The Deep End: 2025 Alternative Investments Review

Good afternoon, everybody. This is Michael Cembalest with the December Eye on the Market podcast. This is on our biennial Alternative Investments Review. I started writing this piece about a decade ago. An idea was to focus on returns, risk underwriting, and the outlook for private equity venture hedge funds, real estate and private credit. And it’s that time of the year or two-year cycle again for us to do this.

A couple of quick things. First, I apologize for the Tommy Bahama sweater, but I’m going fishing for Trini—for tarpon in Trinidad next week, and I need to wear the sweater with the fish on it to get me mentally ready and dialed in. And then just a couple of quick slides on another topic that we’ll be talking more about in the, in the, Outlook, which is the debt explosion in the fourth quarter related to all the hyperscalers and data centers. The debt markets were a pretty boring place until the fourth quarter as it related to things, related to data centers. And then all of a sudden, let’s see if I can get this thing to work, there was a, there was an absolute explosion of about $150 billion of borrowing from Meta, Amazon, Google and Oracle. And here we’re including all the debt, including the hotly debated Meta- Blue Ow—Blue Owl structure that, that Meta convinced a bunch of their accountants to allow them to avoid consolidating. But we’re including that here.

So here you can see this explosion at a $150 billion on top of what was really kind of $50 billion on a year-to-day basis. That’s a lot of borrowing. Now to be clear, the net debt to EBITDA ratios for most of the big AI-related companies are still pretty low. Oracle is and maybe IBM are the exceptions. The rest of them are very low, if not negative. Google, Nvidia, AMD, for example, have more cash and cash equivalents than short- and long-term debt. So those ratios are zero. But these numbers are starting to move. And the numbers from Meta and Oracle in particular were significant relative to their amount of cash flow. And unsurprisingly, we’re starting to see the credit default swap markets reflect that. Here you can see the spreads, zooming on Oracle and also Intel with smaller adjustments for the rest of the AI companies.

Anyway, we’ll be talking more about that in the Outlook. So let’s get to this guy. This is a picture of a guy in a pool. And the title of the alternatives piece this year is called “The Deep End.” And the, this is a guy that is up to his neck in and, in investments that he would otherwise like to already have sold. So let’s get into it. This, this was another version of the cove, and for those of you that used to watch this show, you’ll know what I mean.

Okay. So alternative assets are continuing to attract a lot of capital. If you look at private equity and venture assets as a share of world equity market cap, the publicly traded equity markets over the last decade or so, they’ve doubled. So they’ve gone from 6% to around 12%. And the banks have played a pretty significant role in financing a lot of this growth in the private equity and private credit industry. And we have a chart here that shows private equity and private credit loan exposure by the banks as a share of their Tier 1 capital. And you can see, you know, among the top three there, you’ve got Morgan Stanley, Goldman and Wells.

So this is not, the basic synopsis of our analysis this year is on the surface of this pool, it doesn’t look like a lot has changed since two years ago. The top-quartile funds in buyout and venture are still outperforming public markets. The median funds are still kind of tracking public markets. Diversified hedge funds still are outperforming risk-adjusted benchmarks, and private credit funds are delivering higher returns than the regular, broadly syndicated leveraged loan market. That said, a lot of managers are swimming at the deep end of the pool. The buyout and venture portfolios that we analyzed are full of unmonetized companies dating back to the middle of the prior decade. Hedge funds remain, have record levels of asset crowding, concentration and very high bid exposure. And then private credit, unsurprisingly, have loosened underwriting standards after a deluge of committed capital.

The private credit section is the longest section in this year’s paper, in part because of all of the debate and issues and, and cockroach allegations swirling around. So let’s start here. The pool is full. This looks at unmonetized venture and buyout by vintage year as a percentage of all of the value that has been reported to LPs. So let me give you an example. Let’s go to the 2016 vintage year. We’re almost 10 years out from the 2016 vintage year, so you can be forgiven for thinking that those vintage years that the average manager would have sold a lot of the companies that they had bought. For the median buyout fund, they’re still around 30 to 35% of the assets left. And for the median venture fund, this is eye popping, the median venture fund has almost two-thirds of its, its assets that’s invested in still unmonetized from 2016, which is kind of amazing. So that’s what’s been happening in the industry, a stark slowdown in the rate of monetization and therefore distributions. And when I first started working on this and people said to me, well, how do you know that’s different from the past? How do you know that, that that’s not always the pace? And okay, good question.

So I went back in, using five-year intervals going back to the early 90s, and we looked specifically at six-year-old funds to nine-year-old funds. And the current cycle has the highest remaining value as a percentage of total value, which is a, is a jargony way of saying they have more stuff they haven’t sold yet. The trunk of the car as a share of all the value that’s been reported to LPs. And that’s the case in buyout. And it’s also the case in venture current cycle is has the highest remaining value percentages.

So now, so what have these dynamics done? And most of our clients know this. Global private equity distributions have been roughly flat, even though there’s more and more money being invested. Private equity exits have declined in number terms. The average buyout holding periods are rising. All of a sudden, continuation funds and secondary funds are rising as a, as a, as a way of getting some kind of exits. And now the good news is there’s a tentative capital markets recovery taking place, and it could not have come at a better time. And there’s a few different ways to think about what that capital markets recovery looks like. You could look at IPO activity in terms of number of IPOs or deal value. You can look at the average return on the first day of trading, and IPOs has kind of picked up. Secondary activity, secondary placement activity has picked up. And then maybe most importantly, announced M&A volumes by quarter for sponsors has picked up. So this capital markets recovery is underway. It could not have come for a better time for a lot of these managers who are lugging around tons of companies that they would otherwise like to sell.

So all right, let’s, one of the things we do in this paper here is we look at absolute returns, and then we look at relative returns in terms of relative to benchmarks. And private equity and venture, you know, there are these swirling debates amongst academics, and, and also investors and industry analysts in terms of how do you measure performance on an absolute basis? How do you measure performance on a relative basis? And there’s no single answer. The only red line I’ve got, my hard line is pick a methodology, and then you have to use that same one. You can’t hopscotch from metric to metric depending upon, you know, what it does to the data, what you like to look at. So this slide looks at buyout performance in terms of multiples on invested capital and then internal rate of return. For around 20 years, pardon me, through 2019, the median buyout manager multiple on invested capital hovered around 2x with IRR of 15 to 20%. And for most investors, that was perfectly fine.

For the more recent vintage years, the returns are lower, but it takes time to figure out if the recent vintage lower return numbers are just a J curve issue in terms of when money gets put to work, or if it’s a performance issue. So the, the story on absolute returns and buyout look fine for median managers and then in particular for the, for the 75th percentile manager.

Venture is a little bit different story. For several years following the dot-com bust, venture returns barely generated positive absolute returns. I mean it was pretty bad. Then following the financial crisis, things got better because in a scarce capital environment, people were able to make better valuation investments. And then the median MOICs were also around 2x and median IRRs of 13 to 15%. Since 2019, venture performance has been slipping. And I don’t think this is just a J-curve issue. I think a lot of capital was destroyed during the metaverse SPAC investment cycle. And so the poor performance of 20, 2021, 2022 vintages is not just a J-curve issue. They’ve got some, some, bad investments in there that they’re getting around to recognizing.

Then in terms of relative performance, you got to pick your poison. I think a sensible place to start is where most of the industry starts, which is to look at performance relative to the S&P 500. And the good news is, for the most part, from the early 90s to 2020, the median buyout manager, whether we’re looking at the average manager or the median manager, consistently outperformed the benchmark S&P 500. And you know, that’s good. And as usual, the top-quartile managers did much better than the median. And then the fourth, fourth-quartile private equity managers did do poorly since 2020. The buyout performance relative to the equity market has declined. But again, I think this is a J-curve issue. And also the fact that since 2021, the S&P 500 benchmark, we’re comparing private equity buyout returns to, you know, the hyperscalers and the Mag 7 and a bunch of stocks that look nothing like what are in private equity portfolios.

So we, and then on venture, the picture is not as good for investors. You need venture—limited partners need to consistently invest with top-quartile venture managers to outperform the S&P 500. The median venture manager has at best matched public equity markets. And the huge gap between the average and median managers, kind of a clue that there’s a select small group of venture funds that are doing very well, and the rest aren’t, and then fourth-quartile venture managers have been a money pit, like destroying value relative to the equity market consistently since, since the 1990s.

So we, in the piece, which you can read, we get into all the other stuff people debate. What are other benchmarks that could be used? How about a leverage benchmark? How about a small-cap benchmark? We talk about risk-adjusted returns and why that makes no sense in terms of venture and buyout and other illiquid investments, because the, there’s massive autocorrelation of returns. We talk about evergreen funds and secondary funds, dry powder and multiples. So those are all the additional topics that we cover. So let’s move on to the next one, which is hedge funds.

So we, I started doing this around 10 years ago, and it’s an approach that you either accept or you don’t. Most people I talk to do, although maybe they’re just being polite, but this is how I like to look at this question: You can look at a whole bunch of hedge funds, and you can look at their risk and their return. And then you can say, okay, let’s, what would a sensibly diversified institutional-type investor do, whether you’re talking about a, a risk, a plan, a foundation[DK1] , a large family office, what would a sensible, diversified portfolio look like? And in my opinion, that would be 20 hedge funds. You know, with a diversification mix across that driven macro long, short, you know, and, and a couple of other strategies.

And so what we’re showing here is, there’s actually a really good amount of correlation benefit that comes from doing this exercise, because when you start throwing all those hedge funds together, the returns go down a little bit, but the volatility collapses. And the way this chart works is each blue dot is an individual hedge fund, one of 700 that we looked at. And then the gold dots are hedge fund composites with 20 hedge funds each, again where we force them to have a certain number of each of the style, so you’re not just owning 20 event-driven funds. And you can see how the hedge fund cluster of diverse hedge fund composites really collapses volatility compared to the blue cluster of the individual funds.

So how does, how would you feel if you owned that gold cluster, if all you cared about was absolute return? You’d be disappointed. Because if we just take a 70/30 mix of stocks and bonds using the S&P 500 and a Barclays AGG benchmark, that over the last five years, that would have returned around 8%. And most of the gold dots return less than that.

But look at that black dot on this chart. The volatility of the 70/30 mix was almost 12%, which was higher than almost all of the hedge fund composites. So what we did is, we said, all right, let’s create a bunch of different stock/bond composites with different amounts of stocks and bonds, and then match each hedge fund to a benchmark that has the same volatility. And I started doing this a few years ago with one of the large California ERISA plans. It was a state plan. You know, they got a lot of press because they said, we’re really disappointed in our hedge fund platform, we’ve terminated the managers, we’re shutting it down, the returns were way too low, and we were disappointed. And when I looked at all the constraints that they had put on their managers, they basically gave them a fixed income level of risk, so of course they were delivering fixed income levels of returns. And so ever since then, I’ve been kind of committed to this mission of making sure that we look at hedge fund performance on, on a risk-adjusted basis relative to the risks that are being generated by these managers. And so, as you can see here, the vast majority of hedge fund composites outperformed their volatility-adjusted benchmarks. So I consider that to be good news.

We get into other issues related to selective reporting and survivorship bias. Asset crowding. I mean, the, the, the share of hedge fund stock holdings in the top quintile of data is very high, which again is a jargony way of saying they, they, they own a lot of the big hyperscaler momentum stocks. A hedge fund crowding index is at the highest level that it’s been at for the last 20 years or so. So, you know, there’s, there’s a lot of momentum risk in the hedge fund community.

Okay. So private credit, there’s a lot to talk about. Somebody said something about cockroaches, and it reminded me I went to see a play with my brother-in-law at one point where he was dressed as a bug, but that, that’s, that’s beside the point. What was interesting, what’s interesting to me is that during all of this discussion about private credit, it’s not like private, risky private credit is, is being added on top of other kinds of risk. It’s actually displacing both leveraged loans and high yield bonds. So if you look at the total share of credit as a share of GDP in the U.S., the amount has been roughly the same over the last few years. It’s just that private credit’s been taking share from other stuff.

Now, where are we? Looking backwards, okay, I heard—there’s backwards and then there’s forwards, right? Let’s do them separate. Looking backwards, the performance of private credit versus leveraged loans has been pretty good. And so, again, this is as much art as science, but we put together a composite that looks at three different private credit benchmarks. We combine them into one, and then we compare that to leverage loans. And the composite has been delivering around 300 basis points a year in excess of leveraged loans, which it should in an economic expansion, right? So, given the, given the concentrated nature of private credit portfolios, given the lower credit quality of the companies, at least as the way the rating agencies look at, you should be compensated for that. And during an expansion, 300 basis points sounds about right.

So, and as we look at things right now, there are limited signs of stress in the private credit. Well, there are some signs of stress, but they’re so far limited. The ratio of upgrades to downgrades looks pretty good. Default rates are very low, even when you include selective defaults, which are like defaults that would have happened, but some kind of reorganization plan to avoid it. Nonperforming exposures, a share of total loans, whether we’re looking at middle market loans or the broadly syndicated loans, are still below 1%. And this issue gets a lot of press. The PIK share of gross investment income is barely moving, right? So what does that mean? PIK is payment in kind. In the private credit markets, most of you are all aware that if companies can’t come up with cash, they can, they can pick the payment, which means I’m not paying you just to add it to my balance at the end, and then we’ll assume are all good. And so on an accrual basis, there’s money, but on a cash basis there is a gap. When we look at both publicly traded BDCs and non-traded BDCs, the PIK share of gross investment income hasn’t really moved since 2023 very much, so that tells us that, that there’s not a bit of marked deterioration there.

Okay. But this is, I think this next topic, I think is the most important thing in all of the whole private credit debate discussion, which is a couple of years ago, Moody’s did a really good analysis on what goes on in private credit compared to the broadly syndicated loan market. And what they found two years ago was that the managers in private credit are being much more conservative about underwriting. One way they looked at that was to say how much to be part of either—my solo cup. How much do private credit managers allow EBITDA backs[DK2] , which is this kind of fictional thing that I can’t even believe exists in the first place, but some of these private credit borrowers get to assume a certain level of synergistic EBITDA or cash flow growth in order to avoid triggering certain covenants. The broadly syndicated loan market allows that sometimes with no cap, much less of that is allowed in private credit.

And then the chart on the right really digs into the stuff that I’m fascinated by, which are the legal terms and conditions under which these borrower deals get done. So, and the broadly syndicated loan market in those blue bars, a lot of things are allowed inside maturities, which is, you know, you all of a sudden you can borrow money at a shorter maturity than an existing loan. If, if there’s unrestricted, unrestricted covenant room, in terms of restrictive payment clauses, you can convert that into raising your debt ceiling. If you sell an asset, you don’t have to use 100% of the proceeds to repay the debt. There’s an automatic debt increase per dollar of new equity committed. And then, you know, I, sometimes there’s no J. Crew IP blocker, and for those of you who are in the legal community you understand what that means, so whereas in private credit, very rarely, you know, only 10 or 15% of the time or any of these things allowed. Now, Moody’s has not updated this analysis in, in the last two years. As it stands, two years ago, this is what it looked like.

My sense is that some of this is still true, but that the underwriting, the underwriting characteristics in private credit have been getting easier and looser, and so this gap that existed two years ago may not be there as much as it was. We can see that with a following four exhibits. So the covenant light share of new loans, private credit rising rapidly relative to the broadly syndicated loan market, private credit deals without maintenance covenants. The bigger the loans, the more frequently they don’t have any maintenance governance at all. The median leverage of BDCs has been going up. And then lastly, S&P did an interesting analysis where they found that the only reason that some borrowers still have a lot of headroom with the covenants is because the, the debt to EBITDA ratio that was used as a covenant threshold was like 8, 10 or 12x. In other words, you haven’t, you haven’t tripped the covenant because they were set on such a toothless basis to begin with. So the private credit standards are changing.

So to wrap up, the performance of private credit managers has been pretty tightly bunched since 2014, again, as one would expect in the absence of a lasting recession. And remember, there was a recession during COVID, but it wasn’t a real recession. And I have a chart in here that explains what I mean by that.

If you look at the prior three real recessions, the S&L recession and the dot-com collapse, and then, and then the global financial crisis, high yield default rates went up a lot. High yield credit spreads went up a lot, but, and they, and they went up and they stayed there for a while. During COVID, they didn’t. So they spiked very temporarily, and then they came back down pretty quickly. So, the point is it’s been difficult for investors to really tell it’s 15 years out from the last real durable recession, which private credit managers have been underwriting better than others. And you know, those are the things that we’re going to see because eventually, when the next recession does hit, you’re going to see a lot more manager dispersion than we’ve seen in the past. We conclude the private credit section with seven questions to ask your private credit manager, just so you can get an understanding of what kind of risks they’re taking.

Okay, so let me wrap this up. We’ve been talking here for a while. Real estate. So the fundamentals are still kind of bad or really bad, depending upon which corner of the real estate industry we’re talking about. But there are signs of life in, in, in commercial real estate, and I’m not surprised by that because we’ve just lived through the third biggest correction. First, we had the U.S. and oil prices, the great financial crisis. And when you look at the history of the declines in real estate returns, this one matches almost the two prior ones. So the more you have a correction and pricing, the more it’s time to kind of say, okay, I know there’s a lot of bad news, but let me start looking for opportunity. And we’re seeing signs in life in terms of investment returns bottoming out. Transaction volumes are picking up. Debt origination is picking up. Distressed sales are picking up. That’s always a sign of market clearing, which is a good thing.

And, and I know that a lot of people are spooked by this chart on this page, which shows the special servicing rates for, for office loans in the CME’s market. Okay, what does that mean? A lot of debt originators don’t really have the capacity to service loans and defaults or modification with their traditional servicing approach, so they get shunted off to these special servicing departments either inside or outside of the bank, and those special servicing rates are skyrocketing. They were 3% a couple of years ago, and now they’re 16%. And, but I would just remind you of a few things, and if you read the 20-year anniversary piece that came out over the summer, you’ll remember this. During the 2008 financial crisis, bank stocks in the S&P bottomed when only 8% of the eventual bank failures had taken place. And the same thing happened during the S&L—during the 1990 savings and loan crisis. High yield spreads peaked, right? The time for investors to buy at the peak, only half of all the eventual corporate defaults in the high yield market had taken place. And, and there’s many, many examples of this. The bottom line is that markets bottom way before the fundamentals stop deteriorating. And I have a feeling that we’re in that kind of environment right now for real estate, where the fundamentals are going to continue to get worse, but asset prices will be bottoming.

And I don’t want to dwell too much on office, as you can see from this chart, around 10 years ago office was king, right? Office was 35 to 40% of the average institutional commercial real estate portfolio. And that number started collapsing in 2015 and is now below 15%. So we shouldn’t spend too much time on office when industrial properties, including data centers and apartments, are capturing way more capital. But I will say the long office nightmare is gradually slowing. There is a slowing construction, underway. There is a slowing delivery pipeline. Sublease availability is starting to come down. There is, and there’s a very high concentration of vacant space in just a small subset of the square footage. So the, the vacancy problems are very concentrated. The rest of the market’s doing a little bit better.

And here you can see—I thought this was amazing—and this was as of the second quarter, it finally looks like demolitions and conversions into residential in the second quarter were higher than new supply delivered. Right. So that’s, that’s really a turning point in the, in the office narrative when office building is converted into other things or torn down are greater than the, the amount of new supply. So I thought that was a notable thing to talk about.

And one last chart that I just wanted to share here because I thought it was interesting. The work from home story hasn’t really changed very much. It’s still about 70%. So this looks at a bunch of different cities. Pardon me, that’s the, the back to work is around 70%. The residual which is work from home is around 30%. And to get to those numbers, we look at a combination of mass transit recoveries compared to 2019, a Stanford survey by, by, Nicholas Bloom and then the Kastle KeyFob swipe data. And so the most part, you know, Austin, the little bit of exception at 80%, most of the rest of the cities, the back-to-work ratio is in the neighborhood of around 70%.

Okay. I think that’s the last, let’s see, the last topic, and I’m not to spend too much time on this is, there was this executive order in August that talked about, let’s, let’s democratize alternative assets, and try to find ways that they can be added into 401(k) plans. And that that was, that was pretty notable. It got my attention. And so I added a section on this question of democratization of alternative assets. And certainly even before anything is done about trying to figure out ways of putting them in 401 (k) plans. Retail fundraising has been rising pretty rapidly. A few years ago it was like $25 billion, and it’s on track for $175 billion this year. So there’s a lot of retail money being made, raised in privately placed that read some BDCs interval funds and different kinds of private equity and infrastructure vehicles.

And there was an interesting paper that came out. I agree with parts of it. I don’t agree with parts of it. Some parts of it, I strongly disagree with. But it’s called “Private Equity, Public Capital and Litigation Risk,” and the general argument of this paper is that if the regulators don’t figure out a way to protect retail investors, the, the, the litigation process will, and that the markets and actual retail litigants through the courts are going to, are going to discipline the industry, even if the regulators don’t.

And their three strongest arguments are related to, seek to, to, unclear, vague language as it relates to things like fiduciary duty, how net asset values are computed, all the different expenses, and whether they’re reported on or not reported on, you know, for, for 1940 ACT vehicles they’re fine because you’re subject to the same protections and requirements as a regular mutual fund. But for alternative asset vehicles sold to accredited investors, they may not be required to show all their fund level expenses and portfolio level expenses, and things like that. So there’s some basis for litigation here. There’s a lot of counter arguments. And well, when I showed the paper to someone who for a living at one of the big white shoe law firms in New York writes these documents to presumably shield the alternative asset managers from retail litigation, he, he, he hit the roof. He actually jumped on a Zoom in a t-shirt because he was so anxious to talk to me about it. But, you know, they, they list their counter arguments and things like that, and you can read through those, why they believe that, that the legal litigation risk presented in this paper are offside.

The only thing I would say is that this whole democratization of alternatives thing, it may be accretive to portfolios in the long run, but if you get a sharp recession and a liquidity crunch at the same time, these documentation firewalls that were supposed to shield the alternative asset managers are going to be tested. And I concluded that section with the review of the ongoing litigation in 401 (k) plans related to excessive fees and, and performance issues, and, and who could forget a lot of the litigation that took place both around the failed auction rate security market around 15 years ago, as well as the SPAC boom and bust. So there are plenty of examples here where people thought they were firewalled. And it turns out that they weren’t as it relates to dealing with retail investors.

So that is a brief summary of what is otherwise a long slog through the alternative asset markets that we do every couple of years. And so that’s that. And we will see you again on January 1st when we’re going to launch our 2026 Outlook, most of which is going to, no surprise here, look at what’s going on with hyperscalers and pathways to profitability on $1.4 trillion of hyperscale or cap and spending since GPT was launched in 2022.

Thank you very much for listening, and wish me luck next week. Bye.