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Tetragon Financial Group
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== Market outlook: Macro conditions favour alternative strategies<ref name=":2" /> == While the global economy recovers from the pandemic-induced slowdown, investors are now mostly concerned about high inflation and monetary tightening, as well as uncertainties on global supply chains and trade routes (further exacerbated by lockdowns as part of China’s ‘zero-COVID’ policy, and sanctions on Russia following its invasion on Ukraine). The World Bank recently reduced its expected GDP growth in Europe to 2.5% in 2022 from 4.2% earlier (mostly due to rising energy prices) and cut the US growth forecast by 1.2pp to 2.0%. With slowing growth and high inflation, investors are likely to be drawn to (1) assets benefiting from rising interest rates or having embedded inflation protection and (2) alternative assets, which are exhibiting low correlation to equities. === Private infrastructure rises in popularity === One such low correlation asset is the global private infrastructure market, estimated at c US$1tn in 2019 by PwC. Infrastructure investments (which Bain & Company estimates in its Global Private Equity report 2022 attracted US$120bn of new capital in 2021) are sought by many investors for stability in the face of economic uncertainty and are also considered a natural hedge against inflation. As a result, Preqin expects it to become the largest real assets strategy by 2026 (overtaking real estate). Although the increased investor interest brought the dry powder in the sector to US$230bn in 2020 (after growing by 13% pa since 2010), it represents less than the global deal value in 2020 (and compares to the private equity market with about two years’ worth of deal value currently, according to Preqin). This is coupled with unmet need for infrastructure investments. According to Global Infrastructure Hub, the gap between infrastructure investments needed to keep pace with economic growth (and meet the committed sustainable development goals) and government spending amounted to US$445bn globally in 2020 and is expected to widen to US$820bn by 2040. Tetragon’s indirect exposure to infrastructure investments is its 75% stake in Equitix, which manages US$10.8bn of infrastructure assets and accounts for 25% of Tetragon’s net asset value (NAV). === Real estate is considered an inflation hedge === Similarly, commercial and residential real estate investments are garnering interest as a potential hedge against inflation according to Savills. The total value of global commercial property amounted to US$32.6tn in 2020 and was down 5% y-o-y (Savills). The decrease is associated with the global economic contraction induced by the pandemic, amplified by the adoption of working from home and uncertainty over office space going forward. However, a revival of the market was seen in 2021 as life gradually returned to normal, as reported by JLL, with 21% y-o-y growth in leasing volumes globally. Residential real estate remains the world’s most significant store of wealth (US$258.5tn) and increased by 8% in 2020. Real estate-related investments made up 13% of Tetragon’s NAV at end-2021 and comprise investments in BentallGreenOak-managed funds, assets managed by third-party managers as well as a 13% stake in BentallGreenOak itself. The underlying assets include commercial, residential and agricultural real estate in the United States, Europe, Asia as well as South America. === Increasing interest rates support CLOs’ cash generation in the near term === In the near term, the rising interest rates should have a positive impact on collateralised loan obligation (CLO) cash flow generation, especially by increasing the residual cash flow to CLO equity tranches. Since the beginning of 2022, three-month Libor increased from 0.21% to the current 2.20% (27 June) and given the record-high inflation (the US CPI hit a 40-year high of 8.5% in March 2022) the consensus expectation is for the Federal Reserve to continue raising rates throughout 2022. In the long run, however, the increasing cost of debt may translate into higher default rates and collateral quality deterioration. In this scenario, cash flow would be redirected from equity (and potentially also junior debt) tranches due to internal test breaches. So far, the default rate in the United States has increased only slightly (0.6% on a last 12 months (LTM) basis) and is expected to reach 1.5% in 2022 and be in the 1.25–1.75% range in 2023 according to Fitch. This compares to c 4% recorded at the pandemic peak (September 2020) and over 10% in late 2009 as a result of the global financial crisis (Fitch). Tetragon is currently invested only in US-based CLOs, predominantly in equity tranches. Tetragon is exposed to the CLO market in several ways. It owns a 100% stake in CLO manager LCM and CLO-investing asset manager Tetragon Credit Partners (TCIP). Tetragon also invests in TCIP-managed funds, as well as directly into CLOs managed predominantly by LCM but also third-party managers. The combined exposure amounts to 19% of Tetragon’s NAV.
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