Interest Rates: There’s a Light at the End of the Tunnel

"The current interest rate is likely at or near the peak of this tightening cycle."

- Jerome Powell, Fed Chairman

It is not controversial to observe that interest rates have been the most pronounced influence on portfolio-level returns since the Fed started hiking rates in March 2022. Among a litany of other ripple effects, rising rates have compressed renewable energy returns, created a historically volatile US bond market, introduced uncertainty into discounted cash flow models, and thrown a wrench into so-called “risk-free return” assumptions.

Despite this tumultuous backdrop, as Mr. Powell recently suggested, there’s light at the end of the tunnel, and the market is seeing it. June inflation of 3% year-over-year (a downside surprise against consensus estimates of 3.1%) increased the likelihood of rate cuts, perhaps commencing in September. The market met this news with understandable enthusiasm. Align CIO, Matthew Weatherley-White recently touched on what interest rate cuts would mean, and his projections remain sage:

“We anticipate this will benefit our impact-oriented credit strategies as interest pressure abates and the delta between conventional fixed-income and private credit widens. Further, as the cost of capital ratchets lower, growth-driven strategies like venture capital should experience an easing of margin pressure, possibly elevating exit valuations.”

Private Markets: The Liquidity Log Jam Begins to Loosen… Barely.

“Despite recent challenges, we remain optimistic about the opportunities in the venture capital landscape, [...] we are beginning to see green shoots in dealmaking activity.”

- Fifth Wall Venture Capital

There’s an old saying in the real estate business: if it’s a good time to buy, it’s a bad time to sell. That story is continuing to play out in the private markets more broadly, as rising interest rates have compressed exit valuations, forcing fund managers to hold on to their portfolio companies and execute fund life extensions. This creates a circular domino effect in which:

Fund managers are reluctant to sell their assets/portfolio companies due to low valuations;
Thus investors don’t experience liquidity from their existing investments;
Which leads to a lack of cash available for investment in newly launched funds; and,
Fund managers see this lack of liquidity, and hold off on launching new funds;
Which reduces available startup and growth capital for promising companies.

Fortunately, we’re seeing signs that this domino effect may be loosening. One “leading indicator” of the inflection point is the pricing of these mature funds’ LP interests on the secondary market. When liquidity is low, the price for these secondary interests is also low, which had been the case until very recently.

Fresh data from Zanbato indicates that the prices of these LP interests may be hitting their bottom. In essence, secondary prices hitting their bottom (if this really is the bottom!) is a solid, if preliminary, indication that the market is anticipating more price competition, which means a higher velocity of fund flows and flows back into VC funds. Essentially, this is a very early sign of a positive reversal of the domino effect referenced above.

The Impact of Impact on Private Market Returns

“The financial performance of ESG-committed asset managers varies, but quantitative evidence that the use of ESG in the private markets necessitates sacrificing returns has not emerged.” -Pitchbook

The impact of ESG on public market returns has been a source of vociferous debate from Reddit to Congress. While that debate will seemingly rage on, we have new data on a subset of the market with historically sparse data: the impact of impact on private market returns.

A recent pitchbook study analyzed the performance of private funds that are signatories to the Principles for Responsible Investment (PRI) compared to non-signatory funds, during the preiod from 2010 to 2018. It evaluated internal rate of return (IRR) and total-value-to-paid-in (TVPI) capital across various asset classes, including private equity, real estate, real assets, and private debt. The results showed no statistically significant difference in performance between PRI signatory funds and non-signatory funds.

Equally interesting is what appears to be a narrowing of the IRR range. In other words, top-decile impact funds underperform top-decile conventional funds, whereas bottom-decile impact funds outperform bottom-decile conventional funds. This suggests that there may be an incremental cost in pursuing impact, but that this cost is offset by downside protection. It is a fascinating confirmation of some of the core theories underpinning impact investing writ large.

While we should note that PRI signatory status does not necessarily indicate a clear, dedicated impact investing strategy, it does signify, however, that signatory firms have committed to some degree of ESG integration in their investing. So, while this data is not a definitive answer to this debate, it provides yet one more encouraging data point toward the larger, more complex answer.

Spotlight: Artificial Intelligence

“The efficiencies that technological advances are unlocking could transform whole sectors and ways of work — possibly even ways of life. AI has both environmental use cases, like optimizing the efficiency of energy-intensive sectors like buildings and transport to reduce GHG emissions; and societal applications, like self-improving learning apps and improving the accuracy of cancer diagnosis.”

- Impax Asset Management

Artificial intelligence continues to swallow up headlines, with AI chip-maker Nvidia (NVDA) being the hottest stock of the quarter (up 37% in just the second quarter and a whopping 150% year-to-date 2024). Long-term, AI seemingly has the potential to radically alter worker productivity but early returns are inconclusive on whether this potential will be fulfilled. In the short-term, AI’s impact thesis remains murky - while there is theoretical optimism for uses like those mentioned by Impax above, it remains a massive source of energy demand and questions loom large regarding the soundness of governance to ensure ethical development.

One thing is clear: funds that have not held AI stocks (like NVDA) have underperformed significantly this year. All eyes are on generative AI to see if it can fundamentally disrupt the corporate world, and our eyes are on its impact value proposition as it comes into clarity.

Spotlight: Energy Demand

“The outlook for US energy demand is positive. After a decade of stagnation, demand is projected to grow by 5-6% annually, driven by factors like AI, onshoring, and electrification. This surge necessitates significant investment in generation and distribution infrastructure, creating a powerful tailwind for renewables.”

- Greenbacker Capital

AI, along with the shift in our economy towards the electrification of cars and houses (and, well, everything else), is poised to increase the demand for energy in the form of electrons. The demand for electricity has been increasing steadily in the US since the Industrial Revolution. Hence, the opportunity to shift the energy complex allocation is a generational one.

How much, you might wonder, has this increase in demand increased prices? The answer - it hasn’t! But that may be about to change.

Historically, the increase in demand for electricity was offset by gains in the efficiency of its use and production - the Jevons Paradox in living color. This is why, on a real (adjusted for inflation) basis, prices have remained astonishingly flat. However, since 2023, demand for electricity has been spiking, outpacing efficiency gains and creating a new era of increasing prices, as we race to add supply to the grid.

This is good news for investors in renewable energy; increasing prices and demand on an inflation-adjusted basis will be a positive driver of returns in the coming years. Impact portfolios are well positioned to take financial advantage of this trend and to fill a gap in demand growth for renewable energy that would have otherwise been met with fossil fuels in the absence of the solutions they have invested in.

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