturn in stock markets around the world as global economies and finance markets appeared stable (save, perhaps, for a concern about the technology sector). The ‘shock’ seems to have come from the realisation that the era of low risk and high return credit investments had come to an end.

This new market dynamic will likely demand a shift in investment strategy back to assets that are higher risk and higher return. This is the case for two interrelated reasons. First, from a return standpoint, credit products cannot perform as well if interest rates drop. Institutional investors will simply not deploy significant cash into asset classes that barely outpace inflation. Instead, those investors will look to financial products that generate higher returns, which have always included alternative assets typically housed within private funds. Hedge funds, PE funds and VC funds may take on a new shine as the economic landscape shifts.

Greater returns are only one side of the equation, however. One of the reasons credit products have been so alluring in the recent past was because of their perceived low risk. Enter the second reason there may be a shift in demand toward alternative assets: the global economy may be softening. Credit is simply a financial term for debt, whether public or private. In an expanding economy, the risk of a credit default, whether by a sovereign or from a private or public company, is relatively low overall. As economies weaken, however, the risk of default increases.

While structured credit products, such as collateralised debt obligations, can mitigate such risks, they cannot completely stave off negative results. Regardless of the structure of the debt, a weaker economy means more defaults which means more risk. Investors who initially bought into what appeared to be low risk and high return credit products may suddenly discover that those investments have inverted to become high risk and low return. This realisation should result in a shift of capital back to alternative investments and private funds. The financial press has already picked-up on this trend, with headlines such as ‘Biotech Winter is Beginning to Thaw’.

However, not all alternative assets are created equal. For example, as credit markets wane, structured debt might not be the best investment choice while credit default swaps may see a resurgence. Certain asset classes, such as litigation finance, are more tailor-made for the combination of lower interest rates and economic downturns. Most litigation finance funds use pooled capital to invest in litigation across a panoply of industries. These funds typically promise outsized returns, normally multiples of credit returns, while presenting a higher risk profile.

This asset class can perform well regardless of the general state of the economy but becomes even more desirable during downturns because litigation finance is generally believed to be uncorrelated to the markets. Whether a party wins or loses a law case has no connection to the broader financial markets, thus making litigation finance funds a partial hedge against correlated assets. Furthermore, certain types of litigation tend to run countercyclical to the economy as a whole. This is particularly true of financial services litigation where parties tend not to engage in expensive dispute resolution unless there has been a significant loss. As a result, a slowing economy tends to benefit the litigation market generally and litigation finance specifically.

Given the overall market dynamics, it would appear that we may be entering a new investment phase where alternative assets and funds, and especially litigation finance, see renewed interest from institutional investors. If that is the case, investors should be prepared to shift assets away from bond and structured credit products and back into a plethora of alterative assets and private funds. To borrow the so-called biotech winter phraseology, we may be entering a private fund spring.

Jonathan Sablone is chief litigation officer and a managing director at Delta Capital Partners Management LLC. He can be contacted on +1 (617) 460 2591 or by email: jsablone@deltacph.com.

Jonathan Sablone

Delta Capital Partners Management LLC