NEWS

Interview by Muskan Arora

Marcus Frampton is the chief investment officer of $80.9bn Alaska Permanent Fund Corporation, who is known for his investments in oil and energy. With major allocations in the US and Europe, the system has been witnessing growth in marketable debt securities whilst increasing allocation to its private equity sleeve by targeting growth-focused managers. Like Frampton, multiple investors are eyeing mid-market buyout strategies in hopes of diversification and returns on investments. This interview with Muskan Arora of Markets Group explores his favorite investment strategies, which managers he finds promising, as well as his strategies for the future. 

Muskan Arora: Considering that you recently spoke about your private equity sleeve performing well, are there any sectors and strategies that you're eyeing?

Marcus Frampton: The last decade was dominated in private equity by tech and healthcare, which were extremely successful areas for us. Biotech for us grew to 15% of our private equity portfolio on the back of strong returns. I think that part of the reason why tech and biotech and healthcare did well the last 10 years is just the 0% interest rate environment, with very low inflation. In the 2000s, a period with higher inflation, energy was hot in private equity but now, due to lack of investor appetite, it is a very small percentage of private equity AUM.

From a contrarian standpoint, Energy is an area that we think will do well, and we've made some commitments in the last 12 months in the sector.  We also continue to actively invest within middle market buyout.  I really like the size of APFC’s portfolio as we approach the private equity opportunity - we get scale benefits on negotiating different terms and seeing co-investments, but we're small enough where we can make $30, $40, $50 million commitments and they really make a difference. That enables us to be effective in middle market, smaller buyout funds, whereas if you look at some of the other big state funds, they're writing $200, $300 million checks and can't really be as active in that area.

While most of these mid-market buyout funds are generalist, there are exceptions. Carnelian's is one exception we've committed to recently where it's a sector fund within energy.  In other cases it is middle market buy funds with some industry specialization.  For example, the fund might be broadly a generalist but with some real expertise in specific areas like business services, industrials, some tech deals. I think I would say biotech within venture and energy within buyouts are the areas where we think it's important to back sector specialists. We did reup to Arch, which is a biotech manager, earlier this year, and Carnelian is the other sector specific fund that we backed.

Arora: Are there any trends that you're seeing in energy space specifically?

Frampton: I think of energy as more cyclical than trending. When you talk about oil and gas, a lot of it is the capital cycle and a lot of it's the oil price cycle. Where are oil prices? Where are they expected to go? How much money is trying to get into this area? Whereas, if you're talking about biotech, or tech, or something, it is trends. It's like, okay, where's AI going? Things like that.

Energy, I think is still very under-appreciated by investors as there are still a lot of banks that don't want to do energy lending. There are still a lot of allocators that have various ESG targets that make them reluctant to pursue the space. This dynamic makes it an interesting area for APFC.

Arora: Absolutely. Moving onto private credit, how and why do you think that interest rates are impacting the asset class?

Frampton: Private credit loans are predominantly floating rate – as a result we are seeing higher absolute returns from the category, but also lower interest coverage by end borrowers. In the existing portfolio, higher interest rates are putting pressure on credits. The percentage of cash flow that's going to EBITDA on the companies that private credit lent to over the last few years is much higher than at extension of the loan.  These interest charges might have represented 10, 20% of EBITDA. Now, typically, 60 to 70% of EBITDA is going to service interest. Those portfolios are weathering things fine for now, but their margin for error has gone down because interest rates are up so much, and the borrowers are spending more on interest. Thus an adverse credit cycle, if we enter a recession, is the issue to watch with private credit.

The positive is that we're benefiting from those higher rates. We're the recipient of those higher interest payments. Like I said, there hasn't been a material spike in default rates as of now. Our existing portfolio is performing well. On the new deals, that are being underwritten in this environment, the amount of leverage is down a notch and the borrowers can more comfortably service the interest. It’s good for private credit that rates are higher because of their floating rate. Just a thing to watch out for is if we go into a recession or there are hiccups in the economy or whatever, their margin for safety is a little bit lower now that rates are higher.

Arora: Absolutely. Which strategies do you think would perform well or perform badly in such a state?

Frampton: There’s a lot of uncertainty in the economy right now. We just had benign inflation numbers this week. In the scenario where inflation stays under control and the Fed can land the plane and lower rates, I think private credit will perform really well. If you go into a recession, like I said, the margins for error is much lower. What sectors do well or don't do well will depend on how that recession, if it comes to pass, plays out.

We went through a terrible default cycle in energy from 2015 to 2020, but that's because commodity prices were so low. By the same token, I think some of the sectors that drew the most attention in the last decade price software would be the biggest example where there were high purchase multiples, fairly high leverage on software buyouts.

It would, of course, be an oversight to exclude commercial real estate from any discussion of a credit cycle because anyone lending to, for example, office buildings would not be sleeping well right now. My earlier comments about private credit revolved around corporate private credit, but there is a big market for commercial real estate private credit. Given how fundamentals are deteriorating in certain areas of commercial real estate, I would expect some serious default issues and would expect some interesting investment opportunities to come out of them.

Arora: Something which I have been hearing a lot is that owing to the current financial environment and the crisis with the banks, every manager is talking about offering credit and it's becoming hot again. Do you have any thoughts or experience dealing with that?

Frampton: Generally speaking, as a firm, we're positive on that area. We like the returns we can get in private credit today. The thing to watch for, like I said earlier, is it is non-investment grade credit, so if you go into recession, you could have some defaults in there. I see some people that invest in private credit as a substitute for investment-grade fixed income, and I think that's a mistake.

I believe an investor is fooling themself if they think private credit is analogous to owning a Microsoft bond or other forms of low risk fixed income. You're getting that extra yield because there's credit risk, and I think our board and staff has been thoughtful about where that fits in the portfolio, and we all understand the risks. For us private credit is an equity risk and equity return-seeking area of the portfolio.

Arora: How do you think allocators and specifically private credit should invest just to stay afloat even if there's a dip or something happens because all the managers offering that?

Frampton: The name of the game is to have a long-term target for what you want in the area and then to steadily deploy into the market. If we go into a bad recession, which could happen, the older investments we made probably will incur some losses, but if you continue to deploy, you'll get exposure to those newer vintage years, which should be better. The biggest mistake people make is when they're over-allocated to a private area right as you go into a downturn and then you must stop investing right when it's the most attractive time to invest.

I've been trying to be cautious about how much we commit into the different private areas, so we don't make that mistake. If investors are being judicious about pacing, I don't think they have to worry about the cycle. They do need to worry about the cycle if they're going all in during the good times and then they're licking their wounds in the downturn instead of continuing to invest.  Every cycle there are examples of investors that over-committed when times are good and then aren’t in a position to take advantage of investment opportunities in the subsequent downturn.

On the performance side, I think the critical thing is to back top-quartile managers. I think when there's a downturn, people will be tested and if you did a good job backing higher quality funds, whether it's a venture fund or a private credit fund, the gap between who does well and who does poorly will be wide.

Arora: Now that so many office spaces have leases that are coming to an end when they started during COVID, what do you think is going to happen there then when the leases do end?

Frampton: It depends on the property. We own an office building on Park Avenue and leasing activities, like extremely strong, mid-'90s percentage leased. But at the same time, there are office buildings in downtown LA that cannot attract tenants, and then what's happening is, if someone owns an office building and they have debt on it, the appraised value is very important, and so they try to hold the line on lease rates to maintain appraised value.

These weaker markets where there's an oversupply of office, those will have to sell through one way or another. Whether the banks foreclosed, whether the equity owners threw on the towel and there'll be a new equity owner at a lower cost basis.

I expect that we’ll see very few new office being developed so that limited new supply will be coming on over the next 10 years and this will help work out issues in the sector. I think though if you're a lender on one of these troubled properties, that gives you no consolation that it's going to work out well in 10 years for what you're sitting today.

Arora: Through your infrastructure and real sleeve, what kind of investments are you looking at and why? What kind of strategy sectors do you find interesting in that space?

Frampton: In real estate, we really like the lending area. We're very active lending into development projects. It's probably a little over 10% of our real estate portfolio, right now is different forms of real estate lending. We like that because with uncertainty on a lot of fronts, we're more protected, and we're generally lending to properties that we wouldn't mind owning it if a given loan or property got into trouble.

We look at it from the standpoint of what would it look like to own this building. We've been very active there, and we've been very active on multifamily development. Across the country, we have six or seven apartment developments at different stages. I feel in real estate, the cap rates on stabilized properties have not gone up to compensate for how much interest rates have gone up. When we're doing development, we're doing projects where we can build to a higher cap rate versus what we can get buying. Then on the debt side, we're benefiting from the higher interest rates because we're the lender in those circumstances.

On infrastructure, most of what we're doing is investing in funds and co-investing. Generally, we've been backing managers that are active globally across sectors. With that said, we've been active co-investing.  Fiber specifically and telecom infrastructure generally are themes we’ve invested behind recently in infrastructure.

Some of the commonly thought of areas in infrastructure like airports and toll roads have gotten a little expensive. Some of the areas that we've co-invested in that are interesting to us are a little different or newer for infrastructure, like waste management and fiber is just a high-growth area that we like.