ALTERNATIVE MARKETS SUMMARY 2023 – FEBRUARY 2024

2023 followed the core theme of 2022 with a key focus on inflation and interest rates. At the beginning of 2023, inflation was a huge concern, due to its high level. In the US, inflation was at 6.5% and already declined substantially from its peak in June 2022 at 9.1%. This trend continued in 2023 until it reached its bottom in June 2023 at 3%. Since then, US inflation remained steady between 3% and 4%. The EU and the UK saw a very similar development of inflation throughout 2022. Their respective inflation started at around 5.5% in January 2022 and rose to 10.5% by the end of 2022. As soon as 2023 started, inflation in the EU started to decline and eventually declined to as low as 3.1% in November 2023. Despite this promising development, inflation began to increase again to 3.4% in December 2023. While the UK’s inflation development was almost equivalent to the EU’s in 2022, this changed in 2023. Inflation in the UK remained above 10% until April 2023, at which point inflation was at 10% or higher for almost an entire year. Nonetheless, UK inflation also came down later in 2023 and reached the 4% mark at the end of December 2023. Based on the overall relatively similar development of inflation around the world, it is likely that inflation will stay at elevated levels in the short term. Another key reason for relatively stale inflation is that central banks stopped hiking their interest rate for a while now in 2023. Figure 1 summarizes the development of inflation in the US, EU, and the UK.
With the soaring inflation in 2021 and afterward, central banks had to react. Financial markets enjoyed rates close to zero, if not negative, for a long time. As a response, central banks started raising their interest rates. The Bank of England was the first to raise its interest rates in December 2021. The Fed followed in March 2022 and hiked its rate in every meeting and by a higher amount on average than the BoE or the ECB. The BoE did so too, but did smaller hikes on average. The ECB followed in June 2022, but they did not hike at every meeting. At the start of 2023, the interest rate in the US was already at 4.25% compared to 3.5% in the UK and 2.5% in the EU. Consequentially, the ECB hiked more in 2023 but did not reach the same heights as in the US or UK, which are currently at 5.25%, while the ECB’s interest rate remains at 4.5%. With interest rates now higher than inflation rates in each of those economies, most market participants expect interest rate cuts in 2024, especially due to an elevated possibility of a recession ahead.

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RESEARCH PERSPECTIVE VOL. 220 January 2024 Financial Markets Summary 2023 2023 followed the core theme of 2022 with a key focus on inflation and interest rates. At the beginning of 2023, inflation was a huge concern, due to its high level. In the US, inflation was at 6.5% and already declined substantially from its peak in June 2022 at 9.1%. This trend continued in 2023 until it reached its bottom in June 2023 at 3%. Since then, US inflation remained steady between 3% and 4%. The EU and the UK saw a very similar development of inflation throughout 2022. Their respective inflation started at around 5.5% in January 2022 and rose to 10.5% by the end of 2022. As soon as 2023 started, inflation in the EU started to decline and eventually declined to as low as 3.1% in November 2023. Despite this promising development, inflation began to increase again to 3.4% in December 2023. While the UK’s inflation development was almost equivalent to the EU’s in 2022, this changed in 2023. Inflation in the UK remained above 10% until April 2023, at which point inflation was at 10% or higher for almost an entire year. Nonetheless, UK inflation also came down later in 2023 and reached the 4% mark at the end of December 2023. Based on the overall relatively similar development of inflation around the world, it is likely that inflation will stay at elevated levels in the short term. Another key reason for relatively stale inflation is that central banks stopped hiking their interest rate for a while now in 2023. Figure 1 summarizes the development of inflation in the US, EU, and the UK. With the soaring inflation in 2021 and afterward, central banks had to react. Financial markets enjoyed rates close to zero, if not negative, for a long time. As a response, central banks started raising their interest rates. The Bank of England was the first to raise its interest rates in December 2021. The Fed followed in March 2022 and hiked its rate in every meeting and by a higher amount on average than the BoE or the ECB. The BoE did so too, but did smaller hikes on average. The ECB followed in June 2022, but they did not hike at every meeting. At the start of 2023, the interest rate in the US was already at 4.25% compared to 3.5% in the UK and 2.5% in the EU. Consequentially, the ECB hiked more in 2023 but did not reach the same heights as in the US or UK, which are currently at 5.25%, while the ECB’s interest rate remains at 4.5%. With interest rates now higher than inflation rates in each of those economies, most market participants expect interest rate cuts in 2024, especially due to an elevated possibility of a recession ahead. Figure 1: Inflation Rates and Interest Rates in the US, EU, and UK from January 2022 to December 2023, Sources: Stone Mountain Capital Research & Trading Economics, January 2024 In 2023, US equities experienced a remarkable performance, defying analysts' expectations. The S&P 500 closed the year 2023 with a significant gain of over 24%. Arguably, the bull market started in November 2022, when the S&P 500 was down more than 20% from its value at the beginning of 2022. Until April 2023, equities were quite volatile and the gains and losses offset each other in most cases. Following April 2023, the S&P 500 was close to reaching the levels of the beginning of 2022 by August 2023. September and October as well as November and December 2023 mark two different market views. In September and October 2023, markets plummeted, as many viewed the Fed’s approach as too aggressive and mostly viewed the development negatively, especially as the recession risk was higher at the time. This view shifted in November 2023, when the Fed stated that there is a good chance of multiple interest rate cuts in 2024, which led to optimism from investors. This trend continued in January 2024, which even led to net gains for the S&P 500 compared to before 2022, as shown in Figure 2. Aside from the more recent optimism about interest rate cuts in 2024, there are numerous other reasons for the excellent performance in 2023, despite rather bleak expectations. More generally, these include substantially lower inflation than in 2022 with an overall positive trend in addition to a much more resilient economy than expected, which includes a healthy job market and still relatively high consumer spending. The latter has suffered in 2023 but not the anticipated degree, although consumers are hurt by high inflation. Lastly, it needs to be noted that a majority of the gains from the S&P 500 are driven by the “Magnificent 7” and the underlying optimism about AI. Figure 2: S&P 500 and Its Cumulative Growth from January 2022 to January 2024, Sources: Stone Mountain Capital Research & Yahoo Finance, January 2024 In 2023, European equities experienced a mixed performance amidst challenging economic conditions. Throughout most of 2023, European equities remained relatively flat. Similar to US equities at the end of 2023, European equities surged too. The Stoxx 600 almost managed to surge to levels last seen in 2021 but fell short by a couple of percentages. The underlying reason for the year-end surge is equivalent to the US, as the outlook for lower interest rates in 2024 bolstered investor confidence. European equities are also less technology-heavy, which made up most of the gains in the US in 2023. Consequentially, European equities also exhibit less volatility, which tends to lead to lower performance when markets are strongly surging. This also has its benefits, as European equities rarely dropped lower than -20% in 2022, while US equities were much more under this threshold. Figure 3 shows the development of the Stoxx 600 Index in 2022 and 2023 along with its cumulative performance. European equities are under substantially more pressure than US equities, despite the promising inflation development. The key difference is the state of economies and the fact that the EU’s recession risk has been higher for a while now. The most important countries in the EU are facing substantial problems. Germany, for example, has shown weak economic data with a contraction of GDP in Q3 2023 and a weak outlook. Similarly, the economies of Italy and France also stalled in 2023. In addition, with the latest hike by the ECB occurring in September 2023, the full effects may also negatively affect economic growth and unemployment. Despite the challenging economic backdrop, European stocks remained lowly valued compared to historical and international standards, suggesting potential for share price gains in 2024. European equities were also supported by the possibility of wage growth running ahead of inflation, boosting consumer demand and confidence. Figure 3: Stoxx 600 and Its Cumulative Growth from January 2022 to January 2024, Sources: Stone Mountain Capital Research & Investing, January 2024 The development of UK equities differed substantially from the US or the European markets. This is especially evident when looking at the past five years. When comparing index levels in the US and Europe now and five years ago, they strongly grew, while the UK’s equities remain flat. The economy recovered its Covid-19-related losses by the end of 2021 and the FTSE 100 remained between 7,000 and 8,000 ever since. This is particularly notable, as UK equities ended the year 2022 net positive, while Europe and the US lost more than 10%. It also meant that the UK only gained a few percentage points compared to the double-digit returns in Europe and the US. The most notable impacts in 2023 stemmed from the banking crisis in March 2023 and subsequently further interest rate hikes by the BoE, which led to decreased investor sentiment. The widely different development of UK equities is shown in Figure 4. Figure 4: FTSE 100 and Its Cumulative Growth from January 2022 to January 2024, Sources: Stone Mountain Capital Research & Investing, January 2024 Hedge Funds Summary 2023 The hedge fund industry enjoyed the year 2023 with gains across most strategies. This was an important turnaround of the industry, due to their relatively weak 2022. For the most part, hedge funds failed to mitigate drawdown sufficiently. This led to a decrease in investor confidence in hedge funds. The industry saw a net outflow of assets totaling $55bn in 2022, which marks the largest net inflow since 2016, according to HFR. Unfortunately, this trend continued in 2023, as the recent perception of hedge funds did not change substantially in 2023. This resulted in total net redemptions of $80bn as of October 2023. A key reason is the difficult economic environment. One reason is the high interest rate ecosystem, which makes safer strategies that aim to provide steady, but relatively low, returns unattractive to investors, as they can obtain these returns by buying bonds. Similarly, equity indices performed well, largely due to the surge of the Magnificent 7, which are also very common assets in investor portfolios. Many funds were not able to beat this performance. Despite these outflows, the industry has been steadily growing since Q3 2022. The AuM of the hedge fund industry remains above the $5tn mark, according to BarclayHedge. As of Q2 2023, hedge funds collectively manage $5.1bn, as shown in Figure 5. Equity hedge funds are the sector that manages more than $1tn, closely followed by fixed income with $973bn and balanced funds with $764bn. Although the current trend in the industry includes significant challenges, the growth since 2018 has been extraordinary. The hedge fund industry grew by 72% measured in total assets. Within the different strategies, balanced hedge funds, which include equities and fixed income, grew by more than 200% in this timespan. Multi-strategy funds also managed to double their assets during this time. Macro strategies disappointed and shrank by 26% in assets since 2018. Figure 5: Total Hedge Fund AuM in Billion USD from Q1 2018 to Q2 2023 Sorted by Sectors, Source: BarclayHedge, January 2024 As mentioned in the previous paragraph, equity hedge funds achieved a solid positive performance. Most industry benchmarks, place the aggregate return of equity hedge funds between 5% and 12%, as shown in Figure 6. Our equity benchmark achieved a gain of 10.69%, which ranks highly across industry-wide benchmarks. In particular, the Long-only US Equities High Conviction strategy managed to achieve a strong return of more than 35% and beat the performance of the S&P500, which only a few funds could achieve. Unsurprisingly, long-only strategies were among the key winners in 2023. These strategies are likely to continue their strong performance in 2024 if the economy develops as most outlooks anticipate. Most outlooks state that a crisis can be averted and see the S&P 500 close 2024 at a higher level than at the start of the year. Market-Neutral and Long-Short strategies also show promise for 2024, especially if the economy does not land as smoothly as expected. It is also expected that the equity market will continue to show quite diverse movements, as technology companies did in 2023. Assuming the economy will remain resilient, there will also increased interest in equities, as risk appetite tends to grow, and investments in safe, but low-yielding, strategies will likely flow into other strategies. Figure 6: Performance of Stone Mountain Capital’s Equity Hedge Funds and Benchmarks as of Q4 2023, Source: Stone Mountain Capital Research, January 2024 Fixed income funds managed to bounce back from one of their worst years in history in 2022. Back in 2022, most funds lost more than 10%, which is remarkably high for fixed income and tends to be a relatively safe investment. Luckily, this trend was reversed in 2023, and fixed income funds managed to produce strong returns. Most industry benchmarks for fixed income funds place the aggregate gain of the sector between 6% and 9%, as shown in Figure 7. Our SMC Credit Strategy Index surpasses the fixed income benchmark and yielded almost 10% in 2022. Since 2022, the total assets of credit hedge funds have remained relatively stable. The sector also saw a relatively low net outflow compared to the hedge fund industry as a whole, despite the challenge of high interest rates. Earlier in the year, high inflation decreased the attractiveness of the strategy. Now the strategy is highly appealing, as interest rates will not fall as quickly, while inflation is relatively low to the current interest rate levels, and barring any further negative shocks, inflation will continue to decrease. Fixed income also provides a good hedge, in case there is a recession. One notable negative development for the strategy stemmed from the banking crisis in early 2023. Banks became more hesitant in credit approval, which enabled private debt, in particular direct lending, to strengthen its market position. While they do not operate in the same market, their risk-return profile is similar, and investors have shown substantially more interest in private debt recently. Figure 7: Performance of Stone Mountain Capital’s Fixed Income Hedge Funds and Benchmarks as of Q4 2023, Source: Stone Mountain Capital Research, January 2024 Global macro hedge funds have been in a highly eventful time since 2022 with numerous central bank interest rate decisions. In 2022, these funds achieved great performances, due to a high degree of volatility in markets partially induced by soaring inflation. In 2023, the extensive central bank measures continued. However, these strategies struggled in 2023, as most asset classes, especially equities and fixed income, increased and volatility and recession fears declined. While the geopolitical tensions have caused more volatility, in most instances, it was short-lived and markets did not react strongly. Global Macro and CTA funds varied between losses of around 5% and 1%. Our Tactical Trading Index is down more than 10% in 2023. However, the index is of limited reliability, as it consists of only two funds, one of which experienced significant losses. Figure 8 provides a more detailed summary of the performance of a variety of benchmarks. Figure 8: Performance of Stone Mountain Capital’s Tactical Trading Hedge Funds and Benchmarks as of Q4 2023, Source: Stone Mountain Capital Research, January 2024 Cryptocurrencies and consequentially cryptocurrency hedge funds had another great year in 2023. Cryptocurrencies started strong in 2023 with a gain of almost 40% in a single month. By March 2023, Bitcoin was already up 76%, at which it remained until around October 2023. It then continued the rally, fuelled by the anticipation of the first spot Bitcoin ETFs, and closed the year up 155%. Few other cryptocurrencies could follow the performance of Bitcoin but achieved outstanding returns nonetheless. Our Cryptocurrency Hedge Fund Index grew by 104% compared to HFR’s suitable index which gained 65% in 2023, as shown in Figure 9. The underlying reasons for this strong performance are elaborated in more detail in the section “Blockchain” section below. Figure 9: Performance of Stone Mountain Capital’s Cryptocurrency Hedge Funds and Benchmarks as of Q4 2023, Source: Stone Mountain Capital Research, January 2024 Funds of Hedge Funds (FoHF) experienced a decent 2023. Depending on the source, such funds returned around 4%-7% in 2023. Our dedicated FoHF Strategy Index returned less than the industry average at 1.7%, while our aggregated hedge funds returned 30% for single managers and 27% for all of our funds, as shown in Figure 10. Overall, 2023 was not a great year for FoHF strategies, as they tend to be safe investments and focus on diversification. In a strongly surging market, this results in relatively low returns compared to other strategies and hurts its attractiveness to investors in such an ecosystem. Figure 10: Performance of Stone Mountain Capital’s Funds of Hedge Funds and Benchmarks as of Q4 2023, Source: Stone Mountain Capital Research, January 2024 Private Equity & Venture Capital Summary 2023 As 2024 starts, the private equity industry is navigating a landscape shaped by several key factors that emerged in the previous years. The industry has experienced a shift from the record-high dealmaking and fundraising activities that characterized the post-pandemic period, primarily due to increased macroeconomic uncertainties, rising interest rates, and geopolitical tensions. All of those factors substantially affect the private equity market negatively. High interest rates lead to substantially higher financing costs, especially for new and small companies. Uncertainty and geopolitical tensions tend to reduce the risk appetite of investors, as a potential crisis can cause significant drawdowns in private equity. Unsurprisingly, this led to a decline in activity in the private equity industry, as shown in Figure 11. In comparison to the past five years, 2023 marks the year with the lowest aggregate transaction value and the lowest number of deals. While it was evident in 2022 already that the macroeconomic ecosystem would be challenging for the space, the full effect was shown in 2023 and possibly beyond if the economy should develop negatively. Especially Q1 and Q2 2023 saw a stark decline, especially in larger transactions and most of these transactions were take-private transactions. Figure 11: Aggregate Transaction Volume in USD Billion and Number of Deals in Global Private Equity and Venture Capital from 2019 to 2023, Source: S&P Global, January 2024 The limited deal activity in the space also leads to substantially fewer exits. This is especially evident in comparison to 2021 when deal activity was at a record high with on average very high valuations. Most larger companies took advantage and raised significant amounts of capital during this time. This also means that those companies are not necessarily dependent on further capital injections at this time, which they will likely try to avoid, as valuations have gone down substantially. This lack of general activity in the private equity space also led to substantially less capital distributions to LPs. In 2023, only 7% of invested capital was returned, compared to 16% in the previous year and 25% on its historical average. Especially, during times of elevated uncertainty, liquidity is crucial to balance portfolios of institutional investors. This led to a strong surge in secondaries transactions in 2023, as shown in Figure 12. In total, almost $110bn was exchanged through GP-led or LP-led secondaries transactions, which is only around $20bn behind its record year in 2021. This relatively small difference shows how important this market has become in this ecosystem, especially when considering that overall deal values fell from $1.18tn in 2021 to only $474bn in 2023. The interest in secondaries is directly related to the current state of the economy and private equity itself. The most important reason is certainly the need for liquid capital to rebalance portfolios and general de-risking of assets. For LPs, they manage to get liquid capital for their illiquid assets in private equity funds. Similarly, GPs can exit positions and distribute some capital to LPs. Due to the high demand for liquidity, secondaries prices decreased accordingly, which can also present attractive valuations for the other party to acquire the offered secondary asset. Figure 12: Total Secondaries Transactions Sorted by GP-led and LP-led from 2013 to 2023, Source: Evercore Private Capital Advisory, January 2024 The current dynamics in the private equity space also affected fundraising. Investor appetite for the industry is difficult to estimate, as recession fears were looming in 2023 and generally decreased interest in more risky strategies. However, the industry provides an alternative to equities, as drawdowns are less pronounced. Additionally, crisis years or years with elevated risk and less successful years have led to great performance in the private equity space. Nonetheless, fundraising is directly affected by fewer deals, as less capital is returned to investors, which is typically invested in new private equity funds. While fundraising is down in 2023, it remains at strong levels. Compared to 2022, fundraising declined by 11%. In 2023, slightly more than $800bn was raised compared to $1.03tn in its record-breaking year in 2021. However, the drop in fundraising has had a strong impact on the number of funds closed. While more than 5,000 funds were closed in 2021, in 2023, slightly below 2,000 funds were closed, as shown in Figure 13. Figure 13: Private Equity Fundraising from 2019 to 2023, Sources: S&P Global & Preqin, January 2024 Following the development of limited transaction volume and still relatively strong fundraising, the dry powder of the industry grew to above $2.5tn by the end of 2023. In total, alternative assets surpassed the $4tn mark according to BlackRock. Figure 14 shows the composition of the $4tn dry powder in the alternatives space. For 2024, there is a possibility that dry powder might decrease. With a more positive outlook on the economy and the “soft landing” assumption, equities are estimated to continue their surge in 2024. This should also help the private equity market, as investor confidence will increase, and valuations with it. Then, deal activity should increase as well. Additionally, fund managers are under pressure to deploy their capital, as they held it for a while now and have to deploy it eventually, as LPs do not pay them fees for holding their capital. Figure 14: Dry Powder of Alternatives (Private Equity, Private Debt, Real Estate, Infrastructure) from 2000 to October 2023, Source: BlackRock & Preqin, January 2024 The general dynamics in private equity also apply to venture capital (VC). VC is especially affected by high interest rates, as startups mostly do not have reserves to absorb the very high financing costs. On the contrary, VC investments are less sensitive to valuation decreases, as macroeconomic factors do not affect startup valuation as much as in later-stage investments. From an investor perspective, VC deviates from private equity in terms of risk-return ratios by being substantially more risky with higher expected returns. Over the past year, this was evident in the performance of the two asset classes. Private equity managed to post slightly positive returns at 3%, compared to venture capital, which lost around 4% as of Q3 2023. On a yearly basis, the difference is even steeper, as VC lost more than 10% compared to private equity’s solid 5% growth. Blockchain Summary 2023 Cryptocurrencies had a very successful year in 2023. The current market capitalization of cryptocurrencies is $1.63tn compared to $795bn at the start of 2023. The strong performance of 2023 is certainly amplified by the bear market in 2022. The bear market started in 2021 when FTX collapsed. At the time, the market cap of cryptocurrencies was over $2.7tn. Throughout 2022, the value of tokens continuously fell until it reached around $700bn by the end of 2022. The initial surge of 2023 can be attributed to a reversal of the previous bear market. In March 2023, cryptocurrencies again gained significantly following the banking crisis. This raised questions about the stability of the banking system, which increased interest in the cryptocurrency market. The market then remained relatively flat until October 2023 when talks around the approval of the first spot Bitcoin ETFs were heating up. The final decision was delayed multiple times until it was eventually approved on 10th January 2024. The first trading day for spot Bitcoin ETFs was hugely successful and they collectively saw inflows of $4.6bn. This is especially notable, as Bitcoin is frequently compared to gold, which only saw inflows of around $1.6bn when its spot ETF was approved. After the first few days, cryptocurrencies lost a lot of their gains in anticipation of the approval, which is quite common in the cryptocurrency space, as investors bet on positive news, take the profit, and sell it afterward. Bitcoin (BTC) has achieved a return of 155% in 2023, while Ethereum (ETH) returned 90%, as shown in Figure 15. This return distribution is common in the crypto market. In most instances, following a bear market, BTC is the token that gains the most. This is likely due to the psychology in the space, as cryptos crash relatively hard and most people lose a lot. When the market starts recovering, investors are hesitant and move into BTC first, as it is considered a relatively safe investment in the space. The first major difference occurred during the banking crisis in combination with tempered optimism in the space. In June 2023, BlackRock filed an application for its spot BTC ETF, which naturally affects BTC stronger than any other cryptocurrencies. This dispersion continued throughout 2023 with a pronounced effect closer to the effective approval. After the approval hype, this gap narrowed. Figure 15: Growth of Bitcoin and Ethereum from January 2023 to January 2024, Sources: CoinMarketCap & Stone Mountain Capital Research, January 2024 Historically, bear markets have been extremely beneficial to the industry, as they incentivize developers to truly focus on their projects without seeing the need to participate in market upswings as quickly as possible. This was especially notable in the peak in 2017 compared to the peak in 2021. Most of the protocols developed in 2017 have disappeared and are no longer “big tokens” in the space. Figure 16 shows an overview of the 20 most valuable tokens in the space. One of the main technological developments in the cryptocurrency market in 2023 was the emergence of Web 3.0 platforms that leverage blockchain technology to create decentralized applications (DApps) and protocols. Web 3.0 aims to provide more privacy, security, interoperability, and user sovereignty than the current web. Some of the leading Web 3.0 platforms in 2023 were Solana, Polkadot, Cardano, and Avalanche, which saw significant growth in their ecosystems and valuations. Most of these protocols focus on improving the infrastructure of the blockchain industry. Solana, for example, has identified that scalability is a problem, especially for BTC and ETH. Solana is also especially notable, as the token soared more than 12x in 2023. Another major development was the adoption of layer-2 solutions for scaling and enhancing the performance of existing blockchains, especially Ethereum. Layer-2 solutions are secondary networks that run on top of the main chain and enable faster and cheaper transactions while preserving the security and decentralization of the base layer. Some of the popular layer-2 solutions in 2023 were Arbitrum, Optimism, and Polygon. Similarly to Solana, these protocols tackle the scalability problem. Instead of creating a new infrastructure, they use the highly beneficial properties of ETH and its already existing network and improve upon it. Arbitrum emerged as the forerunner among these protocols towards the end of 2023, when it reached multiple milestones. In January 2024, the protocol surpassed a daily transaction volume of $1bn and processed more transactions than its underlying blockchain Ethereum. A third notable development was the innovation in decentralized finance (DeFi), which refers to the use of smart contracts and DApps to provide financial services such as lending, borrowing, trading, and investing, without intermediaries or centralized control. In contrast to most other protocols, DeFi remained relatively flat in terms of value-locked in 2023. Currently, $56bn is locked in DeFi protocols, but it remains far away from its heights in 2022 when the total value-locked was nearly $180bn. Currently, lending protocols are the most dominant in the space, which includes Aave, Maker, and Compound. A fourth notable development was the adoption of zero-knowledge proofs (ZKPs) for enhancing the privacy and scalability of blockchain transactions. ZKPs are cryptographic techniques that allow one party to prove to another that a statement is true, without revealing any information beyond the validity of the statement. For example, ZKPs can be used to verify that a transaction is valid, without revealing the sender, receiver, or amount of the transaction. ZKPs can also be used to compress large amounts of data into smaller proofs, reducing the storage and bandwidth requirements of the blockchain. This form of validation could further reduce the energy requirements of the crypto space, even after the commonly used Proof-of-Stake approach, which already uses 99.9% less energy than Bitcoin’s Proof-of-Work approach. A fifth notable development was the evolution of non-fungible tokens (NFTs), which are unique and indivisible digital assets that represent ownership of various forms of art, collectibles, gaming, and metaverse items. NFTs were one of the hottest trends in 2021 and 2022, as they attracted mainstream attention and generated record-breaking sales and volumes. However, in 2023, the NFT market experienced a significant slowdown, as the hype and speculation faded and the supply of NFTs exceeded the demand. Many NFT projects and platforms suffered from low liquidity, high fees, and poor user experience, and failed to retain their users and communities. Nowadays, most people see the application of NFTs in gaming and metaverse items to create a digitalized economy in these ecosystems. Figure 16: Top 20 Coins in Crypto Peaks in 2017, 2021 and Currently Excluding Stablecoins, Source: Pantera Capital, January 2024 Private Debt Summary 2023 Private debt has emerged as a viable alternative source of financing for many businesses, especially in the middle market segment, as banks have become more selective and constrained by regulatory requirements. This is in particular the case, as early 2023 saw a banking crisis, which led to further cuts of the lending business of traditional banks. While the current macroeconomic environment is largely beneficial for private debt, there are some challenges private debt funds need to manage carefully. On the one hand, high interest rates increase the borrowing costs and the returns of private debt funds, making them more attractive to both lenders and investors. On the other hand, high interest rates also imply a tighter monetary policy and slower economic growth, which could lead to lower consumer spending. These factors could increase the risk of default and impair the recovery prospects of private debt portfolios. However, with the recent decline in inflation and the likely case that interest rates will remain higher for longer, private debt funds will achieve significant returns which are no longer evaporated by inflation as was the case in 2022. Moreover, the economy is expected to avoid a hard landing and maintain a moderate growth rate, which should limit the impact of macroeconomic shocks on default rates. Therefore, the risk of a substantial wave of bankruptcies is relatively small. Nonetheless, fund managers still need to be vigilant, if signs of a more severe recession should occur. The private debt industry is in a very healthy state, especially compared to most other alternative asset classes. Aside from the adverse effect of a potential recession, the private debt industry is placed very well with high interest rates and an overall promising outlook. Higher rates mean higher returns. While risk increases too, the industry has historically managed crises quite well and mitigated a lot of drawdowns. Private equity business will also pick up in 2024 and beyond, which offers private debt funds attractive opportunities alongside private equity funds. Companies may also want to hold off on raising equity capital at currently low valuations and may directly go into private debt to bolster their capital. This approach is becoming more common, as the industry has manifested itself in a prime position. According to Oaktree, US banks and securities firms accounted for more than 70% of loan issuance in the corporate world in 1994, compared to only 10% in 2020. With the banking crisis, this development continued in the favour of private debt funds. Preqin estimates that the AuM of industry is at around $1.5tn (at the end of 2022), but will soar to $2.8bn by 2028 with an annual growth rate of 11%. Following the promising growth outlook for private debt, fundraising significantly increased in 2023. Fundraising in 2022 already was at a relatively high level for the industry at $218bn. As of Q3 2023, global fundraising for private debt stands at $151bn and is on track to close the year similarly successful as 2022. With the very promising outlook of the industry, this is certainly possible. The industry is also maintaining its around $500bn dry powder, as shown in Figure 14. In contrast to most other alternative asset classes, dry powder is not rising, which shows that there is sufficient activity in the space. This in conjunction with record-breaking fundraising shows the strong growth of the industry in the current macroeconomic ecosystem. Direct lending, which refers to the provision of loans by non-bank entities to businesses, is one of the main segments of the private debt industry. Direct lending funds have seen a surge of demand from both borrowers and investors in 2023, as they offer flexible and customized financing solutions that are often unavailable from traditional lenders. According to Preqin, direct lending funds raised $76bn in the first three quarters of 2023, surpassing the $72bn raised in the whole of 2022. Direct lending funds also account for 50% of the total private debt funds in market capitalization, indicating a strong appetite for this strategy. The performance of direct lending funds has been robust, with a total annualized return of 11% since 2004, according to the Direct Lending Index from Cliffwater, as shown in Figure 17. Direct lending funds have also shown resilience in the face of macroeconomic uncertainty, as they typically lend to companies with stable cash flows and high-quality assets. Moreover, direct lending funds can benefit from the higher interest rates environment, as they can charge higher interest margins and generate higher yields for their investors. Figure 17: Cliffwater Direct Lending Index Total Annualized Return from September 2004 to September 2023, Source: Cliffwater, January 2024 Real Estate Summary 2023 The real estate industry remains under substantial pressure even as the year 2024 starts. The industry was also plagued in 2022 and suffered from a suboptimal macroeconomic ecosystem. In 2022, the industry mostly suffered from high inflation which continued into 2023 but faded towards the end. High inflation reduces the attractivity of steady, but relatively, low income, as most of those gains are absorbed by inflation. Contrarily, interest rates started relatively low in 2022 but gradually increased, which raised the cost of building substantially. This trend continued in 2023 and will continue in 2024, as interest rates will not reduce substantially. The environment of higher for longer interest rates does not favour real estate, as it increases the costs of building and makes other fixed income investments, such as bonds and private debt, more attractive. From an adjusted return perspective, real estate and fixed income investments provide similar characteristics. Thus, when fixed income instruments are attractive and real estate is struggling, most of the capital will flow into fixed income. At least the developments in terms of a recession and a corresponding real estate bubble are fading. It became more evident in 2023, that it is likely no severe recession, and housing prices have come down from their record highs in 2022. The difficult macroeconomic ecosystem also showed in 2023’s real estate data. Dealmaking collapsed in 2023. In comparison to 2022, which already was not a great year, the number of deals closed is only 42% as of Q3 2023. The total value of deals as of Q3 2023, corresponds to only 35% of total deal value in 2022. While fundraising was very low in 2023, the fact that real estate’s available dry powder of nearly half a trillion (see Figure 14), barely declined, highlights the difficulties in deal activity in the space. The limited fundraising also caused a significant decline in new funds closed in 2023. As of Q3 2023, 306 funds were closed. In comparison to 2022, this number is 45% lower, and in terms of capital, it is slightly more than half of 2022. The space is also quite saturated, as the total number of active funds has risen by 27%. While it is generally a good sign that the market supports more funds, in this ecosystem, it elevates the pressure on each fund to find deals. This could lead to suboptimal deals, as funds outbid themselves. The residential sector is in a decent spot. Despite the challenging macroeconomic conditions, the demand for housing remains strong, especially in urban areas where population growth and migration are driving up prices. The residential sector also benefits from the low inventory of existing homes, which creates opportunities for new construction and renovation. An issue arises from the high mortgage rates currently, which most people cannot afford. This in combination with a low inventory of existing homes increases prices even further. While construction can be attractive at these prices, it may be difficult to sell them. The residential sector also offers more diversification and stability than other real estate segments, as it caters to different market segments, such as affordable, luxury, or senior housing. Therefore, investors looking for opportunistic returns in the real estate industry should consider the residential sector as a viable option. The office sector is facing a challenging outlook in 2024. The pandemic of 2020-2021 has changed the way people work and accelerated the trend of remote and flexible work arrangements. This has reduced the demand for office space and increased the supply of vacant and subleased space. According to CBRE, the global office vacancy rate rose to 13.9% in Q3 2023, the highest level since 2010. The office sector also suffers from the high interest rates and inflation that affect the real estate industry as a whole, making it harder to finance new projects and reducing the returns on existing assets. The office sector is not homogeneous, however, and some segments may offer more resilience and potential than others. For example, offices in prime locations, with high-quality amenities and sustainability features, may attract tenants who value collaboration, innovation, and corporate culture. Offices that cater to specific sectors, such as technology, life sciences, or media, may also benefit from the growth and dynamism of these industries. 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