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Will Edwards, S&P Global Ratings
Will Edwards, S&P Global Ratings

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AIFs turn to debt amid tough economic conditions

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Alternative assets funds under are predicted to reach as much as USD25.3 trillion worldwide by 2027 representing a compound annual growth rate of 7 per cent since 2018, according to figures from PwC.

Yet the very reason investors are allocating to these markets – the potential for attractive yields and low correlation to movements in interest rates and inflation – could put alternative investment funds (AIFs) under pressure in the coming 12 months.

This is the view of Will Edwards, analyst at S&P Global Ratings, who argues in a report ‘Uneven liquidity and strained valuations are pushing some funds toward debt’, that current economic conditions will create a “host of challenges” for the AIF market.

“Global AIFs will come under pressure in the next year. For private equity and venture capital in particular, valuations are uneven, fundraising is slowing, and liquidity needs are rising for AIFs and their portfolio companies,” Edwards says.

With UK interest rates hitting 5.25 per cent this year from lows of 0.1 per cent in 2021, and the US hiking its rates 11 times since March 2022 as central banks on both sides of the Atlantic struggle to bring inflation under control, AIFs have faced, Edwards says: “An inability to sell investments to return cash to their limited partners and a slowdown in fundraising.”

He adds: “At the same time, inflation and increasing interest rates are squeezing their portfolio companies and prompting them to seek help.”

This help will come in the shape of debt which, Edwards says, AIFs will use to shore up their positions and bolster balance sheets. 

“They can use the financing proceeds to purchase new assets, return capital to limited partners to lock in internal rates of return, and provide support to portfolio companies.”

But the pay-off could be a negative impact on the ratings S&P allocates to such AIFs since long-term leverage weakens their view of funds’ financial positions, while the interest burden tests its assessment of liquidity.

However, Edwards says the rated AIFs covered in his universe “should be able to handle” taking on extra debt since they already have low levels of permanent leverage. 

In addition, uncalled capital in place at the fund level provides some liquidity flexibility, and third, general partners are sitting on record-high levels of uncalled cash that could bolster their funds’ financial flexibility. 

He continues: “Some corners of the industry, like private credit and infrastructure appear to be in good health, with fundraising stable, and asset prices and volumes remaining supportive. All told, most ratings should be able to absorb AIFs’ shift to long-term leverage, even as their foundations are tested.”

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