AXA: Why alternatives are here to stay

The investing environment has become volatile and unpredictable, but Isabelle Scemama and Deborah Shire of AXA IM Alts see opportunities ahead for private debt and alternative assets overall.

This article is sponsored by AXA IM Alts

Globally, the world is gradually transitioning to a ‘new normal’ reflecting higher inflation, higher yields and elevated volatility. Geopolitical risks and aggressive monetary tightening have resulted in an economic slowdown and allocation targets across all asset classes are back under the spotlight as investors search for the best strategies to mitigate against current macro risks. Isabelle Scemama, global head of AXA IM Alts, and Deborah Shire, deputy head of AXA IM Alts, discuss why this backdrop represents a watershed moment for the alternatives sector and where the current opportunities lie.

Given that you have one of the largest alternatives platforms worldwide, what are your views on the alternatives sector in the current macroeconomic environment? Do you think the current backdrop could have an impact on the long-term growth prospects of an industry that has developed at a very fast pace over the past decade?

Isabelle Scemama
Isabelle Scemama

Isabelle Scemama: As we navigate a tumultuous and volatile environment, there are a number of underlying fundamental long-term characteristics that will continue to make the alternatives sector attractive to investors. These include: diversification, through providing access to underlying asset classes that would not be accessible in traditional markets; a contained mark-to-market volatility; a mitigation of downside risks due to structural enhancements or protections and rights when it comes to debt; and an increasing demand for sustainable investment and ESG-integrated asset classes.

Inflation and interest rate rises remain very much at the forefront of investors’ minds, but alternative assets can offer good protection from inflation. This is especially the case when revenues are indexed to inflation rates, for example in real estate and infrastructure – or in the alternative debt space, with its floating rate component. Obviously, investor appetite depends on where they stand versus their target allocation, but many are still far away from reaching this target, or are actively looking at opportunities derived from the current market strains and volatility. All of this should drive further inflows to the asset class.

Based on previous experience, the current market strains and disruptions are likely to present additional opportunities. Subsector dynamics will be key to outperformance, as will themes underpinned by global megatrends such as urbanisation, demographics, digitalisation, decarbonisation and shifting economic power and global health. In this respect, and because it addresses the need for digitalisation as well as green electrification and transportation, infrastructure should remain particularly attractive.

Regarding the private debt and alternative credit space specifically, what is your assessment of the situation? Are inflation, rising interest rates and a potential recession points of concern?

Deborah Shire
Deborah Shire

Deborah Shire: Private debt and alternative credit is obviously not immune to the rise in default rates derived from the current macro environment, but equity cushions are comparatively much larger than when the global financial crisis unfolded.

Regarding interest rates, one fundamental factor is that the industry is usually a ‘floating rate plus spread’ one, which means that private debt is often a good hedge for interest rate increases. Equally, inflation will help to keep real interest rates negative, helping debt erosion and positioning debt favourably to equity. We are seeing a margin repricing of 50 to 200 basis points across different markets, with the drying up of bank financing and lower competitive landscape making private lenders a main source of available capital in the mid-cap space. Ultimately, banks are proving increasingly cautious and unwilling to lend, and the rebalancing of power between lenders and borrowers brings us back to a lender-friendly environment with more discipline observed within financial structuring arrangements. All of this can increase pricing power and produce opportunities for alternative lenders.

In this environment, selectivity and due diligence will become paramount. It is therefore an exciting moment for the asset class, and one that could define its future, provided alternative managers remain disciplined and loss rates remain constrained in the upcoming cycle. After a relatively benign environment, the current crisis will most likely allow LPs to establish a proper tiering of direct lenders, as performances are expected to vary depending on the underwriting discipline of managers over the last few years. The key to resilience will lie in the sector allocation of portfolios, where we have been particularly vigilant in terms of exposure to cyclical underlying sectors.

On the issuer side, do you see rapid secular demand growth continuing? Do you think banks will pull out further from some segments of the market, creating more opportunities for firms like yours?

IS: Globally, available liquidity continues to be withdrawn from commercial banks, and banks in general are faced with challenges of tightening policy and heavy regulation, all of which has led to a further retreat from bank lending, including in the commercial real estate debt space, broadly syndicated loan markets (and more recently the Term Loan A revolver market) alongside mid-market lending. Whereas the US market was already largely disintermediated, we see a new wave of disintermediation in Europe, unfolding similarly to during the GFC.

Globally, we are seeing banks refocus on the core parts of their lending markets that are complementary to the above and cannot be disintermediated. This includes revolvers and liquidity lines for large-cap investment grade corporates that carry minimal returns and strong operational complexity but are nevertheless core to relationships, as well as, on the other end of the spectrum, very granular SME portfolios that present diversification and are usually very local portfolios, but which are too small to create an efficient asset management business.

Where do you see the best opportunities currently in the private debt and alternative credit space?

DS: Given current macro uncertainties, we are focused on defensive plays where the premium has nevertheless reflected part of the liquid dislocation, allowing for strong credit exposure at improved return levels.

The Dutch mortgage market is a good example as it provides exposure to very granular residential mortgage portfolios that have perfectly replicated the rise in interest rates over the last year with a preserved spread pick up to government bonds. At the same time, overall performance is excellent as they have very strong origination and legal criteria.

Senior tranches of collateralised loan obligations also present very strong structural protection against default risk with large cushions on very diversified pools of assets, while having repriced severely as a result of both the widening of the loan market and the presence of forced sellers.

Separately, banks retrenching provides very specific opportunities: in line with the dynamic on banks’ capital that we mentioned earlier, we believe that regulatory capital trades/Significant Risk Transfers present a massive opportunity. These strategies address the needs of banks for Tier 1 capital in front of their core lending prime portfolios. The current dynamic of tightening and regulatory pressure on bank capital provides for very strong volumes (at or above all-time highs) on transactions. Those volumes have led to unprecedented repricing compared with other private markets, more defensive structures and higher overall credit.

Finally, in line with current market trends and banks’ disintermediation, CRE and infrastructure debt remain attractive, given the diversification benefits they provide, and we foresee very good entry points in 2023 with options to get access to the best collateral, stronger capital structures and spreads that have started to widen.

For some time now, you have both been at the helm of a leading player in an industry that remains dominated by males. Have you seen a positive evolution, and what would be your personal piece of advice to other women entering the industry?

IS: We have seen a slow but positive change in terms of the numbers of women choosing to enter the industry, and notably, those that hold leadership positions, although there is still a long way to go. In terms of advice, I think it is crucial to: receive support from your personal environment, especially if you want to balance work with having a family; make sure you pick a supportive employer who will nurture you in your ambitions while providing much needed flexibility; and proactively build your network to find supporters who can provide insights, act as role models and build your confidence.

DS: I believe that the change will come from the next generation, and it is our responsibility to create the pool of talent from which tomorrow’s leaders will emerge. That is why we as a business do as much as we can to engage with students through talks and events, so that we can show role models what a career in this industry might look like, while teaching them to be their authentic selves.

ESG concept

On ESG, what’s your assessment of the progress made over the past five years? Do you think the current macroeconomic environment could delay the integration of ESG into the private debt and alternative credit industry or serve as an accelerator?

IS: Overall, significant progress has been made over the past five years in the alternatives industry. ESG is on the agenda of a larger majority of players and this allows the industry to move in the right direction. Of course, there are still challenges, particularly around data collection and limited standardisation of processes without collective industry KPIs or definitions.

However, it is not an option to wait for a perfect world, and companies must act now to do what they can to accelerate the integration of ESG investment policies despite this lack of clarity. That’s what we are doing across our asset classes, notably with the decarbonisation of our real asset portfolios, our infrastructure investments and the launch of dedicated strategies including in natural capital.

DS: On the private debt side, Europe is leading the way on ESG in the wake of the latest SFDR regulations and an increased awareness from LPs and GPs. Investors are requesting a better understanding of the ESG footprint of their portfolios, while lenders are starting to play their part by including ESG commitments in credit documentation, offering margin grid ratchets in return for ESG achievements.

We see this give and take, for example, at Capza, a leading European alternative lender in which we own a majority stake. In its latest direct lending strategy, more than 100 ESG data points are collected each year for each borrower, allowing for an annual estimate of the portfolio’s carbon footprint, while committing to have ESG clauses in more than 50 percent of its credit documentation.

Similarly, in our broadly syndicated loan portfolios and securitised assets, we are deploying data collection for all PAIs and ESG-scoring methodologies in order to report on those in 2023. Across all those syndicated markets, our approach is to play an active role in the creation of homogeneous market standards.