Alternative thinking with Invesco

Where do you see inflation and interest rates going?

So our expectation is that inflation is largely a rear-view mirror problem. In other words, the disinflationary trend is very much in place and we're going to see inflation continue to come down over time. The wheels have been set in motion by this aggressive tightening cycle. Now, having said that, different economies are in different places. The US started tightening early, as did Canada.

So it's in a more mature place in terms of its disinflationary process. But Europe is close behind and clearly the economy has been very, very resilient. But it is following the same trajectory as the US in terms of likely seeing an economic slowdown and, of course, seeing a moderation in inflation. So that gets us to the big question on rates.

And our expectation is that, first of all, the Fed is done. I do believe that what happened in early May, the FOMC meeting and its announcement, while confusing, represented a de facto conditional pause. Now, the Fed has said it wants to keep rates at this high level for a long time. But we could very well see, especially if this disinflationary trend is as strong as I suspect, that the Fed could certainly cut rates by the end of this year. Some kind of a maintenance cut.

As I said, Europe is a little further behind. So what we anticipate is that it's going to take longer to get to the terminal rate, but the terminal rate is going to be significantly lower than the terminal rate on the Fed funds. So we are getting to the end of the global tightening cycle. And I think that's important to recognise.

I think long rates are moving down and, at a certain point, we should see short rates start to follow in any environment. But certainly in an environment of uncertainty, it's important to have a well-diversified portfolio with some asset classes that have lower correlations to the main asset classes, the staples of portfolios like equities, like fixed income. And so I think this is a time in which investors may recognise more the benefits of diversification with alts in a portfolio.

How have alternatives performed over the last year in the face of so much market turbulence?

So if we think about 2022, that was such a difficult period for two major asset classes, equities and fixed income. Investors were disappointed. Many questions were asked on the part of clients about whether or not balanced portfolios make sense.

I think of 2022 as the kind of year in which investors recognised the benefits of alts. Having a diversified portfolio with alternatives exposure. Because they did exhibit a very different performance. They were a lower correlating asset class relative to equities and fixed income, and that was a year in which it really mattered. It helped smooth returns for those investors that did have exposure to alts. And again, to me, that's the kind of year in which investors can look and see the benefits of diversification with alternatives.

Now that interest rates are so much higher, is there still a case for alternatives?

Yes, absolutely. There is a case to be made for alts in any market environment. And I would suspect that, a year from now, the rates environment will be quite different than it is today. The market environment could be very different than it is today. What is enduring is the diversification benefits that investors can get through alts exposure.

So absolutely. Alternatives make sense.

What does a higher interest rate environment mean for real estate?

We have to recognise real estate has historically and still offers high absolute yields. And so I think it's still a very competitive investment option. I do think there's concern that higher rates environment is challenging for commercial real estate, especially since so many loans are anticipated to come due in the next several years. And there's concern they'd have to refinance at a significantly higher rate.

Although I will point out that I think that we could be in a very different rate environment next year and beyond. We're certainly seeing long rates already come down. It's also important to note that if asset classes like real estate come under pressure, that could represent opportunities as opposed to areas of concern. And finally, I think we need to understand that commercial real estate doesn't just apply to office space.

There is this is actually a very broad category that encompasses industrial warehouses, medical office space, dormitories, storage facilities. It's not just about office space. And so, while there are areas that could be challenged because of the environment (let's think about, in a post-pandemic world, less office usage – although I would argue that return to work policies are moving in the right direction for office space), there are other areas where there are some really compelling secular growth opportunities. So this is a time, in my opinion, to not shy away from real estate.

Now that public credit markets are offering higher levels of income, is there still as much of a case for private credit?

I think this is a compelling time for private credit. If you think about the Global Financial Crisis, 2008 to 2009, private credit held up well. It performed well relative to other asset classes. And that's because of the kind of features that it offered, like financial covenants that ensured prepayment that ensured a lot of features that were protective in nature.

And while I am not suggesting we are going into the Global Financial Crisis, absolutely not, I do think the economy is going to get worse before it gets better. And so this is this is a time in which the kind of financial covenants offered by private credit could be could be a very attractive feature for investors.

At Invesco, we also have a broad range of exchange-traded commodity products. How might these come into play, given your outlook?

Well, if you think about our outlook, our expectation in the short term is that we are going to experience significant headwinds that are going to exert pressure on risk assets. And, in that kind of environment, typically defensive positioning has worked. Part of defensive positioning tactically would be an overweight in gold. And so one could easily access that overweighting of gold exposure through ETFs.

Now back to our macro outlook. Our expectation is that those macro headwinds are likely to be relatively short-lived. That, at a certain point, we'll see clear and convincing evidence that that central banks are done tightening and markets will start to discount an economic recovery going forward.

And that would mark a distinct market regime shift to a more risk-on environment. So, for a tactical allocator, that would mean going into their commodities allocation and moving from an overweight to gold to an underweight, while at the same time moving to an overweight in oil, which is a cyclical commodity. One that that's closely tied to the economic cycle.

And so, for investors who are tactical allocators, ETFs and the access they provide to commodities can be very valuable in making those tactical calls.

What is Invesco Real Estate, and how does it differ from other managers?

Invesco Real Estate is one of the largest real estate investors globally, with over US$90 billion under management. That already makes us a little different to most other managers. There are relatively few who are global. We have 21 offices around the world in all of the key markets we invest in, and we have people on the ground.

I think boots on the ground is incredibly important. Real estate is a local asset class. You don't trade real estate on a screen. You trade it by having good contacts with the other market participants. We have that. We also cover a wide spectrum of different strategies through from core, to value-add, to opportunistic, through to equity and debt, and also listed and unlisted.

It's unusual to have all of those combined within one firm. And we're also independent. We're not tied to an insurance company or a bank. It's our clients’ interests that motivate us. It is for our clients that we deliver performance. We don't have any other external influences. So it's a pretty unique offering in terms of being a real estate manager.

Invesco Real Estate is a global manager. What are the benefits of this for clients?

We'll look, for this interview here, we're sitting in the UK. The UK is the largest real estate market in Europe and yet it's less than 5% of the global commercial real estate market. So, by investing in a single country or even a single region, you're giving up on huge opportunity. If we're sitting in Europe, Europe's roughly a third of the investment universe, so you’re giving up on two thirds. There are no listed asset classes where people just invest in their own country or region, they tend to invest globally.

Exactly the same should apply for real estate. But, actually, it's almost more important for real estate, because real estate markets around the world differ hugely. What influence a lot of these markets are very local factors. So, what happens here in London is pretty much unlinked to what's happening in Tokyo, for example. Or Seoul. Or perhaps even Washington D.C. They're not terribly well linked.

So, unlike listed asset classes, which tend to be very correlated, real estate markets are a lot less correlated.

What are the main investment themes you're keeping an eye on?

When we invest, we try to look long term. For example, in the US, we have an aging population, as we do in many countries. That means, typically, as you get older, you need more medical intervention and, in the US, there is a privately funded healthcare system. There are more people who need medical attention, creating demand for healthcare. So healthcare buildings, medical offices, as they’re sometimes called, are a secular theme that we invest in.

If I look at other trends, if I look at Asia for example, there's a huge urbanisation trend. So, in less than a decade, 60% of the world's urban population will be in Asia. And that creates demand for real estate – from residential to offices (people need to work – they don't all work from home) to retail. And other opportunities which you might not think of immediately.

So one which we're interested in at the moment is cold storage. Take Japan, for example. The amount of convenience food which is consumed in Japan is estimated to increase between 2018 and 2026 by almost $50 billion a year. That's huge. But with more convenience food, that means more storage and that means more cold storage. So it's those secular themes which tend to drive what they're doing. They're all new ones. They're not the same around the world. So we look at them differently in different regions. But it's really the secular themes which are a key driver of our approach.

Can you share a case study of a building or project you recently invested in?

We've recently completed a building which is an industrial warehouse building on the outskirts of Milan in Italy. It meets a number of our investment criteria. First of all, it’s a big industrial warehouse logistics building. It meets the demand for the change from bricks-and-mortar retail to online retail. You need more warehouse space just to store goods for online retail. It meets that demand.

So Italy is undersupplied. Northern Italy is the economic powerhouse of Italy itself. So it's an undersupplied market in an economically strong region. And that's another endorsement for this. And then the last part of the rationale for investing is sustainability. Sustainability (or ESG) in Europe is incredibly important when investing. It has grown hugely in the last five or ten years. It'll continue to grow. And so, when we developed this building, it was with sustainability in mind.

And so what we've done is create a building which is in demand for occupiers. We've been able to let it very well. It is in a country which is undersupplied, which hopefully allows us to deliver premium rents, and it is sustainable.

It is the number one logistics or warehouse building in terms of sustainability in Italy, and we think it is in the top five globally. So that's great from a sustainability point of view just on its own. But, also we see sustainability within real estate as adding value. We can hopefully deliver better performance by being sustainable, as well as delivering all of the other benefits in terms of reduced carbon, etc.

What are some examples of sustainability features you have added to buildings?

There are lots of things you can do to a building. So first of all, we don't just look at new buildings. I think, historically, many investors have tried to invest in sustainable buildings which are new and kind of ignore their legacy. Were they sustainable when they were being built? So we look at the whole journey, if you like, the whole life cycle.

So things you would do within a building if it's a refurbishment (which is what we tend to prefer rather than building a new building) is look at power usage, to reduce your level of power needed or energy needed. So that can be from augmenting that with things like solar on the roof. That works particularly well in logistics buildings.

It can be just having a more efficient building. If we look at just the lighting alone, it's commonplace these days to use more LED lighting. So those are factors we incorporate. Also, recycling rainwater – also known as rainwater harvesting. Many office buildings historically have used fresh water just for toilets, for example. Now that seems illogical. So, if you can capture rainwater and then reuse that for flushing toilets or even cooling, if you need that in the building, that also seems sensible too.

So all of these are things we can incorporate into buildings as we create them. But it's also looking at things like embedded carbon. If you build a new building, you're using a lot of new concrete. And concrete can be very carbon inefficient. Whereas if you refurbish a building, you retain a lot of the existing frame. There's a lot of embedded carbon in that, which is a much better way of constructing something. You're not actually increasing the carbon output.

And then there’s also recycling concrete on site, which you can do. And we've done that in buildings where you can recycle, in our case, up to 90% of the concrete on site. That's another very efficient way of creating buildings which are fit for purpose for today's market. But also being environmental at the same time.

How do you see ESG as a value driver for real estate?

ESG, or sustainability, is increasingly important, particularly in Europe where I am at the moment. But increasingly globally as well. And it's a valid driver for a few reasons. One is that actually you can create additional value by creating more efficient buildings. And let me give an example. If you have a building which is more energy efficient, it reduces the cost, the energy cost of occupying a building.

And if you're a tenant leasing a building, if you're the CFO, you don't just look at the rent. You look at your total occupational costs. If you can reduce those occupational costs by having a more efficient building, you can afford to pay more rent. That adds directly to investment value. High rent, higher income. That creates higher value.

So that's one aspect where just being sustainable has an investment benefit as well. But there are other benefits too. So one is just attracting the right tenants. You know, we tend to focus on very high credit quality tenants. That tends to be big corporate occupiers. They almost all have sustainability criteria today.

And then the other aspect is just our ability to sell. When we invest in a building, we're always looking at how we exit at some point. We don't necessarily hold buildings forever. And some of the most active buyers in real estate are some of the very big pension funds and insurance companies, many of which have sustainability criteria. They won't invest in a building unless it's sustainable or meets certain criteria.

And therefore, by having sustainable buildings, you're increasing your buyer pool by ensuring that you’ve got some of the biggest institutional investors in that buyer pool. And that may add value as a result.

What benefits can real estate bring to an overall portfolio?

Why have real estate in a portfolio at all, and why have global real estate? Most investors have the majority of their investments in listed asset classes, so equities or fixed income. Listed asset classes have high volatility. You know, they can go up on a daily basis. They are impacted every day by what happens in the news.

And so these markets, as we experienced in 2022, can all fall at the same time and fall pretty dramatically. Real estate, on the other hand, is a very liquid market, but it takes a lot longer to trade. As a result, it is a lot less volatile. And so, by having real estate in your portfolio, you can dampen the volatility. You can dampen the risk significantly by having it as a meaningful allocation in the portfolio.

How can real estate help investors diversify their portfolios?

Real estate markets around the world are relatively uncorrelated. So they're not well correlated with listed asset classes. They're not terribly well correlated with themselves. You know what drives risk and return is often local factors. The local economy. Local things like planning regulations. Supply and demand. And so, by having a global real estate portfolio, you are also reducing volatility and risk. So it's even more stable. And if you put that in an overall portfolio where there’s a mix of listed asset classes, real estate is a is a great stabiliser. It just reduces your risk significantly. And so, if I think about that in terms of numbers, when we look at our global strategy, the volatility of that, it's around 4%. That’s incredibly low. When you compare that with what you see in equities and fixed income, it's lower than both by a huge margin. So, you know, that alone gives it a role within a within a portfolio.

What kind of clients invest in your portfolios? What objectives do you solve for them? 

This year, we're celebrating Invesco Real Estate being around for four decades. So it was set up in 1983. For the bulk of that period of time, we have been investing for large institutional investors. So that's pension funds, insurance companies, some sovereign wealth funds. We built our business of over US$90 billion really based on those investors and satisfying their needs.

And that's through a combination of having either open-ended funds in each region, which is pretty unique, closed-ended funds which are higher returning, sometimes separate accounts or SMAs, plus some more specialist strategies (so they can be residential or hotels). And so we built our business over many years on that basis. But we also broadened it more recently because we felt that investors such as defined contribution pension funds (you know, that's a sector of the market which is growing dramatically) have historically been very poorly served from a real estate perspective.

The only way they could really access real estate was on the listed side, which is fine. You know, they can invest in global REITs or regional REITs, but they tend to be very highly correlated short term with public equities. And so, what we have sought to do more recently is to make some of the investment opportunities which have been available to large institutional investors, large pension funds, to make those opportunities available to more DC investors and even more private investors.

Can you talk about today’s market environment. How is that creating opportunities, particularly in the “value-add” space?

So today's environment, which is one of a bit of turmoil, if you like, rising interest rates, higher inflation, some people say risk of recession. All of that is great if you're a real estate investor. You know, real estate is about being local. It's understanding different market nuances. We love it when there's a bit of turmoil going on in the market, because it's that turmoil that creates opportunities.

So, as an active investor, what we are looking at today is opportunities where we can take advantage of that. For example, there may be motivated sellers because higher interest rates have meant that they cannot refinance – or it makes it less affordable. That's a great opportunity for us to invest in those kind of buildings at more stressed pricing, if you like.

If we look at this kind of environment where there may be more motivated sellers, we see some redemptions coming out of some real estate funds around the world. That also creates an opportunity, perhaps, to invest in buildings which are at more stressed pricing generally. You know, the market isn't going all one way. There's lots of uncertainty.

It means some investors sitting on the side-lines. That's great. You know, if we see a lot of investors sitting on the side-lines, then that's often an opportunity for us to be a bit more counter-cyclical. To be able to jump in and find those opportunities when there's less competition. Today, being an active manager looking to deliver more value-add or opportunistic returns (and so that means returns of 15% plus), this is an ideal environment. We sometimes describe it as a vintage year. And, if I speak to my colleagues who are actively involved in that (those high returning strategies), they think the next one or two years will be some of the best vintage years they will have seen in their career.

So today we think there's a huge opportunity to invest, because there's turmoil. Turmoil creates opportunity, and that's what we take advantage of.

Invesco Real Estate. Discover our broad range of strategies, with investment opportunities from around the globe.

What is Invesco’s private credit platform? How does distressed credit/special situations fit into it?

At Invesco, our private credit platform is actually incredibly unique versus our competitors in that we manage roughly $40 billion in assets and we do that across three different buckets of capital: broadly syndicated loans, direct lending, and distressed credit and special situations. What's unique about our private credit platform is it is entirely private side. Most of our competitors co-mingle their public high yield business and other public businesses with their credit platform.

Our private credit platform is not commingled with our high yield business. It's entirely separate. So what that means for us is that we are able to take private side information across all three of our verticals, distressed credit, broadly syndicated loans and direct lending. And that's very unique in today's market.

What exactly is distressed credit? Please could you give an overview of the asset class?

So if you think about distressed credit and special situations at its core, going back 20, 25 years, when this asset class began, it really began in many ways as a form of trying to find asymmetric returns for investors. And by that we mean thinking about taking credit risk but generating equity like returns. And in our view, that's really what distressed is meant to be and how we approach philosophically the asset class.

So when we think about an investment, we think about investments that can make investors 16 to 20% net internal rate of return two times plus or minus money multiples. But really, while they're taking primarily credit risk. If investors want symmetric return profiles where they can make a lot of money and lose all their money, they can find that in listed equity markets.

They can find that in private equity.

What are the risks and how do you mitigate them?

So in terms of risks, when we think about risk, there's really two things to think about. One is everything we look at has some level of risk to it because we're investing in companies that are in some level of distress, right? Whether they're stressed, distressed, restructuring, going through a bankruptcy process. Right. Something has gone wrong. Hopefully they're good companies in good industries and they're just going through a transitory period where we can come in, we can help them, we can reduce the amount of leverage on the company.

We can inject new capital into the business to help them grow, and we could help augment the management team, if necessary, with operating partners and C-suite executives that we've worked with in the past. We do have some sector expertise in six or seven different sectors so we can bring that to bear and install really a new form of governance with the business.

And it can, along with the injection of capital into the business, help the company really restart and begin growing again. But there's inherent risk in that, right, in terms of restructuring a business, changing the balance sheet, taking it through a restructuring process. So we try to mitigate that by doing things out of court. We don't like formal bankruptcy processes.

We generally take control of businesses in a consensual way where the other lenders and the equity owners of the business are incentivised to turn over the keys, if you will, of the business to us because we are willing to provide new capital and because we have a strategic vision for the business. The other way to think about risk goes back to thinking about the type of risk return profiles we're really looking for here in that we, as a private credit platform, are very focused on senior secured debt.

And that's true in our broadly syndicated loan group, it's true in our direct lending group, and it's also true in what we do in distressed credit and special situations. We generally enter situations through senior secured debt initially. That allows us to get a coupon payment, which helps us de-risk the investment. It allows us to control the restructuring process because secured creditors have tremendous control in a restructuring in the US, in Canada, in the UK, in certain southern European countries where UK English law is present, and in in the Nordics.

So we like secured creditor rights and they help mitigate risk in a material way. And then the final way to think about risk is that we're cheap. We don't pay fair prices for anything. We don't show up at auctions. We don't generally compete for companies or for pieces of debt. We try to pay as little as little as we can for our business, and we try to create the business, if you will, to use that term, well inside the intrinsic value of the business.

So not paying for it, not paying up for a business, not paying up for an investment is the easiest and quickest return we can make for an investor. So we're very focused on mitigating risk by just being cheap.

You’re a very active manager, partnering closely with the businesses you invest in. Tell us about this process.

The whole goal of our strategy right is really to be rescue and revitalisation capital for these businesses, right? That's really the heart of what we do.

And in many times coming into these situations, the company is under some kind of stress or distress, going through a transition period. It could be a failed integration of an acquisition. It could be a liquidity issue. It could simply be they took on too much debt and the economy is slowing and their earnings are going down and now they're over leveraged.

So it can be any number of issues. But what's important for us is to get into the company early, to speak with their owners of the business. In most cases, private equity firms. We are one of the largest financiers in our private credit platform of private equity firms in the world. So we have a lot of connectivity to the private equity firms that own many of the businesses we look at.

We have a great relationship with them. So our first goal is to talk to the owners, talk to the management teams about how we might be helpful. That could be by buying debt and helping restructure the balance sheet of the company. That can be by providing new capital to the business, which we do on certain occasions.

It could be partnering with the management team and thinking about ways that they can grow the business if they were to reduce the debt or to take incremental liquidity from us. But the whole goal is really to get in partner with the company, the management team and the private equity owner of the business generally, and find a solution that works and generates an outcome that's best for the business.

We've never been involved in a liquidation. We've never been involved in a reduction in force of any size. We don't generate value by liquidating or selling assets or by laying off folks en masse. Our whole goal is really to provide capital to these businesses in a way that allows them to take on growth initiatives that they were unable to do because they had so much debt on their balance sheet.

Can you talk a little about how you integrate ESG considerations into your investment process?

So ESG is a part of every investment committee memo that we write and everything that we bring to investment committee. We have the benefit of being part of a platform that was an early mover in the ESG space, in that we were the first loan manager in Europe and the US to launch dedicated ESG loan funds. And so we've incorporated some of that technology, if you will, into our underwriting process in distressed credit and special situations.

Our general view is that businesses that score negatively on those scales are businesses that we need to be very, very careful with and businesses that don't warrant a good multiple in terms of their valuation and may ultimately be very challenging to exit. So, while we are not an ESG specific fund, we do consider ESG in everything we do.

It's part of every investment committee memo we write, and we generally think businesses that score negatively on those metrics are ones that we ought to be very, very thoughtful about. And very, very careful about and think pretty hard about, not only what we would pay for those, but whether we can ultimately exit those investments at a certain point in time.

Now, taking apart the E for a second and just talking about the S and G, we would think about what we do from an investing point of view as very, very much focused on the S and G part of these businesses. Our whole goal in looking at companies and working with them is to partner with them. To provide them with capital. To help them deleverage, and to help them embark on a new growth plan which, ultimately, should create jobs and create more wealth for the employees and the management team and ultimately our clients and investors.

And so we think one of the ways that that we find, particularly in smaller businesses, that that can be very beneficial, is that focusing on the governance piece is something that's typically missing there. And so we try to construct boards that have a diversity of thought and opinion. We try to construct management incentive plans that don't just have all of the equity with the top three people in the company.

We push that equity as far down as it's valued because we think having all of the employees rowing the boat in the same direction generally leads to a better outcome. We would argue there's a tremendous amount of social good where when you step into a business that would otherwise be liquidating and actually provide it capital and help it transition to becoming a healthy business that grows and can employ people and actually contribute to the economy.

So we think what we do is actually an incredibly friendly strategy from an ESG point of view, albeit one that most investors don't often think of as an ESG specific strategy. So I think many of us in the distressed and special-sits space in the last 12 months have really looked forward to the next two three years as what's likely to be the golden age of distressed investing.

What is your outlook for the asset class?

I think most distressed managers today, and we would agree with this, believe that this next cycle will be the best cycle that we've ever seen. I think we have a bit of a different view as to why and and it's worth expanding on that for a moment. Our view is that while many out there are focused on generating higher returns in this distressed cycle, we think actually returns will probably be about what we normally target: 16 to 20% net two times plus or minus money multiple.

But your probability of achieving those returns and the risk you're going to take to achieve those returns is going to be very different than we've ever seen in any cycle in the last 20, 25 years. Your probability of getting good returns is higher and the risk you're taking is a lot lower. And we would prefer investors focus on less risk and a higher probability of good returns than aiming for a higher return target overall.

The reason we think there's a lot less risk and a higher probability of returns today than prior cycles, is that what we're going to experience, in our view, in the next two or three years is probably a good old fashioned recession. It's probably not like any cycle we've seen before. And if you go back and you think about prior cycles, in 2001, we had a tech telecom cycle. In 2005-6, we had an auto cycle in Europe. 2007-8, we had the global financial crisis, which everyone remembers, right?

Very mortgage related, banking related. Homebuilders, housing, casinos, building products, etc. In 2015, we had a crisis driven by OPEC increasing production. Thanksgiving in the US. And then we had an Amazon period of time for the last ten plus years, where Amazon has disintermediated everyone in the retail space, practically. The interesting combination of all of those cycles, if you will, is that they're all driven by an industry change, if you will, right?

There's an industry event or series of industries that are in transition, in secular change that are causing those periods of distress or recessions. What we're going to see in the next two or three years is just a general slowdown in the economy that impacts all businesses. And if you look at any business today, every part of their cost structure is inflated. Labor, wages, energy, utilities, rent, transportation, logistics, cost of borrowing, interest rates. Everybody's cost structure is inflated and everybody's top line is going down because consumers aren't willing to pay higher prices for things anymore.

So the reason that that's important is that the opportunity set is no longer industry specific. It's across everything. And so you should be able, as a distressed manager, to really skew your portfolio to really, really nice companies in really good industries that are just over leveraged. So we're going to get a crack at good companies with bad balance sheets for really the first time in the last 25 years.

And that's why we're really excited about this next vintage.

In today’s environment, why choose private credit over private equity?

All of our senior team began their life in private equity. So we all came from that industry. It's an industry that's been around now for 50 years, so it's a very mature industry. It's incredibly competitive. And if you look at where private equity is today and you can look in Prequin or Pitchbook or any of the publications that cover private equity, right now, private equity sponsors are being forced to put down about 50, 55% of equity in terms of funding their acquisitions and their borrowing costs, which were 4 to 6%, are now 12%.

So their cost of financing has gone up two, three, four times, and the amount of equity they have to put down went from 20% to 50% plus. So you can imagine the only thing that can give there is price. They have to pay a lot less to buy businesses in order to make a decent return.

So one of the one of the things that you see as a result of that is that M&A activity is down to record lows today because there really is no private equity ability to pay a fair price for something. That's great if you're a strategic business looking to acquire something because you don't have competition from private equity anymore.

But it's really, really challenging right now to deploy money as a private equity investor. The other part about private equity that's worth noting is that, when you invest in a private equity fund, your goal in our view, is to double your money or more. But there is a chance that equity, while it has the ability to have infinite returns, it also has the ability to go to zero.

And we would argue that's a much more symmetric return profile than what we're looking at today. We're looking at a market today where the distressed opportunity set is exploding. There is more leveraged credit out today by a factor of somewhere between three times on the low end, five times on the high end, than there was during the GFC.

The maturities over the next 36 months, half of the maturities over that period, are split B-rated or lower, and almost half of them are in the small cap universe. In our world.

Invesco Private Credit. Partner with one of the world’s largest and most experienced private credit managers.

What is Invesco Investment Solutions? How do you help clients?

Invesco Investment Solutions is an independent multi asset team whose purpose is to help clients get the best out of Invesco. We’re a team of investment practitioners from around the world. And our job is to really understand the client's needs, whether that's fees and liquidity requirements, ESG constraints or regulatory considerations.

We receive a number of tasks. It can be from asking to do portfolio analytics through our proprietary software, Invesco vision, or it can be to design customised solutions. And that can be anything from target risk and target date strategies, dynamic multi-factor solutions, or multi-alternative solutions.

What barriers do clients face when trying to invest in alternatives? How can you help?

The market landscape for alternatives has grown in scale but also in complexity.

So there are new emerging strategies coming to market every day and it can be quite time consuming to understand these asset classes and whether they fit within your portfolio.

Even if you know what you want to invest in, there can be serious implementation considerations. So first of all, you may need significant AUM to be able to invest in the first instance. You also may need internal resources to be able to look at cashflow modelling, monitoring your portfolio and be able to report on performance. So this is where the Solutions team comes in.

We're able to act as an extension of staff and help you navigate these markets through our capital market assumptions. We can also help with implementation – so dealing with onboarding and reporting.

Tell us a bit more about your private markets platform. How does that work?

The alternative solutions platform provides streamlined access to private market capabilities, both at Invesco and through our third-party managers.

Through this open architecture approach, we're able to design diversified private market solutions with a greater choice. And through this, we can reduce AUM requirements and ensure fees are kept to a minimum.

Being a part of the Solutions team, we're able to combine private and public asset classes to produce truly bespoke and diversified alternative solutions, taking into consideration return targets, fee constraints, and every other investment criteria that the client needs.

What kind of private market assets can you access through your platform?

Through our trillion dollar open architecture platform, we have access to a variety of private asset classes across real estate, real assets, private equity, and private credit. The beauty of an open architecture approach is that we have a greater choice, and we're not wedded to one particular investment manager, meaning that we can ensure that our client has a solution that's fit for purpose.

So every potential manager and fund, whether they're Invesco or otherwise, is assessed using a rigorous due diligence process, ensuring that every underlying strategy we select is fit for purpose for our clients.

What kind of clients do you help?

The Solutions team caters to a variety of clients from sovereign wealth funds, central banks, insurers, pensions and private wealth.

Because of our nature, we are very flexible in the way that we implement strategies. So if you're looking for a co-mingled solution, a customised isolation or simply advice, we're here to help. But the main thing is for us to understand exactly what your needs are before offering anything.

Can you walk us through the full client journey, from the moment a client first comes to you?

The first thing we do is truly understand our clients’ objectives. So that's looking at things such as return requirements, liquidity constraints, fee targets, and any ESG considerations. Through that, we take each client's existing portfolio and conduct analysis using Invesco Vision. This is a proprietary analytical software that we use to understand the client's portfolio and help them make investments decisions through our capital market assumptions. We can develop proposals for an asset allocation that we think fits the client's needs.

The second step is manager selection. Through our open architecture platform, we're able to thoroughly assess managers from both Invesco and third-party managers, which leads on to implementation. We're able to be very flexible in the way that we implement our strategies, whether it's through advice or through custom solutions. We can help the client overcome any challenges that they have faced when investing in alternatives.

Tell us about your capital market assumptions. What are the key themes at the moment? Do alternatives look attractive?

Invesco Investment Solutions develops over 170 capital market assumptions.

These are long-term ten-year assumptions that help us construct our strategic asset allocation. In the public space, we're seeing that fixed income capital market assumptions are expected to exceed previous ten-year returns. In equities, we're seeing the reverse. This is due to higher valuations from a Q1 market repricing. In the alternative space, we're seeing higher expected returns due to strong illiquidity premiums.

But we'd say in this current macroeconomic environment, it's better to be a lender than a direct equity holder. This is because of the floating rate nature of private credit strategies. Also, in the equity space, we're seeing that there is a decrease in valuations, but that's offset by an increase in cost of financing, not making it any particularly more attractive. In real estate debt, we're seeing high single digit to low double digit return expectations due to that floating rate nature of these strategies, as well as the fact there are conservative lending standards and modest loan to values.

What exactly are senior secured loans? Please could you give an overview of their features?

Senior secured loans are just that – they are generally loans made to companies that would be Fortune 500, Fortune 1000 size corporations. So big business names. Household names that people would be familiar with.

There's a big market here in the US. It's about a $1.4 trillion market in the US. It's about a $500 billion market in Europe. So it's a very important part of the financing for transactions, whether they be LBOs, companies looking to take dividends, companies making an acquisition, or companies being acquired by a private equity sponsor.

All of those are uses for these types of loans. It's a very large, liquid market and trades very actively on the secondary market. And we traded about $800 billion on broadly syndicated loans last year across the markets. We can offer large, liquid, everyday liquidity strategies in this type of product.

Where do broadly syndicated loans sit in the capital structure? Why is the “senior secured” status a benefit?

They are “secured” – so they are the senior-most obligation in the capital structure. We are secured by all the property, plant, and equipment of the corporation. That means that, if there is a default situation (and these are all below investment grade obligations), we can accelerate, take possession of the company and use and sell the company or restructure the debt so as to pay ourselves down first. The advantage of that is that, in the event of default situations, senior secured loans have typically recovered somewhere between 70 and 80 cents on the dollar. So being senior secured enhances our recoveries in the event of default.

High yield bonds, which in many cases the same corporation has, are below us in the capital structure. High yield bonds typically recover 30 to 40 cents on the dollar in those type of default situations. There's real value in terms of protecting investors’ money by being senior secured at the top of the capital structure.

Senior loans are floating rate securities. What does this mean, and why is it a benefit?

Now, one of the other attractive qualities mentioned before is that these are floating rate obligations. So they are, generally speaking, tied to the one, three or six-month LIBOR or SOFR. And, as interest rates have increased (and that's obviously what we've seen over the last 18 months or so), the coupons on our loans have increased as well. There has been an almost “lockstep” relationship between rising short-term rates and rising coupons in our portfolios.

So, if you look over the last 18 months here in the US, you've seen about 500 basis points of rate increases from the Fed. Well coupons on our portfolios have increased by about 500 basis points during that same period of time. So senior secured loans, because they are floating rate, are a very effective hedge against rising interest rates and against inflation.

They're the only asset class in fixed income that actually benefits from rising rates, because they have no duration (unlike high yield bonds). And unlike other fixed income securities that have duration (generally prices for those obligations fall in a rising rate environment), senior secured loans actually benefit from rising rates and the coupons increase in accordance with short-term interest rates. So there are several advantages.

You are a private side investor. Please can you talk a little about the benefits of this?

Being a private side investor at the outset of the transaction means that we can sit down with the management team, with the private equity sponsor, and have access to the company's internal projections of how they think the business is going to perform going forward.

That's information that people on the public side of the wall don't receive. So we receive more (and better) information upfront.

We also have the opportunity to establish a relationship with the management team at that point which means, throughout the transaction, we can call that management team up between reporting periods and ask them how the business is doing. And that information, which again is not available to public side investors, is information that we can trade on.

We can trade on that information because this is not a security. This is a private asset class and managers within the asset class have different levels of information. They can trade on that information that's available to them.

And then, third, if there is a restructuring situation, we're never conflicted. We never have a situation where we own the senior secured loans and the high yield bonds and therefore have to wall ourselves off. Likewise, we never have the opposite situation either (where we want to trade the bonds, so we can't participate in the restructuring or the restructuring committee that frequently negotiates with the company).

We can always sit on that steering committee and have access to their private side information. This part of the restructuring process, generally speaking, results in enhanced economics and better returns and better recoveries for our investors than those investors that don't have access to that private side information that we talked about before.

What role can senior loans play in a client’s overall portfolio?

Since senior secured loans are floating rate obligations, they are a very good diversifier for clients’ investments.

As I said, most fixed income instruments fall when rates rise. Senior secured loans benefit from that. So there's only about a 0.47 correlation between senior secured loans and investment grade fixed rate bonds. And there's actually a negative correlation to equities. So senior secured loans provide a very effective diversification tool for clients’ portfolios. They also provide a very high current income because of the increase that we've seen in interest rates over the last year and a half. Senior secured loans right now are yielding about 10%.

So you're providing very high current income and diversification tools for clients’ portfolios. In other words, there’s very little correlation with other fixed income and equity investments that they're likely to own in their portfolios right now.

Can you talk us through the types of issuers you typically consider, sharing a couple of case studies?

In terms of sector biases, we are generally speaking overweight the leisure, entertainment and travel spaces, as well as chemicals. Let’s start with those, the first three: leisure, entertainment and travel.

Even with the prospects of slower economic growth or perhaps even a recession here in the US in the second half of the year, demand for leisure, travel and entertainment remains very strong. Obviously, airline fares remain very high. All sorts of travel costs remain very high. The providers (the airlines, the hotel companies) have been very disciplined in adding capacity. They have been able to maintain price. They're willing to take price over volume. That has resulted in very strong performance for these companies. And so many of these companies, despite that strong performance, are still trading at a discount relative to par. So we view those sectors in total as being very attractive.

In the chemicals space it's sort of a different story, with the feedstock cost (particularly in terms of energy, whether it be oil or natural gas) having come down. However, despite this, these companies have been able to maintain price. As a result, we've actually seen their margins expand during this period of time, and that's resulted in stronger results for these companies as well.

And a third sector that we’re interested in is the food sector. It's a relatively small part of the market here in the US, but in our European funds, it's a significant portion of the market. It’s a very similar story where the feedstocks have come in. So, for instance, edible oil and other commodity prices have come down. But, as anybody who’s been to the supermarket recently knows, you're certainly not seeing food prices come down. So these companies have been able to expand their margins dramatically as well, and that's resulted in strong performance for these companies.

On the flipside, we're underweight the health care sector and the technology sector. In health care in particular here in the US, the issue really has been one of rising labour costs. Skilled nurses’ wages and physician wages have been increasing quite sharply. At the same time, the primary payer here in the United States is the United States government. They've only been allowing rate increases of less than 1%. So you have a situation where your top line is flat, your costs are going up and your margins are getting squeezed. As a result, health care companies, especially those that are in high cost of care settings, for instance acute care hospitals, have seen a margin squeeze and have performed very poorly.

And then similarly with technology, it’s sort of the same issue. There’s very strong labour demand, and high costs for these companies. But, at the same time, they've really not seen the demand side be quite the same. As a result, valuations have come in quite sharply in that space and those companies, generally speaking, have had very high leverage even coming into this rate hiking cycle.

So you have a combination of much higher interest costs, high leverage on these companies, higher costs in terms of labour. And as a result, their margins are getting squeezed. Their free cash flow and their liquidity profiles have declined dramatically. And as a result, we've been underweight that sector as well.

What kinds of clients can access your capabilities?

Our institutional loan products are accessed by a variety of different clients. It's corporates who are looking to put corporate cash to work. It's pension funds, it's insurance companies, it's large wealth management platforms. We're on the wealth management platforms of virtually every large wealth manager across the world in the US, Asia and in Europe. All those clients access our funds in our commingled core Zodiac strategies. There are more than 200 different investors in our US strategy, and more than 75 different types of investors in our European strategy. So we have a broadly diversified investor base across the board there.

In addition to our co-mingled strategy, we also offer separate accounts. So if you are a large client that wants to customise your portfolio, we can do that for you as well. And we have, again, pension funds, insurance clients, corporates there that we provide separate manage accounts for.

Can you talk a little about how you integrate ESG considerations into your investment process?

ESG, in our view, is credit risk. And as we mentioned before, we incorporate ESG risk in our underwriting of every name in our portfolio. It's part of our credit package. It's a risk that we take into consideration when pricing the deals. And in some case, there is no price for that ESG risk.

When we first started looking at ESG investing, we quickly realised that most of the services like MSCI and Sustainalytics that provide ESG ratings for investment grade and high yield securities simply don't do it for the bank asset class, because these are private instruments and they don't have access to the companies and the information.

So, about five years ago, we started the process of developing our own ESG questionnaire that we send out to every company and every investment that we make. And we developed our proprietary ESG rating system for every loan in our portfolio. So we're the only manager to have done this. It's completely proprietary. Every asset that we invest in has our own ESG rating, as well as a combined score that our analysts have determined. And that's a differentiating process for us. As far as we know, we're the only manager to have their own proprietary ESG scoring system within the loan asset class.

What is your outlook for the asset class? Is today’s environment a positive one for senior loans?

Yes. So I think senior loans are really set up and have actually enjoyed a very strong start to 2023. In the US, senior secured loans are up about 4% year to date.

In Europe, they're up more than 7% year to date. So senior secured loans have performed very well in 2023. I think we're set up for a very good year for a couple of different reasons. One, from a technical perspective, demand for the asset class, particularly from institutional investors and particularly from silos, remains very strong. We've seen CLO creation year to date at almost the same pace as we saw in 2022. And 2022 was the second strongest year on record in terms of CLO issuance. So very strong demand from institutional investors.

At the same time, we’ve seen relatively muted supply. There's not been much new issuance in both the US and the European markets. US issuance is down more than 80% year to date. And this is really sort of the hangover effect of a number of large loans that were underwritten in 2022 that the banks have not yet cleared off their books.

As a result, underwriting activity this year has been much more muted. So you have the situation where you have very strong demand, relatively muted supply. That's what's driving prices higher in both the US and the European markets. That being said, the US and European loan markets are still trading at a fairly hefty discount to par. Right now, the US market is trading about 92 cents on the dollar. European markets are trading about 90 cents on the dollar. So the entry point in terms of discount to par remains attractive.

If you look at the current coupons on both the US and European loan portfolios, they're in excess of 10%. So right now, if we do nothing but clip coupon for the rest of the year, you're looking at low double digit returns for the asset class in both the US and European market. We think that's very attractive.

Now, typically, when loans have been trading at 92 cents on the dollar (as they are currently), what we've historically seen over the next 12 months is that returns have been somewhere between 10% and 11%, according to research at J P Morgan. And most of those returns have come in periods where current coupons were much lower than they are today.

So it's largely come in the form of price appreciation. So if we see any sort of form of price appreciation in 2023 on top of coupons, you could easily see that 10% or 11% return that we're talking about right now boosted several points higher. So we really think that this sets us up very well from a technical perspective.

From a fundamental perspective, leverage on borrowers today is lower than it was pre-COVID crisis. So we've round tripped all the levering that occurred in 2020. Companies are less leveraged today than they were in 2019. Interest coverage ratios for our borrowers, while they have come down as a result of rising rates, still remain very strong. The average company in our market right now can cover its interest costs 3.7 times. And so, while that has come down from a peak of north in four, that's still very robust.

The typical company does not have trouble servicing its interest costs until that interest coverage ratio falls below 1.5 times. So even with the rate hiking that we've seen, companies on average today are very far from the point where they're going to experience an inability to service higher interest costs overall. So if you add up that relatively strong fundamental environment and that strong technical environment, even with rising rates, we think that the asset class is set up for a very strong 2023, and we've seen that in returns year to date.

How do senior loans perform in periods of stabilising or falling rates?

I think if you look at the forward curve right now, that’s suggesting the United States will see one, maybe two more rate hikes. So we don't think that the rate hiking cycle is done.

But even if it is done and rates are where they are right now, they're expected to stay at that level. Rates are not expected to start falling until 2024, maybe even less. And even when they do fall, they're not expected to fall precipitously. So investors will continue to enjoy very high current income, even if the rate hiking a cycle is over and we simply have rates where they are today.

And that's just in the US. In Europe, we're just at the beginning of the rate hiking cycle and so, as a result, we could easily see coupons on European portfolios continue to move up even when rates have been falling. J P Morgan did another survey that showed how, in periods where rates have peaked and then have begun to fall, loan returns over the next year were still in excess of 7% on average.

So even if rates fall, the forward returns for loans historically in a falling rate environment have still been very attractive to investors. And you still have that diversification tool and that high current income, and you're still senior secured at the top of the capital structure.

Invesco Private Credit. Partner with one of the world’s largest and most experienced private credit managers.

Hi, I'm Kathy Kriskey, a Senior Commodity Strategist with Invesco’s ETF and Index Strategies team. 

We have been managing commodity ETFs since 2006 and are now one of the leading providers of commodity exchange-traded products globally. Our range of commodity ETPs is managed by a seasoned team of commodity portfolio managers with an average industry experience of over 20 years.

What has happened in the commodities market in recent years? What’s the long-term outlook for commodities?

As a recap, commodities were the best performing asset class in 2021 and 2022. As the world embarked on our post-COVID reopening journey, demand for commodities surged beyond expectations, bringing global supply shortfalls to the forefront. This caused commodity prices to skyrocket, and global economies experienced inflation for the first time in over a decade. 

To make matters worse, in 2022, a war broke out between Russia and Ukraine, two significant players in the commodities world, further upending already constrained energy and agricultural supplies. 

Some analysts believe we are currently in the midst of a commodity super-cycle, and these typically last over ten years.

What are the benefits of investing in commodities?

1. Inflation hedging  

One of the key benefits of investing in commodities, as well as the primary driver for the influx of investors into this space in the past two years, is inflation hedging. 

As investors became increasingly concerned about inflation, which rose to a four decade high in the US in 2022, many turned toward commodities. Broad-based commodities have historically been a strong and efficient hedge for inflation compared to other asset classes like real estate, equities, fixed income and even gold.

In our analysis of the asset classes, (data to the US year-on-year Consumer Price Index (CPI), based on data since 1998), we found that the Bloomberg Commodity Index, a popular broad commodity benchmark also known as BCOM, has a high historical inflation beta. The higher the inflation beta, the smaller the allocation that is required to offset the inflation risk in a portfolio.

Furthermore, commodities have also tended to show strong performance during stagflation, a market condition where a growth slowdown takes place amid sticky inflation. 

2. Diversification

An important potential benefit of investing in commodities is diversification. This alternative asset class is completely different to stocks and bonds, as illustrated by its very low and even negative correlation to these traditional asset classes. 

Adding a differentiated investment like commodities can potentially lower the overall risk of a portfolio in challenging market conditions.

3. Return potential 

Investors look to commodities for return potential. Not only do many analysts predict we are currently in the early innings of a multi-year commodity super-cycle, but the global energy transition is strongly supportive of commodity prices across the board in energy. 

With the shift to lower carbon fuels, producers are disincentivised to invest in their capital expenditure, forcing up prices of the commodities they produce in other sectors.

Industrial metals play an indispensable role in the electrification of global vehicle fleets and the build out of electric grids, wind turbines and other green infrastructure. 

While agricultural commodities should be supported by the growing demand for energy (crops like corn and sugar used for ethanol), this global energy transition, which is often compared to the industrial Revolution of the 17-1800s, has already been supporting commodity prices.

In conclusion, investors should keep in mind that, like equities, commodities are a volatile asset class. For conservative investors seeking to gain exposure to commodities for inflation-hedging, diversification or return purposes as this potential commodity super-cycle and the energy transition unfold, a small allocation could potentially be sufficient. Thank you.