Alternative investments may have higher volatility on their own than more traditional investments, but they often have low correlations with or diverge from more conventional asset classes. Investors may find it more challenging to produce consistent income-driven returns and alpha through the public markets alone because of slower economic growth, higher inflation and rising interest rates. On both counts, alternatives have become viable options. 

We asked Michael Underhill, Founder, CEO and CIO of global alternative assets manager Capital Innovations, LLC. and President of ADISA, in an email interview about his investment considerations when allocating to alternative investments; whether he sees allocations increasing or decreasing over time; opportunities in the growing secondary markets; and what role certain strategies play amid higher volatility, inflation and interest rates. 

Underhill, who will be one of the panelists on Alternative Assets Fundraising: Steering Through Rough Terrain at Connect Money’s inaugural Alternative Assets Conference on June 14 in Chicago summed up his perspective in an acronym – VUCA (Volatility, Uncertainty, Complexity, Ambiguity). 

Since the early 1980s, the 60/40 portfolio of public equities and bonds was the gold standard for achieving long-term wealth. But more private market firms have been turning to alternative assets for capital.   

Connect Money: What investment considerations are important when allocating to alternative investments?    

Michael Underhill: Investors are rethinking markets, reallocating portfolios amid dramatic shifts in the macroeconomic and geopolitical landscape. According to TIAA CREF survey of 800 global institutional investors, 59% of investors are actively rethinking, redefining or hitting the reset button on portfolio strategies. Investors are reallocating portfolios as 72% are planning to increase allocations to private market alternative investments, and 71% of investors are prioritizing infrastructure for climate risk mitigation strategy. 

Connect Money: Do you see allocations increasing or decreasing over time? Can you compare alternative investments and bonds as risk mitigators in relation to a long equity position? 

Michael Underhill: Investors adapt their outlooks and portfolios to a dramatically altered landscape. Forces such as geopolitical turmoil, inflation and macroeconomic uncertainty reshaped the investment landscape in 2022 – causing many investors globally to take action. The degree of change in their actions is unusual given institutional investors’ long-term orientation.

After decades of benign inflation, it has reemerged as a major concern to investors. The rate of annual inflation has increased substantially in 2022, reaching a peak of 9.1% in the US and 10.6% in the Eurozone. Inflation erodes purchasing power and hence it constitutes an investment risk. Fortunately, there are ways to mitigate this risk which can be achieved with inflation-linked bonds or inflation-linkers, as they are also called Real Assets: Infrastructure, Real Estate, and Natural Resources. 

Shares of strong private companies are being sold in the secondary market as sellers are coming to terms with the fact that if they want liquidity now is the time to sell in the secondary market.  

Connect Money: What opportunities, if any, are you seeing in the secondary market? What are the main types of deals? Are there new entrants into the market? 

Michael Underhill: Many investors have historically viewed secondary strategies as a beneficial allocation early in a private market’s program’s life due to several potential attractive features, including J-curve mitigation, efficient capital deployment, significant diversification, and, importantly, the compelling opportunity for risk-adjusted returns. 

Infrastructure secondaries are growing rapidly. If we theorize that infrastructure secondaries were to follow the growth trajectory of private equity and real estate – and the primary infrastructure market grows to $2.1tn by 2025 – infrastructure secondaries assets under management could reach between $50bn and $67bn in 2025.  

The research shows that, in September 2021, global infrastructure secondaries stood at $18.6bn and accounted for 1.4% of total infrastructure assets. This is a similar position to that of private equity in 2001 and real estate in 2016. If infrastructure secondaries were to follow the growth of their counterparts in real estate and private equity, this market could reach between 2.4% and 3.2% of total infrastructure assets by 2025. 

Headwinds for traditional assets may be tailwinds for private investment strategies.  

Connect Money: What role can macro, long/short equity, and relative-value strategies, among others, play amid higher volatility, inflation, and interest rates? 

Michael Underhill: Welcome to VUCA (Volatility, Uncertainty, Complexity, Ambiguity), a new era in which the certainties that a generation of investors have grown so used to have started to crumble before our very eyes. Communication breakdown is the main attraction in financial markets.   

Nothing seems particularly moderate about today’s macro climate. We are experiencing turbulent times as we are confronted with the highest US inflation as well as the lowest Chinese GDP growth of the past 40 years, record-low consumer confidence in the US and the Eurozone, the Russian war in Ukraine, and an energy and food crisis. The largest global growth engine is sputtering as China tries to stabilize widening cracks in its economic stronghold over the past two decades. 

We believe the longstanding regime of investment-friendly political and economic conditions is under increasing duress. Many secular trends that suggest rising long-term risks have been exacerbated during the pandemic, including record-high debt and inequality, extraordinary monetary and fiscal policies, and rising deglobalization. Inflation, policy and profit risks warrant high levels of strategic diversification. 

Periods of high inflation tend to lead to greater volatility and a challenging market landscape. Historically, however, fleeing to cash once inflation was already high failed to provide better returns over medium- and long-term holding periods. Over the past century, holding a diversified portfolio incorporating macro, long/short equity, and relative-value strategies when inflation had already hit 4% (or above) far surpassed cash returns over the subsequent 3- to 10-year periods.

Hear from industry leaders in alternative assets like Capital Innovations Founder, CEO and CIO, and ADISA President Michael Underhill. Connect in person with top executives in private credit, real estate and more at the Connect Money: Alternative Assets Conference in Chicago on June 14 at the W City Center.