The little-known asset class providing equity-like returns in uncertain times

If it all feels like the world is standing on a precipice, that’s because in many ways we are. We’ve seen extraordinary shifts in the macro environment in the past few years and Apollo Global Management’s Eric Hanno believes investors will need to start thinking about risk in a way they haven’t for a long time.

That is, with rates no longer at historic lows and uncertainty relatively high, investors need to think beyond simply the return of an investment to the volatility and risk associated with the need for downside protection.

But it's not all bad. For instance, Hanno is noting a slow uptick in defaults, while also saying it could be an opportunity for structured credit. Indeed, structured credit is one of the strategies Apollo uses in its portfolio and Hanno argues now could be a great time to pick up a stake in great businesses in need of flexible refinancing. Here, Hanno says there is the potential to generate equity-like returns.

“In this market environment given higher base rates, we are finding pockets of private credit that are attractive that share the same characteristics as structured equity where you're getting an equity-like return, but you're coming into a credit-like security,” says Hanno.

In this episode of The Pitch, Hanno discusses the trends and opportunities he is seeing today, as well as the strategies he is focusing on in the current market.

Note: This interview was taped on Wednesday, July 17th 2024.

Edited transcript

What are some of the key trends you’re seeing in private markets and where do you see the biggest growth opportunities?

I would highlight two trends we’re seeing in private markets today. One ties back to the significant shift in the macro environment that we’ve seen. To highlight that, let me take you back to where we’ve been for the 15 years after the global financial crisis. We’ve had historically low rates, we’ve had a tonne of stimulus from central banks and we’ve had a trend of globalisation, which has led to tremendous tailwinds across risky assets.

If you look at private markets in general, risky asset classes have performed very well in that environment. As we stand here today, one could easily argue that all of those historic tailwinds have become headwinds. So, it’s our belief that, within private markets, investors will have to start thinking about risk in a way they haven’t for a long period of time.

We think there’s a huge opportunity for strategies out there that think not only about the return you’re able to achieve but think about the downside protection, the volatility and the risk associated with those investments. We have some strategies inside of Apollo that have been managed with that mindset for over a decade that we think stand to shine in a more volatile macroeconomic environment.

The second major trend I would highlight is the renaissance of what we’re seeing within private credit. If you read almost any major newspaper right now, there’s a lot of talk about private credit.

We believe that private credit is not just the $1.5 trillion opportunity that is often talked about, there is a huge replacement cycle – what we call the fixed income replacement cycle – where private markets in many cases will fill the gaps that have historically been served by public credit. We view that as a $40 trillion opportunity.

Apollo is the largest private credit manager in the world and I would say those two different product types within Apollo are two areas we expect to see significant growth in the coming years.

You mentioned earlier the need for downside protection and you’re seeing increased risks. Are you able to talk us through the risks you are monitoring in the market today and what signals you use to identify these risks?

First of all, we are value-oriented investors. We think a lot about downside protection, the price that we’re paying for assets. There’s a lot of focus on the way in when we’re underwriting transactions. Once we do those transactions, we’re certainly monitoring the operating performance. Then today, given the significant increase in interest rates that we’ve seen, we are really focused on ‘are we starting to see a default cycle? Is there stress within the financial system that we should be paying attention to?’

That is something we’re keeping a close eye on. I think we have started to see a slow uptick in defaults but at Apollo, we historically have been very good investors in default cycles or periods of high turmoil. We have been looking for opportunities as we start to see distress. 

What is Apollo's approach to investing in private markets and what makes it unique in the market?

It’s a great question because, on one hand, you could argue that Apollo looks a lot like many other private market asset managers. We’ve got a great equity business in private markets. We're the largest private credit manager in the world. We've got a nice real assets franchise, and we do all of that on a global basis. 

If you look at Apollo and you look at the ethos across every single investment strategy that we have, we like to say purchase price matters.

We think the value that you pay for an asset really matters in terms of the risk that you take and the potential opportunity. And then we like to say excess return per unit of risk. We're thinking about that risk when we're making investments. I do really think that the uniqueness of Apollo's value lens allows us to create different content, different strategies, and different products.

Off the back of the trends and risks that you're seeing in the market, are there any segments of the market that you are focusing on or avoiding?

Absolutely. In any given market environment for the strategy that I help to manage, we are trying to find the best opportunity. We are seeing a lot and then we're trying to find where is the best risk-adjusted return.

Today, I would say there's one major trend that is driving a lot of what we're doing, and that is simply the fact that interest rates went from near zero to a much higher level in a short period of time, and now we're about two years into that change, that is causing financial distress and also creating opportunity. There are a couple of areas that we're focused on.

One I like to call out is structured equity. Structured equity is a flexible financing solution that we offer at Apollo. We offer it in size and scale, and we think we're quite unique in offering this solution at the scale that we do.

Effectively, if you are a company that borrowed money at near-zero interest rates and now you need to refinance your balance sheet, if you go back to the bank, the quantum of debt that you can get is less and the cost of that debt is higher. So if you can't go to the bank to refinance your balance sheet, it's probably not a great time to sell your business. Where do you go? And that's where Apollo can step in with these bespoke financing solutions that we call structured equity.

We have a huge pipeline of transactions that we're seeing at the moment and we've been very active and think this might be one of the areas where the percentage of our overall fund grows the most. It is very attractive right now. One unique thing about that strategy is typically we are coming in as more of a credit-like security, but we're underwriting to an equity-like return.

We view that as a very asymmetric risk-reward profile. Anytime we can find situations where we think we can get an equity return but in credit-like security, we view that to be a huge win for us and a huge win for our investors. 

I would say similarly in private credit, for our strategy, targeting equity-like returns doesn't always work. But in this market environment given higher base rates, we are finding pockets of private credit that are attractive that share the same characteristics as structured equity where you're getting an equity-like return, but you're coming into a credit security.

I'd highlight those two as really attractive. Then I would also say we have a strategy to buy high-quality cash-flowing businesses that we want to own for not just a typical four to six-year hold period that you see in private equity, but potentially hold those for 5, 10, 15, 20 years.

The opportunity to buy a great business like that comes up often in periods of distress. And so that distress, the turmoil and the change in markets that we are seeing right now, we hope creates incremental opportunities to lean into what we call our core private equity strategy.

Then, I'll highlight one final area that I think is talked about quite often, and that is private equity secondaries. There is a mismatch in the supply of institutions or individuals that own private equity, either fund commitments or assets that are looking for some kind of liquidity and the buyers of those assets. That's creating attractive discounts, and that's the fourth area that we're leaning into right now. We're actually finding quite a lot of opportunities in different pockets across our various investment strategies, and we are really leaning in and hopefully taking advantage of what is a major shift we've seen in the marketplace over the last few years.

Seeking to provide excess return along the risk-reward spectrum

Founded in 1990, Apollo is a high-growth alternative asset management and retirement services firm. Apollo seeks to provide its clients excess return at every point along the risk-reward spectrum from investment grade to private equity with a focus on three business strategies: equity, hybrid, and yield. Find out more here