ALTERNATIVE MARKETS UPDATE - H1 2023 SUMMARY

​The current macroeconomic volatility has not changed. Interest rates and inflation remain elevated. At least in most markets, the inflation rate is continuously declining. In the US, inflation reached 3% and is on its way to the upper target of 2% in the short-term. Europe is following this development but still has a substantial way ahead before inflation will eventually reach those levels, as inflation remains at 6.4%. In the UK, the situation is more dire and inflation declined to 7.9% after being above 10% since August 2022. In order to bring inflation levels down, central banks have hiked substantially over the past 1.5 years. In the US, the federal fund rate is now above 5.25% with the most recent hike, which has largely been deemed unnecessary by market participants. The ECB also increased its interest rate by 25bps and is now at 4.25%. The BoE also raised its core interest rate by 25bps in their latest meeting and is now equivalent to the US’s 5.25%. The US also reached the status of positive real interest rates since the hikes started. Europe and the UK are following this trend but have not reached this territory yet. Figure 1 also shows how Europe and the UK are lacking behind the US. In the current environment, a recession is still likely. While projections have changed throughout the year, the consensus opinion remains that there will likely be a short and with a shallow to medium impact on the economy. The most notable change is that the recession expectation has pushed further and further into the future. It started with estimations that it will happen by mid-2023, then towards the end of 2023. Now, most estimates place the recession somewhen in 2024.

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RESEARCH PERSPECTIVE VOL. 208 July 2023 Alternative Markets Update Summary H1 2023 The current macroeconomic volatility has not changed. Interest rates and inflation remain elevated. At least in most markets, the inflation rate is continuously declining. In the US, inflation reached 3% and is on its way to the upper target of 2% in the short-term. Europe is following this development but still has a substantial way ahead before inflation will eventually reach those levels, as inflation remains at 6.4%. In the UK, the situation is more dire and inflation declined to 7.9% after being above 10% since August 2022. In order to bring inflation levels down, central banks have hiked substantially over the past 1.5 years. In the US, the federal fund rate is now above 5.25% with the most recent hike, which has largely been deemed unnecessary by market participants. The ECB also increased its interest rate by 25bps and is now at 4.25%. The BoE also raised its core interest rate by 25bps in their latest meeting and is now equivalent to the US’s 5.25%. The US also reached the status of positive real interest rates since the hikes started. Europe and the UK are following this trend but have not reached this territory yet. Figure 1 also shows how Europe and the UK are lacking behind the US. In the current environment, a recession is still likely. While projections have changed throughout the year, the consensus opinion remains that there will likely be a short and with a shallow to medium impact on the economy. The most notable change is that the recession expectation has pushed further and further into the future. It started with estimations that it will happen by mid-2023, then towards the end of 2023. Now, most estimates place the recession somewhen in 2024. Figure 1: Interest Rates and Real Interest Rates in the US, Europe, and the UK from January 2022 to June 2023, Source: Stone Mountain Capital Research & Trading Economics, August 2023 Economic growth is another vital measure to assess the recession risk. Since Covid, there has been an enormous amount of volatility in growth rates across different economies, especially on a quarter-to-quarter basis. In the past year, economic growth has again reached a relatively stable level with the US QoQ growth rates around 3% and flat for Europe and the UK, as shown in Figure 2. Europe’s growth has been more stable than the US’s but at an almost flat growth. The US saw more volatility in economic growth beforehand, which was likely a function of the initial steep interest rate hikes and the concerns for the economy for this rampant increase. In Europe, rates were raised at a slower pace with less immediate concerns. However, the recently higher growth of the US is also following from this development, as the ecosystem looks healthier than Europe’s. Figure 2: Quarterly GDP Growth Rate of the US, Europe, and the UK from Q4 2020 to Q2 2023, Sources: Stone Mountain Capital Research & Trading Economics, August 2023 Hedge Fund The hedge fund industry is in a healthy state currently. The industry was able to outperform public indices in 2022, which was dominated by losses. While those were merely a correction from strong equities in 2021, they led to notable losses across the board. Hedge funds provided solid downside protection, losing only 8.4% according to BarclayHedge in comparison to nearly 20% of the S&P 500. Consequentially, hedge funds saw significant inflows in 2022, as the AuM slightly increased during 2022. This trend continued in 2023 (as of Q1). According to BarclayHedge, hedge fund AuM stands at slightly above $5tn, which corresponds to an increase of around 4% in AuM. The gains in the same time frame amounted to 2.3%. Figure 3 shows the AuM of the hedge fund industry from 2013 to Q1 2023. However, it should be noted that BarclayHedge is on the high end of hedge fund AuM estimations. HFR and Preqin estimate hedge fund AuM to be at $3.88tn and $4.25tn respectively. It is likely that the industry will continue to see inflows, despite the negative perception in the past decade. However, since Covid, the industry managed its assets well, as it protected downside risk in both drawdowns and achieved good returns in the following bull markets. Figure 3: Hedge Fund AuM from 2013 to Q1 2023, Sources: BarclayHedge, July 2023 As mentioned previously, hedge funds are likely to see further inflows, especially in the short term. A large portion can be attributed to the general investor confidence in the asset class. Currently, investor confidence is relatively high compared to the average of the past decade. A core reason is the current volatile ecosystem. As hedge funds performed well in the past three years, the asset class is more intriguing to investors. The volatile ecosystem also enables hedge funds to show their ability in generating alpha, especially in comparison to passive benchmarks. Passive solutions have gained a lot of interest in stable, bullish markets, where they usually perform better than hedge funds. However, hedge funds have an edge in volatile ecosystems. In addition, some generic changes and progress in the industry help attract investors further. With the change of work after Covid, hedge funds are more accessible to investors. Previously, it could be tiring to set up initial meetings, as those were mostly physical. Nowadays, most initial meetings are virtual and do not require as much planning, which streamlines the whole due diligence and investment process for both sides. ESG is becoming more important for institutional investors. Hedge funds in general did not address this topic on a large scale previously. With its increased importance, hedge funds started to implement ESG measures themselves. It started by including filters but has since progressed to incorporate alternative data to access companies they invest in better. This makes hedge funds more appealing to institutional investors with ESG requirements. Technological advances are also crucial for the industry. The recent hype around artificial intelligence (AI) and machine learning (ML) also benefits the industry. Those techniques are able to extract information from a variety of data. If applied correctly, hedge funds should be able to improve their ability to generate alpha. Technical progress also allows funds to reduce their fees. It is straightforward that lower fees are more appealing to investors. However, it should be noted that this occurs mostly in new and in small- to medium-sized funds. The reason behind this is that those funds typically struggle in raising capital. While it has been a problem in the past, with the increased consolidation in the industry, the problem has become more severe. In a volatile ecosystem as currently, the issue persists, as investors prefer downside protection and new funds have no track record to prove that they can offer this. Thus, most investors will default to established managers instead, which increases the problem for small and new funds. That being said, the hedge fund industry is up a couple of percentages in 2023. Depending on the sources it varies from 0.5%-4.5%. Our SMC Cross-Asset indices are up 13% and 14% respectively. Figure 4 provides more details and includes funds of hedge funds performance. In the following paragraphs, the performance and trends of equity, fixed income, global macro, and cryptocurrency strategies are discussed in more details. Figure 4: Performance of SMC Fund of Hedge Funds Strategies and Benchmarks as of Q2 2023, Sources: Stone Mountain Capital Research, HFR & Eurekahedge, July 2023 Equity-based hedge fund strategies had a positive start in the year. To date, our SMC Equity Index is up almost 8% compared to 1%-6% of other comparable benchmarks. However, it does achieve similar performance to the equity market. For example, the S&P 500 index is up nearly 16% as of the end of June 2023. Figure 5 summarizes the performance of equity hedge funds until June 2023. Despite high interest rates and correspondingly low valuations, equity hedge funds are well positioned. The current ecosystem is especially interesting for Long/Short and Market Neutral strategies, as the highly volatile ecosystem presents many opportunities in both directions. Both of these strategies are in a great position to capture both of these upsides. Additional interest stems from the now higher required returns from funds in general. High interest rates require higher returns from funds to justify investments in these funds. While somewhat defensive strategies are preferred to de-risk the portfolio, the strategies cannot be too defensive, as those strategies struggle to deliver returns that are substantially different from investing in the bond market. Figure 5: Performance of SMC Equity Hedge Fund Strategies and Benchmarks as of Q2 2023, Sources: Stone Mountain Capital Research, Credit Suisse, HFR, Eurekahedge, Standard & Poors, July 2023 Fixed income strategies suffered in 2022, as interest rates strongly surged, which led to declines in outstanding bonds. However, as rates are now high and are unlikely to rise substantially more, fixed income instruments become more attractive. This is in particular the case, as inflation is declining. While positive real returns are only available in the US as of now, this is likely to become true for the EU as well towards the end of 2023. In this setting, most fixed income strategies have yielded positive returns in 2023. Our SMC Fixed Income Index is up 5% compared to most other benchmark that achieve returns around 3%-4%. Figure 6 shows the returns of our index and suitable benchmarks. Fixed income funds are interesting to investors, especially once inflation has subsided. However, only a subset of strategies will be intriguing, as funds need to offer a substantially higher return than obtainable by public and relatively safe bonds. Figure 6: Performance of SMC Fixed Income Hedge Fund Strategies and Benchmarks as of Q2 2023, Sources: Stone Mountain Capital Research, Credit Suisse, HFR, Eurekahedge & Bank of America, July 2023 Global macro strategies had a tumultuous 2022 and 2023 thus far. In both years, the performance of funds widely varied. Our SMC Tactical Trading Index is down 15%, while most other benchmarks yielded positive results in 2023. However, it should be noted that our index only consists of two funds, and the negative results from one single fund. Figure 7 provides further performance information. Despite the varying performance, global macro strategies are in a healthy state in this ecosystem. Historically, global macro strategies benefit from high uncertainty and volatility. In particular, discretionary funds can quickly shift their positions, which is highly relevant in such an ecosystem. This also usually helps in mitigating losses or even profiting from it in phases of economic slowdown. Figure 7: Performance of SMC Tactical Trading Hedge Fund Strategies and Benchmarks as of Q2 2023, Sources: Stone Mountain Capital Research, Credit Suisse, HFR & Eurekahedge, July 2023 Cryptocurrency hedge funds have done the best in 2023 thus far. Our SMC Cryptocurrency Index is up around 55%, which is below Bitcoin’s performance of 84%. Figure 8 provides further insights. Unlike in previous years, Bitcoin has one of the best performances in the crypto space. Usually, Bitcoin’s performance is lower than most other tokens’ returns. With less risky investors, there were fewer investments in the crypto space and comparatively more into Bitcoin, as a “safe” way to profit from the industry. Investors will keep looking at such strategies, as they are still new and grow with the acceptance of the crypto space. Additionally, they can provide mostly uncorrelated returns to other strategies. In general, crypto returns only correlated with other asset classes in sharp drawdowns, such as during Covid. The performance of crypto, which also determines a large portion of a fund’s return is discussed in the next section. Figure 8: Performance of SMC Cryptocurrency Hedge Fund Strategies and Benchmarks as of Q2 2023, Sources: Stone Mountain Capital Research, CoinMarketCap & HFR, July 2023 Blockchain The cryptocurrency space had a relatively stable 2023 in terms of performance, despite the unfavorable economic ecosystem. In 2023, the crypto space grew by 47% to $1.17tn. A majority of the growth of the industry stems from its two core coins (Bitcoin and Ethereum). Figure 9 shows the development of the cryptocurrency market capitalization throughout 2023. While BTC grew by 83% and ETH by 51% in terms of market capitalization, the remaining tokens grew by only 10%. This is largely a consequence of the crypto crisis in 2022 and the “failure” of other large and promising projects. The crypto crisis in 2022 was simply a correction from their huge years in 2020 and 2021, which was amplified by several notable crashes, including FTX, Terra/LUNA, and Celsius. The “failure” of other large crypto projects mostly refers to potentially replacing ETH as the dominant enabler for crypto. While BTC is still the dominant asset, it is regarded as digital gold and offers little to enhance the crypto industry. This includes issues around their sustainability, and transaction volume, among others. Over the years, a few coins were heralded as the new Ethereum, but none of them succeeded. This leads to a decreased interest from investors in such potential projects, especially in a more pessimistic market ecosystem. Following the large-scale de-risking of portfolios, crypto lost a lot of capital. It also led to a shift within crypto and more capital is centered in the established projects, most notably BTC and ETH. The less risky preferences are also highlighted by the higher returns of BTC (+76%) than ETH (+51%) this year. BTC also strongly profited from the formal approval for spot bitcoin ETF applications by BlackRock, Bitwise, VanEck, WisdomTree, Fidelity, and Invesco. Figure 9: Total Market Capitalization of Cryptocurrencies in 2023, Source: CoinMarketCap, July 2023 The regulation around cryptocurrencies and digital assets has shifted more into focus with the recent lawsuits of the SEC against various exchanges and projects. Originally, digital assets regulation should have been introduced in their most recent hedge fund regulation update but was dropped in the end. As of now, cryptocurrencies are not adequately regulated and are simply treated as securities. As there is no proper regulation in the US, the SEC prioritizes regulating crypto exchanges. Nonetheless, the fact that there is no classification of crypto and whether cryptocurrencies are in fact securities causes a lot of issues for the industry. This uncertainty and frustration spiked when the SEC sued Coinbase and Binance for operating securities exchanges without registering. Notably, the SEC classified major cryptocurrencies, such as Solana, Polygon, and Cardano as securities, which allowed this lawsuit. In July 2023, the whole setting became more ambiguous, as the SEC also sued Ripple a few years back for being a security and lost in court. While many other countries have introduced at least some initial regulations, it is vital for the industry that there is more clear guidance ahead from the US. With more certainty, the asset class would be a lot more interesting for institutional investors. Following the crash of cryptos in 2022 and the general de-risking of portfolios, the crypto industry saw net outflows in public markets. This is, in particular, true in the private market. In addition to a lower attractivity of the space, venture capital has also been hit hard. This leads to substantially less capital available in the crypto VC space. Figure 10 shows the deal count and the aggregate deal value of crypto VC since 2017. In Q1 2023, crypto VC raised $2.6bn in capital. It seems like a steep decline from 2021/22 when around $25bn/$28bn were raised. However, fundraising only decreased only by 10% compared to the last quarter of 2022. It should be noted that this is the fourth declining quarter in a row and it is likely that funding levels will remain at around this height in the short-term, as valuations have plummeted and the ecosystem is very uncertain. Figure 10: Crypto Venture Capital Deal Activity from January 2017 to Q1 2023, Source: PitchBook, July 2023 The most notable development in crypto stems from Layer-2 (L2) solutions, which use a blockchain and execute transactions on a sidechain. Most attention is drawn by ETH-L2 solutions, as Ethereum remains the blockchain with the most use in the ecosystem. However, the blockchain still faces issues in terms of the number of transactions it can process. L2 solutions alleviate this problem by processing transactions on a sidechain without jeopardizing its security. Through such a solution, it allows the use of ETH more broadly without the need to switch to another underlying blockchain that can handle such a volume of transactions. While there are also solutions for BTC, it is seen as less relevant, as BTC functions as a store of value rather than being the protocol that can replace common means of money transactions. This sector was also one of the highlights in Q1 2023 fundraising. In contrast to most crypto figures, the value locked in L2 solutions has almost doubled in the last year, as shown in Figure 11. The largest contributor to the success of the sector is Arbitrum, which launched its highly awaited airdrop to network operators. It initially overtook ETH itself in terms of the number of daily transactions as well. However, after the initial hype around its airdrop, activity slowed down again, but it remains the dominant force in this market ahead of Polygon and Optimism. Figure 11: Total Value Locked (USD in Billion) of Ethereum Layer-2 Solutions from July 2022 to July 2023, Source: L2Beat, July 2023 Decentralized Finance (DeFi) is another crucial area in the crypto space. Since the collapse in crypto in 2022, the activity in this area has not changed dramatically and has remained steady, as shown in Figure 12. Currently, around $45bn of capital is locked in protocols that engage in DeFi. These mostly concern solutions in liquidity provision or staking, lending and borrowing activities, decentralized exchanges (DEXes), and collateralized debt positions. Staking cryptocurrencies were very attractive back in 2022 but have not been as interesting in 2023. It is most likely a combination of a decreased interest in crypto in its entirety and the fact that sometimes extremely high yields on staking have come down to more reasonable levels. DEXes saw a brief increase in usage after the FTX collapse, but could not maintain these levels. These protocols currently make up around 5-8% of the total number of transactions. Most of these projects are still in their early days and can have problems around liquidity and scalability. In addition, the user interface is often a problem, which distracts users to switch to those exchanges. Institutional interest is very low due to liquidity and scalability concerns. Additionally, as long as the regulatory situation is not clear, this is unlikely to change. Figure 12: Total Value Locked in Decentralized Finance (DeFi) from July 2022 to July 2023, Source: DeFiLama, July 2023 Non-fungible tokens (NFTs) were another huge topic for crypto in the past. Nowadays, most developments around this topic are relatively quiet. NFTs were mostly used in the art context. This is continued by the huge hype around the metaverse and the possibility to use NFTs in this digital world. More recently, the focus of art-based NFTs shifted to art created by AI. Alongside these relatively established use cases, applications in Web3 are also becoming more prominent. As Web3 uses blockchain technology it allows individuals more control over their personal data, and intellectual properties, among others. NFTs allow individuals to monetize and establish an asset ownership structure. Lastly, the most notable development comes from gaming based on blockchain technology. NFTs are well suited in this area, as they allow transactions of gaming assets in the form of NFTs similar to the metaverse setting. Despite these promising outlooks, the industry is still young, and widespread adoption will still take a substantial amount of time. While the NFT market is still very active, it is still well below its heights in 2021. Currently, around $100m are exchanged on a weekly basis. In early 2023, the weekly transaction value nearly reached $300, as shown in Figure 13. Figure 13: Weekly NFT Trade Volume by Chain from July 2022 to July 2023, Sources: The Block & Cryptoslam, July 2023 Fintech The fintech industry is also feeling the pain from the volatile ecosystem and generically declining valuations. It is likely that the industry will not substantially recover in the short term, but in the medium- and long-term, the industry is still well positioned. The premises on which the industry is built remains very promising. One of the most notable factors includes the fact that nearly 80% of adults are still underbanked or unbanked. Fintech companies can reach these customers and when they become more established, they are also likely to disrupt the banking industry as a whole. The current slowdown can almost entirely be attributed to the market correction following 2021 and does not impact the long-term prospect of the industry. For example, BCG estimates the industry’s revenue will grow to $1-5tn by 2030, which corresponds to a 6x increase in the current volume. The impact of the last three years on the industry was huge. After Covid and the strong recovery afterward led to soaring valuations. During this time, 200 fintech companies reached unicorn status in a single year, as shown in Figure 14. When the economy started contracting and the declines of public markets reached private markets, the number of new fintech unicorns collapsed. In the past year, less than 20 fintech companies reached unicorn status with a continuous downtrend in each quarter. By Q2 2023, only two companies reached unicorn status, which is the lowest number in the past six years. Figure 14: New Fintech Unicorns and $1Bn+ Exits Globally by Quarter from Q2 2017 to Q2 2023, Source: Dealroom, July 2023 While not as drastic as the drop in new unicorns, fundraising also took a heavy hit. Similar to the number of unicorns, the industry saw unprecedented quarterly inflows in 2021, in which more than $30bn were raised in each quarter. In 2022, fundraising numbers declined to around $15bn per quarter. The true impact really showed in Q2 2023, when only $7.4bn was raised. It is the first time since 2018 that quarterly fundraising dropped below $10bn as shown in Figure 15. This is a drastic decline but the situation is even more severe when considering that Stripe’s megaround accounted for $6.87bn in Q1 2023, which accounts for the difference between the two quarters. A couple of other megarounds further affect fundraising numbers. The number of deals is also continuously slowing down. Compared to Q2 2022, the deal count has nearly halved in Q2 2023. This also marks a 2.5-year low. While the global decline was substantial, some regions were hit much harder than others, especially compared to Q2 2022. Latin America and EMEA were hit hardest with a decline of 85% and 75% respectively. North America suffered a decline of only 30%. The APAC region managed to mitigate most of the negative impact, as fundraising only declined by 19%. At least there is one positive development. Based on the latest rounds, valuations have risen compared to late 2022. This is a positive development, but it is unlikely that this already marks the turning point for the industry. Figure 15: Global Fintech Funding by Quarter in Billion USD from Q1 2018 to Q2 2023, Source: Dealroom, July 2023 In the past few years, the fintech industry enjoyed a significant proportion of its growth from payment solutions. The appeal of these solutions is that money transfers can be done much faster than regular bank transfers. Many solutions also only require a phone and an account (that is typically very easy to set up) and thereby allow underbanked citizens easy access to payment solutions. While there is still potential, this sub-sector is on a good path to becoming mature and future growth will mostly stem from other sectors. It seems most likely that B2B and SaaS companies will contribute significantly to the next growth phase of the industry. Especially, SaaS companies enjoyed significant growth within the industry. In 2017, SaaS accounted for 17% of capital raised compared to 44% in 2023. 2023 might be an outlier, as Stripe’s megaround accounted for a majority of this growth, but the sector saw continuous relative growth in each subsequent year. Another trend that can help mitigate the current slump in fintech is AI with the recent hype it sees. The technology is very likely to stay in the long run, but its short-term certainly helps the industry. AI fintech companies collectively raised $1bn across 60 funding rounds in H1 2023. As a large majority of the rounds were seed to growth stages, bigger funding rounds can be expected in the next 12 months. Most rounds were in AI companies addressing digital lending, insurtech, investment and capital market technologies. Payment solutions remain the most dominant companies in fintech. In proportion to total fundraising, the sector attracted consistently around 20% over the past three years. It is likely that the dominance of payment companies will fade over time. The values of 2023 are certainly affected by Stripe’s megaround. Without it, it would support the general decline of the sector. Mortgages and lending companies have gained a lot of attraction in 2023. Over three years, mortgages and lending companies have increased their relevance and account for 21% of the overall funding of the industry. AI developments are one factor in the increased interest in the sector. Financial management solutions grew similarly strong as mortgage and lending companies over the past years. In total, these three sectors account for 60% of the total funding received. Crypto and DeFi companies lost some of their appeal compared to 2021 and 2022. This is related to the slump in crypto markets in 2022. 2022 was not hugely affected, as private investments take longer to be finished and the bull run in 2021 led to many inflows. Wealth management companies have lost the most relative funding compared to 2023. The banking sector saw a similar decline. Insurance and regtech companies attracted relatively speaking more funding in 2023 than previously. The interest in insurance solutions is certainly elevated by the increasingly difficult to manage ecosystem and the AI developments. Figure 16 shows the development of relative funding by fintech sector from 2021 to 2023. Figure 16: Percentage of Funding Attracted by Fintech Sectors from 2021 to 2023, Sources: Stone Mountain Capital Research & Dealroom, August 2023 Private Equity / Venture Capital The private equity industry also faces a fair share of issues as most other asset classes. As an inherently risky industry, investors tend to stay away or at least reduce their exposure to the industry in pessimistic environments. Increasing interest rates, high inflation in most countries, and uncertain as well as volatile markets make valuations difficult. Within the industry, this leads to difficulties in finding deals, as buyers and sellers frequently have substantially different opinions on the value of assets. The low deal activity also causes issues to find exits for portfolio companies. This leads to a slower payout for investors. Not only do investors currently prioritize getting paid out rather than rolling over investments, but as more capital is bound, this also reduces the fundraising of the industry. In most instances, paid-out capital gets reinvested in the industry, which is currently lacking as there are a few exit opportunities and the capital cannot flow back to new funds. Fundraising has suffered substantially, as only 166 funds closed in Q2 2023. This is a decline of more than 50% compared to Q2 2022. In actual value, this corresponds to $106bn, which marks the worst quarter since Q2 2018. This is alarming, as none of the quarters after Covid were that low, when it felt like the private markets stand still. Despite most, if not all, metrics being down substantially, the outlook is not as bad as it seems. According to a survey from Preqin, market participants have become more optimistic over the past year. In Q2 2023, 35% of investors plan to increase their capital allocation to private equity and 50% want to keep their current levels. This is a 5% increase in both, increasing and maintaining, their allocation compared to Q2 2022, as Figure 17 shows. The situation is similar for venture capital. The most promising signs from an investor’s perspective are found in early-stage strategies. While funding can be difficult, early-stage companies are in a state, in which the market environment is less relevant as the companies are still very young. Figure 17: Expected Capital Commitments in Private Equity Funds Over the Next 12 Months (Survey), Source: Preqin Pro, July 2023 Buyout strategies are strongly affected by general industry trends. Buyout funds sit at a record $1.1tn in dry powder, which should help the sector to manage the drought in fundraising on an aggregate level. As most of this capital was raised recently, funds are not necessarily in a rush to deploy this amount of capital. In addition to the $1.1tn in dry powder, the sector also has $2.8tn in unrealized assets. Almost 50% of those assets have reached the average holding period of 5 years, and a quarter is exceeding a holding period of 6 years. As mentioned previously, this amount of bound capital leads to a liquidity crunch of LPs which negatively affects fundraising. In the current ecosystem, LPs put a higher emphasis on DPI than usual. Up to 70% of investors in Asia and around 50% of North American investors (the lowest value globally) prefer being paid out. Thus, funds should be open to exit portfolio companies earlier than they might prefer, especially if they do not see better exit opportunities in the short term. One saving grace may be the recently soaring equity market with a moderate inflation level in the US, which might open a window to exit through IPOs. Deal activity for buyout funds also decreased significantly. Globally, the sector conducted deals worth $202bn in H1 2023, which is a decline of 58% compared to H1 2022, as shown in Figure 18. The current downturn is now active for a full year, in which the quarterly deal value is close to $100bn. This is in stark contrast to the previous quarters when each quarter exceeded $200bn. With a limited amount of opportunities in a stalling market, add-on investments are responsible for more than 50% of deals. However, they only account for 9% of the deal value. With the uncertainty in the market, it got substantially harder to get loans. Compared to Q2 2022, syndicated loans are down by 64%. Luckily, private credit stepped in and helped mitigate the financing issue of buyout strategies. Figure 18: Global Quarterly Buyout Deal Value from Q1 2021 to Q2 2023, Sources: Bain & Company, Dealogic, July 2023 As with all private equity strategies, fundraising has slowed down substantially. As fundraising is a factor that lags behind in time, the situation is unlikely to get better in the short term. According to Preqin, funds will seek around $3.3tn in capital, but investors will likely only commit around $1tn capital to the industry in the short term. While established managers with new funds will have fewer problems, it will hit small and emerging managers hard. The industry is facing a trend of consolidation for a while now and in a distressed economy, this issue is likely to get bigger. Due to the lagging nature, even if the economy becomes more stable, the drought in fundraising may well continue until 2024. Venture capital saw similar declines to buyout strategies. On a global level, the industry invested $84bn, which in terms of deal value is the lowest amount since Q1 2020. Close to half of these investments were in the US with $35bn, and $13bn in China, while no other country attracted more than $5bn. US and European deal activity is down by more than 50% in the past year (Q2 2022 to Q2 2023) compared to the previous year (Q2 2021 to Q2 2022). In the US, the average deal activity per quarter is around $40bn compared to $90bn before. The situation is similar in Europe, where deal activity slowed to $16bn compared to $30bn. This decline can be traced back to the generally volatile markets, high interest rates, high inflation, and limited exit opportunities. The number of unicorns this year and the prior is probably the most evidence of the issue. From Q2 2021 to Q2 2022, 750 companies reached unicorn status compared to 120 in the current year. Figure 19 shows the aggregated deal value from 2019 to Q2 2023. Compared to the highly successful 2021 until Q2 2022, all stages except pre-seed and seed rounds have taken a major hit. As private markets lag behind public markets, the issue is likely to take time to be resolved. This is even more true for European VC, as the EU is lacking behind the US with current interest rates and inflation trends. The current ecosystem also led to a shift for companies, as they are facing issues in raising capital. Previously, the common strategy was to aim for as much growth as possible to be attractive. Now, this focus has shifted to cost control to show operational efficiency, and strong financial stability to be appealing for funding or potential exits, once a window is open. This also led to substantial layoffs and hiring freezes in startups. Earlier-stage company deals trend towards deals with more capital than before. However, this is not necessarily beneficial, as it means that there is no capital for many startups and deal activity has become much slower. GPs are investing more restrictive, and take more time for a more sound due diligence analysis. For later-stage companies, the ticket size of investments has decreased with lower valuations. In addition, a significant proportion of total deals are follow-on investments rather than investments in new companies. On a sector level, software companies took a major hit. In 2023, software investments received 29% of capital compared to 40% in 2022. However, AI might change this development again, as it is a very hot topic and attracts a lot of capital. Other relatively stable include less cyclical strategies, such as biotech and pharma. Alternative energy, energy storage, and cleantech are areas that see a lot of interest as well. This trend emerged when the conflict between Russia and Ukraine started and persists until now. Figure 19: Global Venture Capital Investments by Quarter, Source: Dealroom, July 2023 Fundraising is also a major issue the industry faces. In the past seven quarters, the capital raised has been continuously going down. Since Q2 2022, fundraising has dropped below $100bn per quarter. At the height during 2021/22, fundraising per quarter was close to $200bn. This is shown in Figure 20. In Europe, fundraising has reached a decade low, while in the US fundraising dropped to a six-year low. The trend of consolidation is also evident in VC funds. Investors gravitate towards established managers in volatile times, as they have proven themselves in the past, whereas there is no indication for new managers and funds. Another problem investors have with new managers is a performance concern. Many of them launch during the bull market at high valuations. This might seriously affect their long-term performance. Proportionately, there are more new funds seeking capital than in previous periods. But as shown by investor preference, more than 50% of the total capital raised in the industry went to large, established funds exceeding $500m. In terms of preferred strategies, investors are drawn more towards early-stage funds, as those strategies are more long-term oriented and are less dependent on the short-term market environment. Especially the US might have an advantage in dealing with the current crisis, as US VC has accumulated a record dry powder of around $300bn. Figure 20: Global Quarterly Fundraising of Venture Capital from Q1 2016 to Q2 2023, Sources: KPMG & Pitchbook, July 2023 Private Debt The private debt industry is in a good state, unlike most other alternative asset classes. A major contributor is the high interest rates that also increase the yield on private debt. While it makes bonds in the public more attractive, it may cannibalize private debt investments. However, this is not a major concern for the industry as spreads in debt investments have also widened and led to even higher returns for private debt investments. With a highly volatile market and a potential recession, banks have restricted access to loans and they are no longer as easy to get as previously. Private debt can step in and profit from this limited availability of capital. This can best be highlighted by a comparison of private debt investments and the syndicated loan market. In 2022, private debt financing was used 5 times more than syndicated loans. This is a huge increase, compared to the ratio of 1.7:1 which has been steady over the past three years. The more cautious lending also led to private debt financing becoming more prevalent in very large deals. Previously, these instruments were mostly used in the middle market, while some of the largest transactions in 2023 have been heavily supported by private debt financing. As capital is not easy to come by, private debt investors have an additional benefit in imposing tighter and more conservative covenants, which leads to additional protection for their investments. This is especially the case for leverage ratios and debt coverage metrics. The default rate for private debt investments has also decreased in Q2 2023, which makes the investments even safer. According to the Private Credit Default Index by Proskauer, the default rate decreased from 2.15% in Q1 2023 to 1.64% in Q2 2023 for non-financial companies. In addition to the mostly favorable environment for private debt, the industry is also well positioned on the capital front. As of Q4 2022, the industry sits on almost $200bn dry powder, which marks the highest value in the history of private debt. Fundraising of private debt is also in a very healthy state, as the industry raised the third most per quarter in Q2 2023. Private debt raised around $70bn in Q2 2023, which is almost double the $40bn raised in Q1 2023. Figure 21 shows private debt fundraising from Q1 2017 to Q2 2023. Of the total capital raised, the lion’s share goes to direct lending strategies. Figure 21: Number of Funds Closed and Capital Raised by Private Debt from Q1 2017 to Q2 2023, Source: Preqin Pro, July 2023 Direct lending strategies have attracted a lot of attention in the private debt market. While it has been the dominant strategy for years, it has strengthened its position in the current ecosystem. Its performance this year has been resilient and corresponds to the long-time average of around 10% per year. This becomes more appealing with inflation coming down, especially in the US. It is in particular interesting, as direct lending has more opportunities with less bank lending, stricter covenants, and in general more security. The strategy also allows market participants to mitigate the strong volatility in current markets by steady income streams. While the industry may face some issues in the future, these are significantly less impactful than the positive developments. Among others, this includes reduced private equity activity and fewer opportunities. However, with significantly less capital from banks, private debt fills this capital shortfall. On an aggregate level, there are fewer deal opportunities but the size of private debt is substantially higher than before. In the future, especially if the economic situation should move towards recession, a problem could arise from defaults. Currently, this does not seem too likely, and more conservative lending should help mitigate this. Lastly, distressed debt and special situations are also in a promising spot. While it is not entirely true now, its future perspective is promising. The currently high interest rates and the magnitude of change may put companies in jeopardy. With the soaring interest payments and potential defaults following it, the sector is likely to see an increase in opportunities. Unlike during Covid, this ecosystem will stay for the foreseeable future and last substantially longer than during the initial period of Covid. It is also unlikely that companies will get as much support as they have back then, which limited the opportunities for distressed debt and special situation strategies. While the prospect of more opportunities is promising, it may not be as clear-cut as it seems. Many companies extended or renewed their loans in the two prior years when interest rates still were low. For fixed-rate loans, the current environment is unlikely to majorly impact the credit risk of those companies. However, if these companies get into difficulties, it may get difficult to recover, as covenants were much looser back then, which leads to more opportunities. Real Estate The real estate industry remains in a difficult position. The high interest rate environment substantially increases the costs to build new properties. The high rates impact the attractivity of debt instruments that are similar in the payoff structure to real estate, which results in less interest in the industry. The high inflation rate over the past year also makes it difficult for the industry to achieve positive real returns. This issue is likely to fade to some degree in the short term. However, the high financing costs are likely to remain in the medium term. While the ecosystem is not beneficial to the industry and overall deal activity has slowed substantially, capital availability is not an immediate issue. Fundraising has not been particularly strong in 2022 when each quarter remained around its historical average since 2018. In Q1 2023, the industry saw the lowest amount of capital raised since Q1 2018. This changed in Q2 2023 when $57bn was raised, which was one of the best quarters since 2018. While this is promising, it needs to be accounted for that more than $30bn came from Blackstone’s megafund that closed in Q2 2023. In terms of fund closing, Q2 2023 is on par with the worst quarter since Q3 2020, as shown in Figure 22. With decent fundraising levels and a large amount of dry powder, capital does not seem to be a constraint for the industry currently. According to JLL, the real estate industry sits on $404bn. In addition, on the credit side, the market also provides enough capital for projects, despite the more restrictive lending of banks. As mentioned previously, private debt has done a great job to fill some of the capital shortfall. Although capital is no imminent issue, deal activity has come down significantly. This has several reasons. The most obvious is the steeply increased cost of capital for projects. More conservative underwriting also slowed dealmaking. Given the difficult environment, funds are also more focused on their existing portfolios which slows capital deployment. This trend is further exacerbated by the necessity to pay more attention to investor demands in terms of sustainability and potential regulatory requirements. Slowed deal activity is also related to the volatility in building prices. Over the past years, some sectors have skyrocketed and some have plummeted. On an aggregate level, valuations are declining since Q3 2022 and prices should reach more stable levels in 2023, which could spark new investment given the more predictable price levels. This repricing process may also offer interesting opportunities for niche strategies. Figure 22: Private Equity Real Estate Fundraising (Aggregate Capital Raised and Number of Funds Closed) from Q1 2018 to Q2 2023, Source: Preqin Pro, July 2023 While there were notable declines across all major sectors, the housing sector is the most resilient. The sector profits from its underlying fundamental that more and more people need homes. Since the Covid crisis, the housing sector has done well, as more people were interested in bigger homes with more work from home. Over many years, supply tended to be tight, which has not changed. In addition, the currently high financing costs do not incentivise taking on new projects, which only strengthens the shortfall in housing supply. Deal activity is still heavily down, but there are encouraging signs in Europe and the Asia Pacific region, as Q2 2023 saw the first increase in deals after several quarterly declines. The US market faces more challenges and is still down 69% on a YoY basis. The problem is likely to get better when financing costs come down with the large dry powder the sector has at its disposal. Especially Europe is doing well, as capital rose by 18% compared to Q1 2023, whereas Asia Pacific remained flat. The office sector is under substantially more pressure. In addition to the problem the whole industry faces, investor sentiment towards the sector is on the negative side. The sector is in a transition phase that increases the volatility of the sector. Currently, future demand for office space is highly volatile, with the changes to the working ecosystem following Covid. In addition to that, economic growth is likely to slow down in the coming years, which does not make the sector more attractive. With a long-term horizon, sustainability trends are also vital alongside the financial success of the tenants, as finding replacements may become difficult. These are likely crucial factors for future performance and also lead managers to focus on existing portfolios rather than exploring new properties. The current volatility can also be seen in global office space leasing, as shown in Figure 23. In Q2 2023, there were some signs of recovery, at least in the short term. Compared to the previous quarter, office leasing increased by 7%. However, this is still far off from pre-Covid times. Compared to then, office leasing is down 27%. In Asia, levels remained stable, while they decreased substantially in Europe and to a lesser degree in the US. The transition also led to a soaring global vacancy rate of 15.6% in Q2 2023. Unsurprisingly, construction of new office space is substantially down, due to high financing costs, and many existing vacant properties. Figure 23: Global Office Gross Leasing Volumes Across the US, Europe, and Asia Pacific from Q1 2007 to Q1 2023, Source: JLL, August 2023 Logistics is another segment in real estate that is still of high interest. Despite the decline in deals by 50% on a YoY basis, investor sentiment remains positive. While the current slowdown in economic activity is a factor that speaks against the sector, a majority of factors remain positive. Firstly, the strong increase in online businesses that rely on logistics has not slowed down. This required companies to extend their logistic properties, which led to a decline in supply. This is still true and there is a limited amount of vacant properties. It became even more important during the supply chain crisis, which is not entirely resolved yet. Constrained supply is still an issue in most mature markets and requires more storage facilities. It is expected that demand for logistic properties will persist in the US and Europe but with a tendency to normalize and stay at slightly elevated levels compared to pre-Covid. For Asia Pacific, it is expected that elevated levels will remain and new supply is highly sought after. This generally large demand has led to a substantial increase in rent over the past few years. While the overall growth of rents in the sector has declined since 2022, rents are still increasing by a high margin. In the US, logistics rent has increased by 19% on a YoY basis, compared to 12% in Europe, and 6% in Asia Pacific, as shown in Figure 24. Figure 24: Annualised YoY Rental Change in Logistics from Q2 2018 to Q2 2023, Source: JLL, August 2023 The retail industry is a mixed bag, but market participants are cautiously optimistic about the sector. Within the sector, there is a strong segregation. The retail sector is mostly growing in prime, high-quality locations. This includes space in prime high streets, tourist-attraction places, and major shopping centers. The success in those areas mostly came from more resilient consumer spending than anticipated. In other locations, the sector has not done too well. The hotel and hospitality sector also revived from its miserable two years before. With no more Covid implications, and people with the urge to travel, the industry strongly profited and made up some of its losses incurred during Covid. On a global scale, the sector is up by 10% compared to 2019. Especially, the US and Europe have fully recovered and can offset some previous losses. Europe achieved a higher performance than the US given the region’s strong tourism in its subregions. Asia Pacific is still down slightly, as restrictions have not been fully lifted everywhere. The largest impact this year came from China, once it reopened. Macro and Political Outlook August 2023 by Macro Eagle I – JULY RECAP The July equity rally was all about “Bear Extinction”, with hardly anybody left NOT believing in “soft landing”: (1) jobs/NFP came in weaker than expected – brilliant, Fed won’t hike. (2) Headline inflation came in below expectations – brilliant, Fed is done. (3) China growth is weak – amazing, stimulus is around the corner. I continue to be in the “orderly bear” camp, mainly because a lot of the upside narrative relies on the expectation of Fed cuts next year (good luck – more below).  The good news is that there is plenty of scope for stock-picking out there, the key job being to avoid landmines (high debt, financial engineering, unprofitable) and to focus on quality while covering the tails. Long Companies/Short Market. And no – I haven’t seen Barbie or Oppenheimer yet, but I sure will. Figure 25: S&P 500 Performance and Major Market News, Source: Macro Eagle, August 2023 II - TOP 10 in JULY (1) Dow Jones: record streak of 13 consecutive up-days. That takes us back to 1987, the year of ‘Black Monday’ – left chart. (2) Weather: Northern heatwave. Monday, July 3rd, was globally the hottest day ever: 17C. California’s Death Valley hits 53.3C; still short of the 56.67C registered in 1913. (3) Japan: equities hit a 33 year high in early July; 10 year JGB’s hit a 10 year high towards the end. (4) US yield curve: at its most inverted since the early 1980s. (5) Short squeeze: biggest ‘de-grossing’ of hedge fund positions over the past 10 years, mainly by cutting shorts. (6) Big US bankruptcies are piling up at the second fastest pace since 2008. (7) UK house prices record their biggest YOY fall since 2011. (8) Fed hikes rates to a 22 year high. (9) Nasdaq performs a ‘special rebalancing’ as BigTech becomes too big – only the second such special action in 25 years. (10) Biden nominates the first women for the Joint Chiefs of Staff. Figure 26: History of Consecutive Up Days of the Dow Jones & Heatwaves in Northern Hemisphere, Source: Macro Eagle, August 2023 III – AUGUST PREVIEW Apart from the obvious (CPI, jobs, earnings, poor seasonal liquidity), it is ‘geopolitics’ that promises some fireworks: (1) Saudi attempt at Ukraine peace talks in Jeddah this weekend. (2) Taiwanese presidential candidate Lai Ching-te planning to do a stop-over in the US next week, which has Beijing fuming. (3) Putin plan to visit Erdogan, probably in the 4th week – could be relevant for the War/Grain Deal. (4) BRICS summit in South Africa – for sure with a healthy dose of US/West-bashing. (5) First Republican presidential candidate debate – should be highly entertaining if Trump joins. (5) The Fed’s annual Jackson Hole symposium – always good for sharp market moves.  Figure 27: Major News in August 2023, Source: Macro Eagle, August 2023 IV – My “BRO” Since a graph says more than 1000 words, please see below my “BRO” (= ‘Binocular’ of Risks & Opportunities). Blue for “good”, red for “not good”, grey for “important but could go either way”.  Basic message: neither did it make sense to be an “end-of-the-world”-Bear at the start of the year, nor does it make sense to be a YOLO-Bull now (for starters: ‘soft landing’ is not the same as ‘roaring growth’). There is a lot that can go either way. Paraphrasing the wise Deng Xiaoping: this is a time of “crossing the river by touching the stones”. Figure 28: Positive, Neutral, and Negative Developments for Risks and Opportunities, Source: Macro Eagle, August 2023 V – STOCK vs. FLOW A key problem with many of the “not sure” issues listed above is the difference between “stock” (i.e. the absolute level) and “flow” (i.e. the rate of change). Take for example “liquidity” (here: M2), which central banks have pumped into the system post-Covid and clearly have some kind of link to the rally in financial assets (left graph). If I want to be a Bull, I just point to the liquidity “stock” being well above trend (middle graph). But if I want to be a Bear, I point to the “flow” (right graph). You can make similar arguments for excess savings, jobs, debt, etc. The big question is: does the “stock” reversion to trend happen smoothly, or is there some kind of “sudden stop” (the famous “Wile E. Coyote” moment) i.e. when you think there is still petrol in the tank, but there isn’t. I don’t know. But at least I know, I don’t know (and buy tail protection while its cheap). Figure 29: Comparison of US M2 Liquidity vs. S&P500; US M2 from 2003 to 2023; YoY Change in Percentage of US M2, Source: Macro Eagle, August 2023 VI – ALL ABOUT THE US 10 YEAR Year-to-date the 2y US Treasury has been moving higher while shaking like a polaroid picture (from 4.40 to 4.80). Meanwhile, the US 10 year has been relatively steady around 3.90, until last week – see left graph. Two forces have kept the US10 well anchored: (1) Fed cut expectations and (2) low Japanese yields – the world’s 3rd biggest government bond market. On Fed cuts: I think the market is in Barbieland-escapism. Headline inflation is falling, but Core isn’t. And inflation is like “losing weight”: the first kilos are easy, what comes after is the real pain. Ergo: high for longer, as the real battle is Core inflation falling from 4% to 2%. As for Japan: last week’s price action was a strong reminder that what happens in Tokyo, doesn’t stay in Tokyo.  Add the BOJ’s love for “surprises” and you get sharp moves. Evidence: after “no change to YCC” reported on Friday, July 21st via Bloomberg/Reuters, everybody got caught by surprise when Nikkei leaked the “change to YCC” on Thursday, July 27th, leading to US10 yields shooting higher and Nasdaq taking a dive. OUCH! Figure 30: Comparison of US 2y- and 10-y US Treasuries; Implied Federal Fund Rate from August 2023 to December 2024; Comparison of the 10-y Yield of the US and Japan, Source: Macro Eagle, August 2023 VII – “BREAKS” worth thinking about While you are taking it easy in August, some “breaks” worth thinking about: (1) can equities keep decoupled from real rates – left graph? I don’t think so. (2) Can credit spreads remain decoupled from rising bankruptcies – middle graph? Don’t think so. (3) There is an almost record spread between US and Eurozone economic surprises – right graph. But both the S&P500 and the Eurostoxx50 are up 17%/14% YTD. Doesn’t feel right. Something has to give.  Figure 31: Comparison of US Equities and Real Interest Rate; Comparison of Credit Spread and Defaults; Comparison of the Citi Economic Surprise Index in the US and Eurozone, Source: Macro Eagle, August 2023 VIII – GEOPOLITICS & 2024 I have mentioned before that 2024 is a MONSTER YEAR from a political/geopolitical perspective, and not just because of the US election – see table below.  That matters for markets NOW, because it normally sint't the events that matters, but political actions taken into them: incumbents will try to stimulate the economy (Biden/IRA); the opposition will try to find dirt (Biden/Hunter); policymakers are in a bind especially when faced with high inflation vs fiscal stimulus (good luck Powell); foreign policy considerations everywhere (China/Taiwan, Ukraine War) and much more. I’m forming my views on most of the below – so should you. Figure 32: Major Geopolitical Events in 2023, Source: Macro Eagle, August 2023 IX – PORTFOLIO  As mentioned above, I think everybody is getting a bit too excited about “soft landing”. But, I equally don’t believe in some kind of systemic tsunami, just localised whirlpools taking down the non-profitable and/or leveraged, while quality assets with quality leadership benefit from competitors being taken out (and while at it, buy their crown jewels).  So – recommendation as always: own what you understand and where you can get out of. Personally, we continue to find selected European equities a good “long”, while taking advantage of low volatility to cover our left-market-tail. With the Nasdaq100 up 40% YTD (which I missed), I’m not too worried about the right-market-tail. That ship has sailed.  Quick word on the hot weather: Spanish olive prices are at record highs due to the draught. In Miami, Orange Juice futures are hitting record highs. Thanks to Moscow cancelling the Grain Deal same is happening with Wheat Futures. Expect higher food prices/shortages. Figure 33: CNN Fear & Greed Index; Equity Risk Premia from 2003 to 2023; Volatility of Equity and Interest Rates, Source: Macro Eagle, August 2023 I wish you all a great AUGUST/HOLIDAY and may THE MARKET BE WITH YOU !!! Bobby   The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, Stone Mountain Capital LTD. Readers should refer to the Disclaimer. Bobby Vedral MacroEagle E : i[email protected] M : +447899996595 Bobby is a macro-political analyst who runs his own fund MacroEagle. He is also the UK representative of the German Economic Council (Wirtschaftsrat Deutschland) focused on the German-British relationship post-Brexit. Bobby left Goldman Sachs in March 2018, where he was a Partner and Global Head of Market Strats. 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