Stockholm (HedgeNordic) – Alternative asset classes have gained popularity during the decade-long low-interest-rate environment as investors sought higher returns and diversification. However, the recent shift towards a higher-for-longer interest rate environment has reshaped the dynamics and attractiveness of these alternative asset classes, impacting some positively and others less so. Laura Wickström, newly appointed CIO at Veritas Pension Insurance, notes that higher interest rates have changed asset allocation considerations by expanding the scope of attractive asset classes.

“The gap between cash and some assets that performed well in the previous low-rate environment has narrowed,” argues Wickström, who assumed the permanent CIO role at Veritas in July after years as Portfolio Manager responsible for private equity and other illiquid fund investments. “We continually monitor and prepare for even the smallest shifts in the relative attractiveness of different asset classes as market conditions evolve,” she emphasizes. The effects of the higher-rate environment on alternative asset classes vary based on the interest rate sensitivity of each asset class and a wider range of factors.

“The transition to higher interest rates has put downward pressures on some valuations, especially on interest rate-sensitive assets such as real assets and core real estate,” notes Wickström. Core real estate assets, typically located in larger or growing markets with high occupancy rates and long-term leases held by creditworthy tenants, have been particularly vulnerable to higher rates, according to the CIO of Veritas. “Quality real estate assets have suffered relatively more due to the interest rate adjustment and increased return requirements,” Wickström explains. On the other side of the spectrum, private credit has benefited from higher interest rates, partly due to its floating-rate nature.

The Environment for Private Equity

The influence of higher rates on private equity is more nuanced and multi-faceted, according to Wickström. While interest rates had an impact on company valuations, she explains, “returns in private equity depend on a lot more factors beyond valuation multiples and the discount factor.” In this environment, “the valuation lever may put downward pressure on returns,” contends Wickström. However, she emphasizes that the impact of higher interest rates on private equity is much more complex, with a reevaluation that is less dramatic compared to real estate, for instance.

“Returns in private equity depend on a lot more factors beyond valuation multiples and the discount factor.”

“It’s a more subtle and longer-term process of adjustment, which can incidentally lead to a longer holding period due to reduced investment activity, translating into lower internal rates of return,” explains Wickström. As companies expand their business operations and improve their top- and bottom-lines, “they can grow back into their valuations.” Higher rates mean that buyout managers can no longer rely on low-cost debt and multiple expansion to generate returns. Wickström underscores that managers will now prioritize revenue growth and operational improvements to drive returns instead of relying heavily on financial engineering.

“In the last ten years, a significant portion of private equity returns came from multiple expansion and leverage, factors that are definitely more muted in this type of environment,” argues Wickström. “When you take out multiple expansion from the equation, the burden of creating returns shifts to operational improvements and business growth,” she continues. The imperative for operational enhancements may be more important in Europe, where growth prospects are more limited. “The ability and capacity to deliver idiosyncratic operational improvements reveal the quality and impact of managers.”

“When you take out multiple expansion from the equation, the burden of creating returns shifts to operational improvements and business growth.”

The ability, expertise, and track record in delivering operational improvements have been crucial criteria in Wickström’s approach to building the private equity allocation. “While always important, the focus on operational improvement is now more important and perhaps more visible as well,” argues Wickström. In this environment, there is a much clearer distinction between managers who can genuinely drive operational improvements and those who have merely ridden the wave of favorable conditions.

Manager Selection for a Smaller Pension Player

Wickström’s selection process focuses on identifying manager quality, which also reflects the ability to drive operational improvements. “First and foremost, we seek high-quality managers who can withstand various market environments and have a solid history as a firm or team,” says Wickström. Veritas rarely invests in first-time funds, preferring those with a proven track record. “The team’s extensive experience and history of implementing the same strategy they are proposing is the most important factor,” she elaborates. “We particularly evaluate their capacity for operational improvement to ensure we invest in a more all-weather type of strategy.”

“First and foremost, we seek high-quality managers who can withstand various market environments and have a solid history as a firm or team.”

However, the strong market environment for private equity investments in recent years has led to an abundance of managers with strong track records, making it more challenging to identify those focused on operational value creation. As a small institutional manager with €4.6 billion in assets under management, including about €500 million in private equity, Wickström has chosen to invest in smaller growth buyout private equity players. These managers tend to emphasize operational improvement, according to Wickström. “We don’t need to invest in the larger ones for capacity reasons,” explains Wickström. Instead, Veritas focuses on middle-market and lower-middle-market managers.

“We try to find a balance by leaning towards the smaller managers and smaller companies,” says Wickström. While acknowledging that larger players and companies offer more safety in specific environments, providing stability and endurance during difficult market conditions, she adds, “However, smaller managers and younger companies offer more opportunities for operational improvements.”

“Our smaller size is beneficial because we don’t face capacity constraints that prevent us from investing in smaller, interesting managers.”

The size of Veritas’ investment portfolio presents both disadvantages and advantages as a private equity investor. “The lack of resources can be a challenge because investments in private asset classes are labor-intensive and lack passive exposure,” explains Wickström. The team at Veritas, therefore, carefully considers its available resources and avoids overextending its internal resources, which are smaller than those of larger pension funds. “This means we have to pick our battles wisely,” she continues. However, being a smaller player also has its advantages. “Our smaller size is beneficial because we don’t face capacity constraints that prevent us from investing in smaller, interesting managers,” argues Wickström. “Our size allows us access to a broader investment universe.”

The Role of Private Equity and Optimal Allocation

Private equity plays a similar role to public equity for the team at Veritas, albeit with distinct characteristics and additional return expectations to compensate for illiquidity. “Although we have different teams managing public equity and private equity, as a whole, private equity is part of the total equity risk but with different characteristics,” explains Wickström. “However, we require an additional risk premium or return requirement to compensate for the inherent illiquidity in private equity, which is obviously difficult to evaluate ex-ante.”

“Although we have different teams managing public equity and private equity, as a whole, private equity is part of the total equity risk but with different characteristics.”

Currently comprising about 10 percent of the overall investment portfolio, the optimal allocation to private equity depends on various factors, including solvency regulations, availability in the risk budget, and market opportunities. “Private equity is not an allocation that can be adjusted quickly by placing a ticket in a passive investment, for instance,” says Wickström. While Veritas has already built a mature portfolio of private equity managers, the team is looking to increase the allocation to North America.

Having previously used a fund-of-funds structure for private equity exposure to the United States, Veritas now seeks more direct exposure. “The U.S. is a large private equity market, and we wanted more direct exposure as scaling our exposure with the fund-of-funds approach proved challenging,” explains Wickström. The team at Veritas has taken advantage of the current challenging fundraising environment to allocate to high-quality managers. “We have been using this environment to expand our portfolio to include a larger share of quality managers, which happen to be operating mostly in North America.”

This article is part of HedgeNordic’s “Private Markets” publication.