Capital Innovations’ Michael Underhill Highlights Emerging Trends, Strategies in Alts Industry

In the face of economic instability and changing market conditions, investors are becoming more inclined to explore alternative assets as part of their allocation strategy.  

Most investors construct their portfolios by allocating their investments to traditional assets, such as equities, fixed-income securities, and liquid funds. These can offer both growth and a degree of diversification. Nevertheless, certain investors pursue diversification that extends beyond these traditional asset categories. 

Industry experts have heralded the advantages of diversifying investments into alternative assets instead of adhering to the conventional ’60/40′ allocation of stocks and bonds. 

Michael Underhill, CIO of Capital Innovations and past president of ADISA, identified the main drivers of the growing appetite for alternative assets, along with the importance of education, the emerging trends in the space, and what he’s telling his clients, among other topics. 

CM: The data clearly show that the appetite for alternative investments is rising. What do you identify as the main drivers of this increase?    

Underhill: Alternative investment strategies continue to offer the potential for increasingly unique sources of enduring diversification. Alternative investments totaled $13 trillion in assets in 2021, according to market research firm Preqin. The total dollar value in these classes has more than doubled between 2015 and 2021 and is forecast to reach $23 trillion by 2026.  

Real estate, infrastructure and natural resource investments (Real Assets) have increasingly played a critical role in the success of some of the largest endowments and foundations worldwide, with Harvard, Stanford, and Yale allocating north of 25% of their overall funds toward real assets. 

CM: We often hear that investor education is a top priority when investing in alternative assets. Do you agree, and how does that impact your work?    

Underhill: Investor education is of paramount importance. Our focus is on improving investment and societal outcomes of capital allocation through professional education, transparency, and thought leadership across all investor alternatives in our industry. 

Over the last 17 years I have been focused on conducting alternative asset allocation seminars for EDHEC/CFA Institute programs, writing CFA Level 1 exam content, writing the Handbook of Infrastructure Investing while contributing to numerous other industry experts books, publishing over 100 industry whitepapers and frequent media appearances on a global level to help improve financial literacy around alternative investments.   

CM: Where should investors start when considering alternative assets?    

Underhill: A balanced portfolio consisting of various asset classes that offer diversified cash flows, return drivers, and risk premia enables less volatility and lower drawdown risk in achieving those long-term goals 

Alternative investments are naturally opaquer and more complex than traditional markets and therefore require proper education and robust due diligence to effectively evaluate their appropriateness for clients. 

Developed public equity and investment grade debt markets are largely efficient but significant information and pricing inefficiencies remain in private markets and real assets as well as emerging public equity and debt markets. 

Private capital offers unique benefits versus public markets such as a disciplined focus on long-term value creation, better alignment of incentives across the capital structure and management, and a more natural allocation of capital to socially impactful opportunities. 

CM: What emerging trends do you anticipate the industry will see more of in the short-term and long-term?    

Underhill: Trust, transparency, and professional standards are essential to a properly functioning capital market system that serves the public good; regulations and laws are not enough by themselves. The role of capital allocation is to facilitate the flow of financial resources between investors and spenders to improve social, communal and investment outcomes. A purpose driven investment firm with a fiduciary, client-centered culture will produce more sustainable results over time. 

With many financial advisors and brokers seeking to emulate the endowment model with their individual clients, real asset strategies have flourished in the past few years, aided by the unique structures that democratize access to these asset classes through interval funds. 

CM: What made you decide to get into alternative investing?    

Underhill: Early in my career I was fortunate to have a mentor in Jim Fitzpatrick, PhD. Jim was credited with saving the YMCA Retirement Fund from bankruptcy and bringing it back into the black by investing in venture capital, private equity and energy/power infrastructure deals back in the 1970’s. Jim convinced me to work with him and his pitch to me was, “early on in your career you get a choice between working for a great mentor or higher pay, take the mentor every time.” Stan Druckenmiller used that line quite frequently, sometime later after. 

CM: What are the most common questions your clients are asking now and what are you telling them?    

Underhill: How do you construct portfolios? We believe it is important to keep an eye on top-down factors, while focusing on bottom-up fundamental asset level research, which is why we incorporate a macro framework into our investment process. In our experience, this approach has demonstrated an ability to enhance total returns in a variety of market conditions, providing the potential for improved investment results over time. 

What separates Capital Innovations from the large publicly traded alternatives managers? Our focus is on the lower middle market infrastructure and real asset GPs that can generate attractive risk adjusted returns through a combination of operational improvement & financial engineering. We are not competing with large market players that bid for assets at auctions where the largest check wins the deal. Capital Innovations has spent over 17 years building a network of proprietary deal sourcing in private markets infrastructure. 

CM: How does this market compare with other periods of dislocation over the past few decades?    

Underhill: We see the market upside capped during summer due to the inconsistency between consensus call for disinflation and the belief in no landing and earnings acceleration. Even though equities overall have been very resilient to date, within the market there was a more defensive rotation underway in Q2, compared to Q1. U.S. growth momentum is likely slowing from the brisk pace seen in the past quarters.  

CM: What are some alternative strategies worth considering?    

Underhill: The environment we just exited from 2008-2019, with low economic growth, low interest rates, low inflation which benefit financial assets versus the current environment (higher for longer rates, sticky inflation, better economic growth, etc.) which is supportive of real assets, specifically infrastructure. 

In addition, factor in the massive amounts of fiscal stimulus in the Infrastructure Investments & Jobs Act, CHIPS Act & Inflation Reduction Act (IRA – which creates higher inflationary pressures through onshoring). 

It is a perfect storm for real assets which is why institutional investors are increasing their allocations to infrastructure from mid-single percentages to double digit percentages and advisors are revising their models to include 10% allocation to infrastructure. 

CM: What are the primary challenges facing the alternative assets industry today? And how must the industry address them?   

Underhill: Rapid growth of the alternatives industry, as we have seen approximately $14 trillion private markets AUM (14% share of global AUM) growing at 14% CAGR over last 10 years. It is a fragmented industry with pure play private market managers as well as broader diversified asset managers vying for market share. Alternative managers are growing much faster than traditional managers, but growth decelerating of late… and high margin profile in the 40s. 

Alternative asset managers are increasingly focused on expanding retail distribution and growing permanent capital, with some managers further along than others while the successful managers squarely focused on investor education…that will be the key.