What's Happening with Alternative Investments?

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Jaret Seiberg:
Welcome to Two Cents, the financials podcast at TD Cowen. I am Jaret Seiberg, managing director and financial services policy analyst at TD Cowen Washington Research Group. Today, we're going to dig into the world of alternatives with TD Cowen equity analyst Bill Katz. But first, as always, is my partner in podcast, Scott Smith, who is TD Cowen specialty salesperson for financials. Scott, what's going on in the market?
Scott Smith:
Well, Jaret, since we last spoke, we're still in a holding pattern with respect to the Iran war. Although it does feel like investors have started to price in and end a little bit more than they were even just a couple of weeks ago, which has been definitely constructive. We've had decent labor numbers, and so we're back to a place where markets are not really pricing in a whole lot from the Fed for the remainder of the year, which is actually somewhat constructive versus where we had been. And we're coming up on financial services earnings, which actually kick off relatively soon and investors are taking a little bit of a breather into that event. There's a little bit of a setup issue where commercial industrial loan growth has flattened and plateaued, although I think most people will be speaking to that as a transitory issue, if I can borrow an old Fed speak.
And away from that, credit quality is constructive. And so I think people are looking for a decent earnings period, albeit with some potentially slightly soft commentary about risks to macro if things don't get better in Iran sooner rather than later.
Jaret Seiberg:
So Scott, I think Jamie Dimon's annual shareholder letter has in some ways become the new Warren Buffett annual shareholder letter. I know that came out recently. What's your takeaways from what he had to say?
Scott Smith:
I have to say, there was not a lot in there that I would say was surprising, particularly with respect to private credit. Most of that is stuff that we've been hearing about from him before. I think it's all obviously also very much in the market already. I did think the highly blunt commentary about cities being competitive, it was certainly very interesting. I think it was an extremely direct statement pointed very much at Mamdani and Hochul in New York, and we'll see whether that has any impact on the tax policy here.
Jaret Seiberg:
So let's stick with JP Morgan, the big banks for a minute. You mentioned that our earnings season is starting pretty soon here, and the big banks typically kick it off. What are some of the expectations broadly for the industry as we move into April?
Scott Smith:
So I think it would probably surprise you because it surprised me a little bit that capital markets activity overall in first quarter was actually a little bit up on a year-on-year basis. So I think for the big banks, we're going to hear fairly constructive commentary about the capital markets backlog and notwithstanding the fact that some stuff has been on hold because of the macro. I think we'll hear constructive things about credit quality. I also think we'll hear relatively constructive things about most US corporate loan books and how good the demand should be as soon as the little wave of uncertainty passes. So it should be fairly constructive across the board.
Jaret Seiberg:
So Scott, let me get you out of here on this last question. It seems like expectations may be shifting on what the Federal Reserve and the Federal Open Market Committee might be doing. How much attention is the market really giving the Federal Reserve and monetary policy at this point? Seems like rates jumped without the Fed doing anything. Is there a lot of connection here?
Scott Smith:
So Jaret, we went from earlier in the year where markets were definitely pricing in a couple of cuts to, I believe the last time we spoke on this topic, talking about the potential for a rate hike, which had everything to do with the near term inflation shock from the energy move associated with the Iran war. Now that investors are starting to think that that is on the tail end, that's come in a bit and I think it will be something managements will need to address. And investors do care certainly, but I don't think at this point it's significant one way or the other, as much as growth or credit quality in the near term.
Jaret Seiberg:
All right. Well, let's wrap it there, Scott. It should be a fun month and we'll get you back here in May to talk about what we learned from all the banks.
Okay. Time to shift now to the main event. Bill Katz is my colleague at TD Cowen and a fellow Avid hiker. He is our equity analyst who focuses on asset managers, retail brokers and exchanges, and he was the lead author on an ahead of the curve report we published last year, looking at alternative asset managers. I wanted to revisit alternatives today because they've been in the news. We have both a push in Congress and by the Department of Labor to expand the ability of retail investors to participate in alternatives, and we have a stream of headlines raising concerns about the state of private credit.
So Bill, let's start this conversation at the very, very beginning. What do we mean when we say alternatives?
Bill Katz:
Thanks for having me here today and look forward to getting on the trails with you for sure. So alternatives, I guess the way I would look at it is anything that's not considered to be public equity or public fixed income or cash. So when we think about alternatives, we think about private credit, like you mentioned in your comments, private equity. And then I'll say things like infrastructure or other real assets like real estate. And then I would also break it down between liquid alternatives like hedge funds, multi-strat vehicles, long-short vehicles, and then illiquid vehicles, whether it be a drawdown fund or some other kind of mandate that invests beyond the public markets.
Jaret Seiberg:
So I noticed you'd input crypto in there. We do hear crypto sometimes described as an alternative, for instance, by the Department of Labor. Do you see a distinction there or is everything kind of merging together?
Bill Katz:
I think over time it merges together. I would sort of look at crypto as obviously another form of currency and value exchange for sure. It's not an asset class that the alternative managers have been heavily investing in directly. They have been investing into infrastructure and data centers that are benefiting from the explosive growth of AI. So I think of more of a complimentary opportunity for alternative managers over time.
Jaret Seiberg:
So much of the discussion in Washington is on whether retail is going to or should be allowed to have greater access to alternatives. Can you talk a little bit about what the debate is here and why we're having it?
Bill Katz:
Well, I think it's just a natural evolution of where the market has been. If you go back 15, 20 years ago, I don't even think the alternative managers appreciated the opportunity in retail. Mostly you'd raise a drawdown fund that would be something, let's say, 10 or 15, $20 billion range. The alternative management might allocate 5% to retail. That retail would be defined as the qualified purchases or QP kind of investors with $5 million or more of household wealth to invest. And I think that was sort of iteration number one. Iteration number two has been over say the last five or 10 years, really spearheaded by the folks at Blackstone, Blue Island and the rest of the industry has followed suit pretty quickly going after the accredited investor, which is the million dollars or more. I think version 3.0 has really been how does the alternative managers weave their way into the mass market at large? And so I think you're just seeing a natural evolution of the industry.
So at the end of the day, when you look at what's been happening in the industry, you've had insurance been coming more recently institutional where the industry grew up. Allocations there are probably 30, 40, 50% depending on which subset of the institutional distribution channel you want to look at. And so when you look at the retail sector broadly or the wealth sector broadly, that allocation is very close to zero, say sub 5%. So I think where the debate sits now is what is the right product, what is the right vehicle, what is the right structure to allow retail investors or wealth investors more broadly to have access to institutional outcomes that institutional investors or insurance companies have been getting as well?
The issue that I think has been front and center in the media has really been around private credit. And again, it doesn't look like it's the underlying credit quality that's the issue. It's just you've had elevated redemptions, I think exacerbated or attenuated by the media focus on the redemptions themselves, which creates a little bit of a circular reference. But at the end of the day, what's very encouraging with the Department of Labor, I'm sure we'll get into it in a moment, was the new rule that came out really didn't speak to any of the private credit issues that are playing through the media right now in particular, which we took as a very constructive opportunity. So we think it's a huge opportunity for the industry. We think it's going to be an 80/20 rule with some of the larger, more scaled alternative managers will probably be disproportionate winners along the way. And the debate would just be how do you deal with some of these redemptions along the way?
And again, we think that liquidity will drive much more mergers and acquisitions or M&A through the asset managers over the next several years.
Jaret Seiberg:
All right. Well, you already got ahead of me because I want to talk about that Department of Labor proposal. Certainly well telegraphed, we knew it was coming for a year now, but still pretty monumental, right? It's a proposal to try to provide more legal protection to financial advisors that recommend inclusion of alternatives in the 401k market. How big of an opportunity is this for alternatives? Do alternatives want to be in this market? And how should we think about this, Bill?
Bill Katz:
I agree with you, Jaret. I think it is a monumental change, something that certainly when President Trump came out with executive order was a natural next step along the way. So it's very encouraging. So let's just start with that. Over the last several months, I think there's been this contagion risk in the industry that the issues in private credit, the issues in retail, excuse me, were going to foreclose the opportunity set into the 401k market. And I think the Department of Labor's reform that came out or guides that came out sort of debunks some of that anxiety. Now it's a question of how quickly will this play through? We never thought it was going to be something overnight, but just to put some perspective on this, when you look around the world, they look around the divine benefit world, or you look around at other retirement schemes outside the United States, Australia, the United Kingdom, et cetera, allocations can be somewhere between 15 to 20 to 30 some odd percent.
That's not our call, that's going to happen instantaneously in the United States and the 401k world. But the eligible opportunity set here is probably an opportunity of this five to $7 trillion of incremental flow for the industry over time. So if you think the larger players are the ones that are probably best positioned to take advantage of this opportunity, you're talking about significant asset opportunity over time.
Jaret Seiberg:
If this wasn't a vacuum, it would be one thing, but it is part of a broader push in Washington, it seems, to expand access to alternatives for retail. We have the chairman of the Senate Banking Committee talking about legislation to provide a test that retail investors could take to be deemed a qualified investor, somebody who is able to participate in these markets. There's talk of expanding the educational qualifications or industry certifications that would let you play. Is that a big source of potential growth for the market? And what do you think is driving this interest in Washington?
Bill Katz:
Well, anything that expands the opportunity set is going to be helpful for the industry. And it's been evolutionary and maybe I jumped the gun a little bit in my earlier response, but we start out at the really high end, the qualified investor or the qualified participant, and that's migrated down to accredited. But you've already seen the industry anticipate these changes, right? A couple years ago kicked off with KKR linking up with the Capital Group, followed somewhat closely behind by Blackstone and Wellington and Vanguard. And you've seen a lot of iterations across the public private investors as they try to figure out how to best leverage the opportunity set into the lower end of the mass market. There's a hundred some odd million households that have less than a million dollars in the United States. The alternative managers absolutely don't have the efficiencies and the scale to easily go after each one of those households on their own. So to the extent that they can align or merge or somehow consolidate with distributors, it'll give them a tremendous opportunity to further scale the platform.
Now, why is this happening? I think at the end of the day, most of the institutional investors will tell you that the superior returns come from having some allocation into alternatives and/or helping with diversification. So it does seem like in a world where retirement schemes around the world are becoming under increasing pressure, there are some very compelling demographics about the aging of the United States, aging of some of the more industrial countries around the world, and the mismatch between savings, opportunities, and liabilities that the alternative managers should be able to fill that void a little bit and help. So I think that's what's going on as a sort of drive to enhance retirement opportunities globally and then leverage the private markets to help fill some of those differentials.
Jaret Seiberg:
It is fascinating to me. You think of often Republicans as being the big advocates for financial firms and Democrats being more skeptical, but the push to expand access to alternatives really is bipartisan. We've seen the Congressional Black Caucus in particular be vocal over the last several years about wanting to ensure that all Americans have access to this investment option. It must be fun to follow an industry where it's a little less partisan and a little more cooperative.
Bill Katz:
Well, last couple months have been challenging for the alternative managers because of all of the negative feedback loops between what's going on in retail, what's showing up in the Financial Times, in the Bloomberg articles, the media at large, creating this sort of negative feedback loop. If you take a step back away from the noise and think about the signal, the alternative manager is still a growth industry. We cover the asset managers at large. So we cover the traditional asset manager, which are more of the public investors. The long-term growth prospects there are much more muted and much more mixed. So it is nice to take a look at the alternative managers and everything we look at does say that the industry is still growing.
AUM, assets under management are higher, fee paying AUM are higher, carry generating AUM are higher, capital markets capabilities are higher. Retail is just awakening to the opportunity. The 401 still seems in front of the industry at large. The bigger players are probably disproportionate beneficiaries. And then you take this globally. This wave is happening outside the United States as well. And some of these alternative managers are very well positioned, whether it be across Europe and the continent at large, or whether it be in the Asia-Pac regions, whether it be X-Asia and/or including China along the way. So it is fun from that perspective, but the last couple months on the stocks have not been so much, for sure.
Jaret Seiberg:
We got to wrap up on that very question, the not so fun part, which is it does seem like there's been a lot of headlines concerning concerns about credit quality, redemptions in some of these private credit funds. Can you just give us kind of a layman's version of what's been going on here and how our listeners should be thinking about this issue when they see these headlines, whether it's on CNBC or in the Wall Street Journal?
Bill Katz:
From just a very simple perspective, these vehicles, when they were established, I think they took the best of all worlds. Blackstone through BREIT sort of broke the industry a little bit in terms of how they all were not broken in a bad way, but just sort of brought to the market, educated what semi-liquid really means at the end of the day. So what's been happening right now is that there's been a lot of hysteria in the marketplace around some losses, some frauds, et cetera, and the concern that there's going to be a large credit cycle here. Some people have sort of equated this to the great financial crisis, which we do not agree with. And so you've had the media pickup on this. You mentioned a couple outlets. There's been a few others as well. So you've had retail investors looking to redeem.
Now, when you look at some of the underlying metrics of these redemptions, it's a relatively small swath of the overall investor base. It's just been a very high number, and that's what the media has been picking up on. So what's been happening at the margin is some of these alternative managers have been adhering to these 5% quarterly limitations of redemptions or tenders, if you will. And so that's creating a lot of uncertainty around the world. But when you look at what's going on underneath in the vehicles, the yields are still good, not as good as where they were a year ago because base interrates have come down a little bit, but yields are good. Underlying credit quality, most importantly, continues to be very good. Revenue growth, EBITDA growth of the companies underneath that are good. So I think the underlying non-accruals are good, credit quality is good, losses are good. So all those trends that you'd look at to be worried about are not really there.
And most importantly, the system is not nearly levered the same way it was back in the great financial crisis, and these are at the vehicle level, not on the balance sheet level. So there really isn't that existential risk. So I think there's been just a significant misunderstanding or confusion between the transmission issues of some redemptions into some narrowly defined vehicles with the contagion risk for the rest of the industry, which is where we think is the opportunity for these stocks.
Jaret Seiberg:
All right. Well, Bill, I think we're going to stop there, but thank you so much for joining us on the podcast this month. We're definitely going to have to have you back to delve even deeper into the world of alternatives.
Bill Katz:
All right, Jaret, thank you. Great to be here today.
Jaret Seiberg:
And that brings us to our final segment, which looks at the major financial policy issues from the last few weeks and preview what's coming up in the next several months.
All right. So what happened in the last month? Couple of really big developments. We finally got the Basel three end game capital proposals for banks that are regional or the mega banks. This is an all around positive story. We expect a reduction in capital. This proposal probably takes about a year to go from the comment period to a final rule, but we see it as consistent with our theme that Washington is a tailwind for the bigger banks and that the further development should continue to be positive for this sector.
On the prediction market space, litigation continues, though Kalshi won a really big case in the Third Circuit. We still see the Supreme Court as ultimately having to decide whether sporting contracts constitute gambling or whether they are event contracts where federal law preempts state prohibition. That probably takes at least another 12 months, maybe two years before we're in front of the justices.
And then lastly, the Kevin Warsh nomination to replace Jerome Powell as Federal Reserve Chair remains up in the air, though Senate Banking has scheduled a confirmation hearing for Warsh on April 16th. We continue to see Warsh's confirmation as tied to whether the Justice Department drops its criminal investigation into testimony that Jerome Powell gave regarding the renovation of two Federal Reserve buildings. Absent the dropping of that investigation it's difficult to see how the Warsh nomination can get out of the Senate. It means that Powell could still be the chairman on May 15th when his term officially ends.
All right, so what's coming up? We got a lot of hearings over the next several weeks with House Financial Services focused on capital markets fraud, consumer credit. We also have hearings on credit risk transfer, sanctions program, bank capital programs and derivatives. We have the next FOMC press conference and interest rate decision on April 29th, and we're looking forward to the SEC giving us exemptive relief to permit the tokenization of equity securities, something that we've talked about on this podcast several times, and we're waiting for the Supreme Court to rule on whether President Trump has the authority to remove Lisa Cook as a Federal Reserve governor. So a lot coming up in just a few short weeks. We'll talk about all of that when we rejoin you in May for the next edition of TD Cowen's Two Cents Podcast. I'm Jaret Seiberg with TD Cowen's Washington Research Group. Thanks, as always, for tuning in.
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