EYE ON THE MARKET BIENNIAL ALTERNATIVE INVESTMENTS REVIEW 2023

It’s Mostly a Paper Moon

In our biennial Alternative Investments Review, we analyze industry returns in private equity,
venture capital, hedge funds, commercial real estate, infrastructure and private credit. While
private equity and venture capital managers have outperformed public markets, a lot of the
gains for vintages since 2015 are still on paper, leaving investors exposed to how managers mark
positions and prices at which companies are sold in a world of higher interest rates. Performance
of diversified hedge fund portfolios has been better than expected. The debate on private credit:
how different are its underwriting standards compared to broadly syndicated leveraged loans.

By Michael Cembalest
Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

It’s Mostly a Paper Moon1: Alternative Investments Review

As 2023 comes to an end, a few things look better than they did a few months ago. US growth estimates for
2023 were just 0.5% back in January, and now they’re almost 2.5%. US consumers kept on spending in 2023,
although they’re gradually running down accumulated savings. Rising consumer delinquencies (credit cards,
subprime auto loans) indicate that higher interest rates are starting to have an impact.
2023 real GDP consensus growth forecasts Real personal consumer spending
Percent Index, (100 = Q4 2019)
4.0% 110
US
3.5%
105 JPN
3.0% Global
EMU
US 100
2.5%

2.0% 95 UK

1.5%
90
1.0%
85
0.5%

0.0% 80
Jan-22 Apr-22 Jul-22 Oct-22 Jan-23 Apr-23 Jul-23 Oct-23 2019 2020 2021 2022 2023 2024
Source: Bloomberg, JPMAM, November 29, 2023 Source: National sources, JP Morgan Economics, JPMAM, Q3 2023

Something else that looks better than I thought it would: performance of private equity, venture and hedge
funds. However, a lot of the gains for private equity and venture investors are still on paper. As a result, there’s
still plenty of upside and downside risk left for LPs regarding how managers mark positions, and the prices at
which companies are sold in a world of higher interest rates. That’s the main theme of our biennial Alternative
Investments Review. We also include an analysis of diversified hedge fund portfolio performance, a brief look
at commercial real estate/BREIT, infrastructure returns and comments on private credit’s “golden moment” due
to Basel III proposals on banks.
The 2024 Eye on the Market Outlook will be released as usual on January 1st. Topics include the usual suspects,
plus a deeper look at weight loss drugs and US debt sustainability. In case you missed it, November’s Eye on the
Market addressed questions on geopolitics and US politics (US election, Europe, China/Taiwan, Middle East, oil).
The 2024 Energy paper will come out next March or April; one section will analyze what a “Marshall Plan”
reconstruction of Gaza might look like, with a focus on possible contributions from rooftop solar power.
Michael Cembalest, JP Morgan Asset Management

Contents
Private Equity .................................................................................................................................................................... 2
Venture Capital ................................................................................................................................................................. 7
Hedge Funds ................................................................................................................................................................... 10
Commercial real estate, the office sector and BREIT ..................................................................................................... 14
Infrastructure .................................................................................................................................................................. 16
Private credit, Basel III and the battle of the underwriters ............................................................................................ 17
Appendix: what are the systemic risks of more non-bank lending? .............................................................................. 21

1
“It’s Only a Paper Moon”, music by Harold Arlen and lyrics by Billy Rose and Yip Harburg, 1933. A “paper moon”
refers to something that appears real and significant, but which is an illusion. The cover art was created using
generative AI, which is why there are strange items added which I did not prompt for.
INVESTMENT PRODUCTS ARE: ● NOT FDIC INSURED ● NOT A DEPOSIT OR OTHER OBLIGATION OF,
OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES ● SUBJECT TO 1
INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Private Equity
While multiple of invested capital and internal rates of return are interesting, neither measures performance vs
a public equity benchmark. Our preferred performance measure is the Public Market Equivalent ratio, which in
simple terms represents the outperformance of private equity vs a public equity market benchmark. When I
received the latest update from Steve Kaplan at the University of Chicago, I was surprised. The last time we
updated this two years ago, the relative performance of 2016 and 2017 private equity vintage years were barely
above 1.0 (i.e., roughly equal to S&P 500 performance). As of Q2 2023, these vintage years were outperforming
the S&P 500 by a larger amount.
US buyout outperformance
Public Market Equivalent ratio vs S&P 500 The Public Market Equivalent ratio (PME)
1.6
Median compares private equity capital calls and
1.5
Average distributions to investments in public equity
1.4 markets in the same exact time periods. The
1.3 result is a ratio of private equity returns vs
1.2 the public equity benchmark used. As
1.1
shown, the average private equity manager
has outperformed the S&P 500 for most of
1.0
the last 30 vintage years
0.9
1992 1996 2000 2004 2008 2012 2016 2020
Vintage year
Source: Steve Kaplan (U Chicago), Burgiss, JPMAM, Q2 2023

The charts below show how buyout outperformance for vintage years 2013-2017 improved since our last
analysis a couple of years ago2. No material changes in vintages through 2012 since most investments for those
vintage years have already been monetized.
US buyout outperformance, average managers US buyout outperformance, median manager
Public Market Equivalent ratio vs S&P 500 Public Market Equivalent ratio vs S&P 500
1.6 1.6
as of 2023 Q2 as of 2023 Q2
1.5 1.5
as of 2020 Q4 as of 2020 Q4
1.4 1.4

1.3 1.3

1.2 1.2

1.1 1.1

1.0 1.0

0.9 0.9
1992 1996 2000 2004 2008 2012 2016 1992 1996 2000 2004 2008 2012 2016
Vintage year Vintage year
Source: Steve Kaplan (U Chicago), Burgiss, JPMAM Source: Steve Kaplan (U Chicago), Burgiss, JPMAM

2
“Food Fight: Private equity performance vs public equity markets”, Eye on the Market, June 2021. This piece
also included sections on different performance benchmarks; co-investment returns; the impact on IRR from
subscription lines; buyout and venture manager dispersion; carried interest, management fees and net
monitoring/transaction fees; and secondary GP-led funds.
2
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Why did private equity outperformance improve for recent vintage years? Thank you notes are in order from
private equity investors to IPO investors. The IPO boom allowed private equity firms to sell a lot of companies
at inflated valuations. The first chart shows the surge in public listings, and the second chart shows how poorly
IPOs and SPACs3 issued in 2020/2021 performed relative to the S&P Small Cap Growth Index4. The third and
fourth charts show rising private equity exit activity coinciding with rising private equity distributions. Bottom
line: 2020/2021 was a great time for private equity firms to unload both good companies and bad, courtesy of
Federal Reserve and Treasury stimulus which boosted investor risk appetite.
Improving private equity outperformance took place even though managers have been paying more and
leveraging more. The median private equity enterprise value to EBITDA5 ratio for 2017-2019 vintage years was
~11x compared to ~8x in 2010, and the median debt to EBITDA ratio was ~5.5x in 2017-2019 compared to ~4.5x
in 2010. Even so, they benefitted substantially from selling while the real cost of money was still close to zero.
The only question I have is why private equity managers didn’t sell even more of what they bought.
US public listing proceeds by type, $ billions Average IPO/SPAC net returns by sector for vintage years
$350 2020 and 2021, H=2 yr, Percent, vs Small Cap Growth Index
SPACs 0%

Technology
Technology

Consumer
Consumer

Diversified
Diversified
Healthcare
Healthcare
$300
IPOs -10%
$250
-20%
$200
-30%
$150
-40%
$100 IPOs
-50%
$50 SPACs
-60%
$0
2010 2012 2014 2016 2018 2020 2022 -70%
Source: Bloomberg, JPMAM, July 12, 2023 Source: Bloomberg, JPMAM, July 12, 2023

US private equity exit activity Global private equity cash flows by year
US$, billions Number of exits US$, billions
$300 700 $800
Exit value (lhs) Exit count (rhs) Distributions Contributions
600 $700
$250
$600
500
$200
$500
400
$150 $400
300
$300
$100
200 $200
$50 100 $100

$0 0 $0
2012 2014 2016 2018 2020 2022 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
YTD
Source: Pitchbook, Q3 2023 Source: Steve Kaplan (U Chicago), Burgiss, Q2 2023

3
For what it’s worth, I warned investors in 2021 that the SPAC boom was to be avoided: “Hydraulic Spacking”,
February 8 2021 Eye on the Market; “Spaccine Hesitancy", August 19 2021 Eye on the Market
4
As per our July 2023 IPO paper “Mr. Toad’s Wild Ride”, a Small Cap Growth index comes closest to matching
the tech and biotech sector composition of the new issue market and the size of companies brought public
5
EBITDA = earnings before interest, taxes, depreciation and amortization
3
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Despite the surge in private equity exits, for investors in vintage years 2016-2019, it’s still mostly a paper
moon: in other words, a lot of gains are still on paper:
• The fourth and fifth columns in the table show distributions and the remaining value of retained positions6.
By taking the remaining value and dividing by the sum of remaining value and distributions, we can compute
each vintage year’s continued sensitivity to market conditions
• For vintage years 2016-2019, more than 50% of the total value in private equity funds is still reliant on
existing positions (i.e., where they are marked and where they eventually get sold)7. Bain & Co estimates
that buyout firms are sitting on $2.8 trillion of unsold investments, which is another way of understanding
the paper moon metaphor
• For vintage years 2016-2019, there’s also not much dry powder left (paid in capital to capital committed)
US buyout: average manager stats by vintage year
Paid in capital Remaining value as Average Public
Vintage Total value to Distributions to Remaining value
to capital % of fund value + Market Equivalent
year paid in capital paid in capital to paid in capital
committed distributions ratio vs S&P 500
2005 1.00x 1.67x 1.54x 0.13x 8% 1.17
2006 1.02x 1.62x 1.60x 0.03x 2% 1.01
2007 1.06x 1.75x 1.71x 0.04x 2% 1.01
2008 1.03x 1.65x 1.52x 0.14x 8% 1.01
2009 1.00x 2.12x 1.99x 0.13x 6% 1.12
2010 1.03x 1.90x 1.70x 0.20x 11% 1.03
2011 1.04x 1.96x 1.71x 0.26x 13% 1.15
2012 1.03x 1.90x 1.71x 0.19x 10% 1.15
2013 1.03x 2.02x 1.54x 0.48x 24% 1.13
2014 1.05x 2.00x 1.22x 0.79x 39% 1.22
2015 1.04x 1.82x 1.07x 0.75x 41% 1.18
2016 1.00x 2.05x 0.98x 1.07x 52% 1.18
2017 0.98x 1.95x 0.82x 1.13x 58% 1.30
2018 0.98x 1.57x 0.36x 1.21x 77% 1.17
2019 0.90x 1.48x 0.23x 1.25x 84% 1.20
2020 0.78x 1.35x 0.08x 1.27x 94% 1.15
2021 0.58x 1.16x 0.00x 1.16x 100% NA
2022 0.34x 0.96x 0.00x 0.96x 100% NA
Source: Burgiss, JPMAM, Q2 2023. Each value is based on the median of the peer group.

6
Where does our data come from? Burgiss sources private equity cash flow data directly from limited partners.
Its investor universe includes 300 state and corporate pension fund, endowment and foundation limited partner
investors in 1,400 private equity funds and contains net-of-fee cash flow data. Burgiss believes its universe
represents at least 70% of all private equity funds ever raised. Burgiss return data is not subject to survivorship
bias and selective reporting associated with Venture Economics and other private equity/venture data sources.
An example of the problems with Venture Economics. A 2013 paper from Rudiger Stucke at Oxford concluded
the following: “A detailed analysis of its aggregate and individual numbers, however, reveals severe anomalies.
Over 40% of the funds in the database stopped being updated during their active lifetime. Incomplete funds are
missing over 60% of their cash distributions. The result is a significant downward bias of the whole benchmark
with major implications for a large fraction of the established literature on private equity”.
7
Over the last decade, the remaining value-to-total fund value % for vintages that were 6.5 years old generally
ranged from 54% to 65%, putting today’s value at the lower of this range but not abnormally so. The key
difference: this time around, the interest rate regime has changed a lot while unsold investments are pending
4
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Where does private equity go from here in a world of higher interest rates?
Look at that first chart again. Rather than focusing on the surge in exits in 2020/2021, note how exits have
recently dropped to their lowest levels since 2012. Carlyle’s failed acquisition of Cotiviti (healthcare software)
earlier this year is illustrative. Debt financing yields of ~12% reportedly hurt the economics of the potential
transaction, and when Carlyle attempted to renegotiate the valuation downward, the seller walked away. A
trough in deal activity typically means that sellers have yet to adjust their expectations of where things can
actually trade in a world of higher rates; that’s the case in private equity, venture, office and residential real
estate as well. FWIW, I’m not a huge fan of what some private equity firms are doing to sustain distributions
to LPs, such as borrowing against Net Asset Value to make payouts or resorting to payment-in-kind financing;
both approaches obscure the fundamentals of what’s actually happening inside the funds.
US private equity exit activity US LBOs: purchase price multiples
US$, billions Number of exits Equity and debt over trailing EBITDA
$300 700 12x
Exit value (lhs) Exit count (rhs) Equity
600 Debt
$250 10x

500
$200 8x
400
$150 6x
300
$100 4x
200
$50 100 2x

$0 0 0x
2012 2014 2016 2018 2020 2022 '04 '06 '08 '10 '12 '14 '16 '18 '20 '22 Avg of
Source: Pitchbook, Q3 2023 Source: Pitchbook, LCD, JPMAM, August 31, 2023 '04-'18

The 2016-2019 vintage years face challenges regarding financing of debt and need financial conditions to ease
to sustain current multiples of invested capital. Triple-C rated bond and loan issuance is down ~80% from last
year, and B/B- loan issuance is down 70% from 2021 levels. According to Moody’s, more than half of all B- loan
market borrowers will not generate enough cash flow to cover capital spending and debt service by the end of
this year. “Amend and extend” activity is running at its fastest pace since 2009, we have seen an uptick in pre-
emptive Selective Defaults8, and lenders may be less willing now to allow “EBITDA adjustments” which artificially
underestimate leverage ratios by 0.5x to 3.0x, depending on the sector9.
Interest coverage for B- rated issuers in the US loan market US leveraged loans amendments and extensions
Percent Count
100% 550
90% 500
450 YTD
80% Above 1.5x Nov '23
70% 400
350
60%
300
50%
250
40% Between 1.0x-1.5x 200
30% 150
20% 100
10% Below 1.0x 50
0% 0
Jan-22 Jun-22 Sep-22 Dec-22 Dec-23 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22 '23
Source: Moody's Investors Service, 2023 Source: LCD, Pitchbook, JPMAM, November 2023

8
2023 Selective Defaults: Bausch Health, Community Health, Carvana, AMC Entertainment, Rackspace
Technology, Telesat, Shutterfly, Curo Group (fintech) and US Renal Care
9
Covenant Review, 2023. See page 18 for more on EBITDA add-backs
5
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

How realistic are private equity current marks?

The secondary market for buyout funds was only 10% below Net Asset Value during the first half of 2023.
However, this observation is based on pricing from the end of June when the 10-year Treasury was still below
4%. It will be informative to see what these discounts to NAV look like by year-end. There’s also not a lot of
information about the depth of these pricing estimates; a modest amount of demand to buy or sell could change
them substantially.
Secondary market pricing
Percent of Net Asset Value
100%
Buyout
Credit
95% Real estate
Venture
90%

85%

80%

75%

70%

65%
2017 2018 2019 2020 2021 2022 2022 2023
H1 H2 H1
Source: Jefferies, October 2023

Another imperfect measure: secondary market discounts in UK listed investment companies investing in
alternative investments. Using this lens, valuation discounts are closer to 30% for buyout funds, the largest
they have been since 2003 other than during the financial crisis when they reached 50%. However, this is not a
large and liquid market and may exaggerate discounts. Note the 50%-60% discounts to NAV reportedly available
for those buying into closed-ended growth equity funds in the UK market.
UK-listed investment companies discount to NAV
Percent discount, with # of funds and current market value (billions £)
-70%
Market-cap weighted average
-60%
Median
Funds of Equal weighted average
private Leasing Funds
-50% (private investing
equity
Funds funds shipping/ in direct
investing aircraft) property Funds
-40%
in growth investing Renewable
Private
capital in private energy Unquoted
credit
-30% equity funds Credit real estate
funds Infrastructure
funds debt
investing funds
-20% in CLOs Traded
credit
funds
-10%
Highly concentrated fund with 70%
of NAV in a single investment
0%

10%
N=5, £2.8 N=6, £5.1 N=7, £0.9 N=4, £1 N=8, £25.9 N=21, £13 N=6, £1.9 N=6, £1.5 N=9, £12.8 N=3, £0.7 N=10, £1.1
Source: JP Morgan Investment Companies Research, November 17, 2023

6
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Venture Capital
Venture Capital excess returns also look better than they did a couple of years ago, in part due to the surge in
exits shown in the second chart. As we reviewed in our deep dive IPO analysis in July, the performance of many
technology, healthcare, biotech and renewable energy companies that went public in 2020 and 2021 was poor
relative to the equity market. VC managers were fortunate to be able to unload many of them at the time.
Here’s a look at the evolution of VC outperformance and the lags between public markets and private markets:
• In Q4 of 2019, excess returns for 2016 and 2017 vintages were barely above 1.0x given the strong rally in
public equity markets used as a benchmark
• By Q2 of 2022 after the equity market correction, excess returns for 2016 and 2017 vintages looked much
higher since most VC managers had not marked down positions yet
• By Q2 of 2023, VC managers started to mark positions down to reflect market conditions and comparables,
and excess returns for 2016 and 2017 vintage years fell in half from their peak. The third chart suggests
that there could be more markdowns to come
US VC fund excess returns vs S&P 500 US venture capital exit activity
Public Market Equivalent ratio US$, billions Number of exits
2.0 $900 2,500
as of Exit value (lhs) Exit count (rhs)
1.8 2022 Q2 $800
$700 2,000
1.6
as of $600
1.4 2023 Q2 1,500
$500
1.2
$400
1,000
1.0 $300
0.8 as of $200 500
2019 Q4
0.6 $100
1999 2002 2005 2008 2011 2014 2017 $0 0
Vintage year 2006 2008 2010 2012 2014 2016 2018 2020 2022
Source: Steve Kaplan (U Chicago), Burgiss, JPMAM Source: Pitchbook, Q3 2023

Performance proxy for Venture Capital companies

suggests sharp fall in valuations from peak levels, with a
recovery in Q4 2023, Index (100 = January 2019)
400

350 NASDAQ
VC proxy
300

250
The Refinitiv Venture Capital Index
200 Refinitiv starts by observing valuations of venture backed
150 firms during funding rounds, acquisitions and exits. They
then back into the estimated value of each venture backed
100
firm over time. The Refinitiv VC proxy index is then created
50 which uses publicly traded assets to replicate the derived
2019 2020 2021 2022 2023
Source: Refinitiv/Thomson Reuters, Bloomberg, November 17, 2023
performance of venture backed firms as closely as possible

7
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

More paper moon effects: compared to private equity, recent venture capital vintage years are even more
sensitive to market conditions. For vintage years 2013 to 2019, more than 50% of the total value in venture
funds is still reliant on existing positions (i.e., where positions are marked and eventually sold). The chart at the
bottom indicates that the market exposure of VC investors exceeds that of private equity.
US venture capital: average manager stats by vintage year
Paid in capital Remaining value as Average Public
Vintage Total value to Distributions to Remaining value
to capital % of fund value + Market Equivalent
year paid in capital paid in capital to paid in capital
committed distributions ratio vs S&P 500
2005 1.00x 1.29x 1.25x 0.04x 3% 1.10
2006 1.00x 1.23x 1.14x 0.09x 7% 0.86
2007 1.00x 1.66x 1.58x 0.08x 5% 1.17
2008 1.00x 1.64x 1.37x 0.27x 16% 1.02
2009 1.00x 2.29x 1.82x 0.47x 21% 1.20
2010 1.00x 2.38x 1.77x 0.61x 26% 1.41
2011 1.00x 2.38x 1.60x 0.78x 33% 1.61
2012 0.99x 2.83x 1.62x 1.21x 43% 1.59
2013 1.00x 2.40x 1.16x 1.25x 52% 1.48
2014 0.99x 2.20x 0.84x 1.36x 62% 1.44
2015 0.99x 2.23x 0.48x 1.75x 78% 1.32
2016 0.98x 2.20x 0.34x 1.86x 85% 1.52
2017 0.98x 2.20x 0.21x 1.99x 90% 1.48
2018 0.95x 1.85x 0.07x 1.78x 96% 1.31
2019 0.91x 1.40x 0.00x 1.40x 100% 1.23
2020 0.84x 1.22x 0.00x 1.22x 100% NA
2021 0.59x 1.00x 0.00x 1.00x 100% NA
2022 0.23x 0.90x 0.00x 0.90x 100% NA
Source: Burgiss, JPMAM, Q2 2023. Each value is based on the median of the peer group.

Greater share of VC investments have yet to be monetized

Remaining value as a % of fund value + distributions
100%
Venture capital
80% Buyout

60%

40%

20%

0%
2010 2012 2014 2016 2018 2020 2022
Vintage year
Source: Burgiss, JPMAM, Q2 2023. Each value based on peer group median.

8
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

The venture capital landscape is shifting

The charts below illustrate how the venture capital landscape is shifting:
• the rising median time between venture rounds
• the increased number of startups terminated due to bankruptcy
• the large jump in “down rounds” between 2022 and 2023, and the decline in post-money valuations (i.e.,
the company’s value after a new capital injection), particularly for Series C. For example, from 2022 to 2023,
the incidence of down rounds rose from 8% to almost 20%, and when down rounds occurred, in 2023 they
entailed post-money valuation declines of more than 50%
All of this is consistent with tightening financial conditions and a hangover from easy conditions prevailing in
2020 and 2021.
Median time between venture rounds is increasing Startups shutdown due to bankruptcy/dissolution
Days Number of startups
900 225
Q1 2020 Latest No priced round
850 200
Had a priced round
175
800
150
750
125
700
100
650 75
600 50
550 25
500 0
From priced seed to From series A to From series B to Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
series A series B series C 2019 2020 2021 2022 2023
Source: Carta, JPMAM, Q3 2023 Source: Carta, JPMAM, September 2023

Percent of rounds that were down rounds Median decline in post-money valuation
2022
Series A 2023

Series B

Series C

Series D

Series E

0% 5% 10%
15% 20% 25% 30% -60% -50% -40% -30% -20% -10% 0%
Percent Percent
Source: Carta, JPMAM, September 2023

9
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Hedge Funds
One of the most subjective things in investment finance is the evaluation of hedge fund performance. A few
years ago, there was a lot of press coverage of a large state plan terminating its hedge fund investment platform
due to perceptions of underperformance. When we looked at the details, the constraints the plan put on its
hedge fund portfolio resulted in volatilities that were much closer to cash/bonds than equities. As a result, they
should have used a performance benchmark that reflected that (and I’m not sure that they did).
In any case, I wanted to get a sense for how hedge funds have performed over the last few years, including the
drawdowns during COVID, from the perspective of an investor selecting their own funds in a diversified portfolio
(as opposed to a plan exclusively investing in hedge fund of fund or multistrategy portfolios)10.
Step #1: obtain performance for US-based hedge funds (relative value, equity hedge, event driven and macro)
that report on a monthly basis to HFR, and which have 5 years of performance11. The blue dots shows each
hedge fund’s five-year annualized excess return over T-bills, and the volatility of this excess return
Step #2: create random portfolios of 20 individual hedge funds. We used a filter that required the hedge fund
portfolio to be at least partially diversified by excluding any portfolio that had more than 10 funds of one type.
The gold dots show the excess return and return volatility of these randomly constructed 20-fund portfolios
Individual hedge funds and 20-fund composites [HFR]
Annualized excess return vs T-bills since Jan 2018
40%
Individual hedge funds (n=644)
35%
Portfolios of 20 randomly selected hedge funds (n=300)
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
0% 10% 20% 30% 40% 50%
Annualized excess return volatility
Source: JPMAM, HFR, September 2023

10
This information is most relevant for diversified institutional investors that are not subject to taxation. After-
tax analysis of hedge fund performance is complicated given the need to distinguish between different kinds of
gains and income, and the need to incorporate tax loss carryforwards and carrybacks on a fund-specific basis
11
The HFR hedge fund inclusion waterfall: start with database of 6,081 funds; eliminate 3,722 funds that are
not US domiciled; eliminate 1,130 funds due to structure (not limited partnerships or limited liability
companies); eliminate 208 funds that are not one of our 4 core strategy types; eliminate 251 funds that were
launched after 2018; eliminate 44 funds that report quarterly or annually since we cannot compute comparable
volatility; eliminate 82 funds that did not yet report data for August/September 2023; remainder: 644 funds
10
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Step 3: What about a benchmark? The gold cluster shows the excess returns and volatilities for the randomly
constructed portfolios from Step #2. The benchmark is the efficient frontier of excess returns over T-bills for
different stock/bond combinations. So, for each hedge fund portfolio, the question is whether it generated a
higher excess return than its corresponding risk-adjusted benchmark (i.e., is the gold dot above the benchmark
curve). For the five-year period in question, 78% of hedge fund portfolios outperformed the risk-adjusted
benchmark. That’s higher than I expected, but the second chart shows the importance of diversification to the
results: as the number of hedge funds in the composite portfolio declines, the share of composite portfolios
outperforming declines sharply as well. In other words, randomly constructed portfolios with only 5 hedge
funds had only a 55/45 chance of beating the stock/bond benchmark.
20-fund composites vs benchmarks [HFR] Outperformance of hedge fund
Annualized excess return vs T-bills since Jan 2018 portfolios declines with the number
10% of funds included
9% 80%
80/20
8%
70/30 75%
7%
60/40 70%
6%
5% 50/50
65%
4% 40/60
60%
3% 30/70
2% 20/80 55%
Portfolio of 20 random hedge funds (n=300)
1% 50%
Benchmarks (S&P 500 / Barclays Agg)
0% 20 15 10 5
4% 6% 8% 10% 12% 14% 16% 18% # of randomly selected hedge funds in
Annualized excess return volatility portfolios
Source: JPMAM, HFR, September 2023 Source: JPMAM, September 2023
We repeated this analysis using a different hedge fund performance database (Pivotal Path)12, and the results
were even better: almost every hedge fund composite outperformed the risk-adjusted benchmark.
20-fund composites vs benchmarks [PivotalPath]
Annualized excess return vs T-bills since Jan 2018
10%
9%
80/20
8%
70/30
7%
60/40
6%
5% 50/50
4% 40/60
3% 30/70
2% 20/80
Portfolio of 20 random hedge funds (n=300)
1%
Benchmarks (S&P 500 / Barclays Agg)
0%
4% 6% 8% 10% 12% 14% 16% 18%
Annualized excess return volatility
Source: JPMAM, PivotalPath, September 2023

12
Pivotal Path hedge fund inclusion waterfall: start with database of 2,200 funds; eliminate 716 funds that are
not US domiciled; eliminate 59 funds that are not one of our 4 core strategy types; eliminate 327 funds launched
after 2018; eliminate 567 funds that did not report for the entire period; eliminate 61 funds that did not yet report
data for August/September 2023; remainder: 470 funds
11
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

What about survivorship bias?

Survivorship bias tends to inflate performance since funds that stop reporting usually underperform. The HFR
and Pivotal Path analyses above only include funds that reported for each month of the 5-year analysis period.
To capture the impact of partially reporting funds, we ran another iteration that included funds as long as they
had at least 24 months of performance. After a fund stopped reporting, we assumed the prevailing monthly T-
bill return (i.e., the position was assumed to be redeemed and converted to cash).
We were only able to perform this analysis for Pivotal Path since HFR does not include funds that existed as of
December 2017 that stopped reporting afterwards. Pivotal Path does provide data for funds that partially
reported: in addition to the original 470 funds with the full complement of monthly data, we allowed the
composites to also randomly include 432 partially reporting funds. As shown below, while the cluster of
composite returns shifts down, the vast majority of composites still outperform risk-adjusted benchmarks.
The big caveat. In real life, investors are also exposed to the period after a hedge fund stops reporting when it
often sells its most illiquid positions. As a result, we’re not capturing the full impact of survivorship bias on the
return composites. The table on the right shows academic estimates of survivorship bias, defined as the decline
in average annual hedge fund returns once the impact of dead funds is incorporated. While the range of
estimates is high (some are also quite dated and reflect a hedge fund industry whose portfolio concentrations
were generally higher and more volatile), the estimates are all positive. In other words, all studies agree that
excluding dead funds overstates hedge fund returns. The shorter the analysis period (ours is only 5 years), the
smaller the survivorship impact would presumably be.
20-fund composites vs benchmarks [PivotalPath]
Annualized return vs T-bills since Jan 2018
10%
9%
80/20 Survivorship
8%
70/30 Study bias est. Year
7%
60/40 Ackerman 0.16% 1999
6%
50/50 Yuen 0.54% 2018
5%
40/60 Funds with partial data Amin 2.00% 2003
4%
(at least 24 consecutive Horst 2.10% 2007
3% 30/70 months) included Liang 2.24% 2000
2% 20/80 Brown 3.00% 1999
Portfolio of 20 random hedge funds (n=300)
1% Edwards 3.06% 2001
Benchmarks (S&P 500 / Barclays Agg)
0% Fung 3.48% 1997
4% 6% 8% 10% 12% 14% 16% 18% Malkiel 4.50% 2005
Annualized excess return volatility Aggarwal 5.00% 2010
Source: JPMAM, PivotalPath, September 2023 Source: JPMAM

12
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Some observations on hedge fund portfolios from prime brokers. The large prime brokers publish aggregated
information sourced from the hedge funds they transact with. As a result, every prime broker has a different
view of what hedge funds are doing in portfolios. The charts below represent the vantage point of one of the
larger prime brokers (Goldman):
• For most of the last five years hedge funds were underweight Megacap stocks, adding exposure only in
2023. Even so, they were still underweight Megacaps relative to the Russell 3000 Index
• The stock picking opportunity set has not been much different from the barren landscape of 2010-2020,
other than during the 2020 COVID selloff and recovery
• The average fund holds 70% of its long portfolio in its top 10 positions, close to the highest concentration
on record. Similarly, hedge fund crowding in a small number of positions also hit a new high this year
• For the better part of a decade, hedge fund short books earned just 0-25 basis points in yield. Going
forward, short books will earn positive returns if the Fed maintains a positive real cost of money

Weight of Big 7 Megacap Stocks (AAPL, AMZN, GOOGL, Slim pickings for stock pickers other than 2020
META, MSFT, NVDA, TSLA), Percent of portfolio S&P 500 3-month return dispersion
65%
28%
60%
In Russell 3000
24% 55%
50%
20%
45%
16% 40%
In hedge fund long 35%
12% US equity portfolio 30%
8% 25%
20%
4% 15%
0% 10%
2015 2016 2017 2018 2019 2020 2021 2022 2023 1995 2000 2005 2010 2015 2020 2025
Source: GS Global Investment Research, November 20, 2023 Source: GS Global Investment Research, November 20, 2023

Hedge fund portfolio density Most crowding across hedge fund portfolios since 2006
Weight of top 10 positions in median long HF portfolio Percent, Effective N as % of distinct equity holdings
75% 3%
4%
70% 5% More Crowded

6%
65%
7%
8%
60%
9%

55% 10%
11%
50% 12%
2002 2005 2008 2011 2014 2017 2020 2023 2006 2009 2012 2015 2018 2021 2024
Source: GS Global Investment Research, September 30, 2023 Source: GS Global Investment Research, Q3 2023

13
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Commercial real estate, the office sector and BREIT

The good news on the office sector, if there is any, is that allocations in private real estate portfolios began to
decline in 2015, five years before COVID. The office sector is now less than 20% of private commercial real
estate portfolios according to MSCI estimates, and the lower the better: the latest data from Stanford show
work-from-home days stuck at 30%-35% in many large urban areas (in 2019, work-from-home days were around
3% at a national level). Note how the Bay Area is the outlier, which is consistent with San Francisco’s lowest
ranking in our deep dive economic/demographic analysis of 22 major urban areas in October.
The third chart shows that aside from regional malls and office, most CMBS delinquency rates have actually
been improving. The spike in special servicing rates for CMBS office loans point to a lot of pending modifications
and is another example of how office stress exceeds other property types. I’ve heard of funds being raised for
office-to-residential conversions. Good luck finding willing sellers; to make conversion economics work,
properties might have to change hands at 60%-70% discounts to pre-pandemic values (see box).
MSCI commercial real estate core index property type Work from home: large metropolitan cities
allocations Percent of full paid days worked from home
60% Bay Area (45.5%)
40% NYC (36.8%)
Industrial 55% LA (36.7%)
35% Miami (34.6%)
DC (34.1%)
30% 50% Dallas (34%)
Apartments
Atlanta (32.5%)
25% 45% Houston (31.5%)
Chicago (25.6%)
20% 40%
Office
15% 35%
Retail
10% 30%
Medical/Lab
5% Self 25% Employee population: U.S. residents, 20-64 years old, who
storage
0% Other report work-related earnings greater than $10k-$20k
20%
2000 2005 2010 2015 2020 Oct-20 Apr-21 Oct-21 Apr-22 Oct-22 Apr-23 Oct-23
Source: MSCI, JPMAM, Q3 2023 Source: "Why working from home will stick", Barrero, Bloom and Davis, NBER, Oct 2023

CMBS delinquencies by property type Special servicing rates for office and non-office CMBS loans
Percent Percent
25% 16%
Regional malls
Office
Retail 14%
20% Hotel Ex-Office
12%
Retail excl. regional malls
15% Office 10%
Multifamily
8%
Industrial
10% 6%

4%
5%
2%

0% 0%
2001 2004 2007 2010 2013 2016 2019 2022 2002 2005 2008 2011 2014 2017 2020 2023
Source: Moody's, JPMAM, September 2023 Source: JP Morgan CMBS Research, September 2023

On office to residential conversions. In our October 2023 Eye on the Market on New York City, we walked through pro-
forma economics required for a sample conversion of a prewar Class B office building whose rents are now $3.50 psf per
month. Assuming conversion costs of $320 psf plus $40 psf for green efficiency, a decline in post-conversion rentable space
of 15%, new residential rents at the 90th percentile ($96 psf annually for an 875 sq foot 1 BR apartment), the buyer would
still need to negotiate a sales price of just $175 psf to generate 15%-18% returns. This price represents around a 60% decline
in price psf from pre-pandemic levels.

14
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

The same valuation lags seen in public vs private equity exist in public vs private real estate. The chart on the
left shows how REIT returns (blue) recently led private real estate returns (gold) by a few quarters. That’s
typically the case in a downturn, as shown on the right. If that’s the case, there could be some markdowns
flowing through direct real estate valuations in the months ahead, even if interest rates stabilize around current
levels. The other obvious point to make is that private real estate has much lower reported volatility due to the
smoothed nature of appraisal-based returns13.
Private vs public real estate total returns Private vs public real estate total returns
Percent, rolling 4-quarter total return Percent, rolling 4-quarter total return
60% 60%
REITs (NAREIT)
50%
Private Real Estate (NCREIF/ODCE) 40%
40%
30%
20%
20%
10% 0%
0%
-10% -20%
REITs (NAREIT)
-20%
-40%
-30% Private Real Estate
Jun-19

Dec-19

Jun-20

Dec-20

Jun-21

Dec-21

Jun-22

Dec-22

Jun-23
Sep-19

Sep-20

Sep-21

Sep-22

Sep-23
Mar-19

Mar-20

Mar-21

Mar-22

Mar-23

-60% (NCREIF/ODCE)
1980 1990 2000 2010 2020
Source: NAREIT, NCREIF, JPMAM, Q3 2023 Source: Nareit, NCRIEF, JPMAM, Q3 2023

I thought this was interesting: the pressures on Blackstone’s $114 billion BREIT fund subsided during 2023.
The chart on the left shows redemption requests as a % of NAV, and the degree to which these requests were
fulfilled. As the year came to a close, both looked better than they did earlier in the year. And while BREIT
performance has been below cash this year, the fund’s modest 3% exposure to the office sector should mitigate
the risk of sudden large vacancy and NOI problems in the portfolio.
BREIT investor redemptions and fulfillments BREIT performance
Percent of NAV Percent of total request Rolling 12 month return
8% 60% 35%
7% Monthly request (lhs)
50% 30%
6%
25%
40%
5%
20%
4% 30%
15%
3%
20%
10%
2%
Monthly fulfillments (rhs)
10% 5%
1%

0% 0% 0%
Oct-22 Dec-22 Feb-23 Apr-23 Jun-23 Aug-23 Oct-23 2018 2019 2020 2021 2022 2023 2024
Source: BREIT, JPMAM, October 2023 Source: BREIT, JPMAM, October 2023

13
Volatility-based arguments in favor of non-tradable asset classes are very strange in my opinion. My 2012
Jeep Wrangler has an infinite Sharpe ratio since it never trades, yet I would not recommend it on that basis as
an investment. Non-public assets should be evaluated primarily on absolute return and the sacrifice of liquidity.
15
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Infrastructure
Many investors allocate to infrastructure with a focus on transportation, energy/power, waste management
and telecom. A decade ago, public private partnerships were a pillar of infrastructure investing but politics,
challenges to existing projects and complexity were a problem and they’ve fallen out of favor. The archetype
managers generally look for now: control positions in a pure-play asset; an investment grade capital structure;
and earnings mostly derived from remuneration structures and regulator-approved capital investment. This
approach can reduce uncertainty and result in more stable free cash flow for distributable yield. Sounds great,
but what’s a good proxy for the actual experience of infrastructure investing?
There’s as much art as science required to create a private infrastructure return index. MSCI’s approach:
canvas the GPs who run infrastructure funds and aggregate their valuations of power, water, transport and
communication assets. In contrast, EDHEC works with LPs to monitor cash flows of a pool of infrastructure
assets. EDHEC then creates a total return index using a risk factor model drawing from actual transactions taking
place in the industry. The respective assets differ, which partially explains why annualized returns differ (~13%
for EDHEC and ~11% for MSCI for 2009-2020). The larger difference: EDHEC’s approach captures real-world
interim valuations of illiquid infrastructure assets while MSCI does not. This is an even more extreme example
of the impact of appraisal smoothing than commercial real estate.
The index choice is an existential one: do LPs care more about the value of infrastructure assets as reported by
managers and which flow through to return statements? Or do they care more about their real-world value if
they wanted to or had to sell them periodically? MSCI and EDHEC allow investors to choose from either extreme.
One thing’s for sure: looking at Sharpe ratios, correlations or risk adjusted comparisons to publicly traded
infrastructure equities using smoothed private infrastructure benchmarks is an extremely dubious exercise.
Infrastructure rolling one year price returns Infrastructure rolling one year income returns
Percent Percent
30% 14%
25%
12%
20% MSCI
EDHEC
15% Global 10% Infra300
Infra
10%
8%
5%
0% 6%
-5% 4% MSCI
-10% Global Infra
EDHEC 2%
-15% Infra300
-20% 0%
'09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20
Source: MSCI, EDHECinfra, JPMAM, Q4 2020 Source: MSCI, EDHECinfra, JPMAM, Q4 2020

Infrastructure, revenues and inflation

Is infrastructure an inflation hedge? 12 month moving average
That’s a broad question made challenging by the fact 12%

that there haven’t been many inflation spikes over the 10%
UK infrastructure
time frame of observable infrastructure returns. companies' revenue
8%
According to Ares Global Client Solutions, inflation does
appear to result in higher infrastructure revenues one 6%

year later. The chart on the right is based on changes in 4%

UK inflation and revenues of UK-based infrastructure
2% UK inflation
projects. A lot depends on the whether inflation-based (12 mo. lead)
adjustments are part of the contract, and/or if the 0%

contract allows for owners to pass along inflation -2%

increases to users. 2007 2009 2011 2013 2015 2017 2019 2021 2023
Source: Ares, EDHEC, Q2 2022

16
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Private credit, Basel III and the battle of the underwriters

There’s not much to say about private credit performance given its recent emergence and the lack of a prior
default cycle. Assets under management are surging, allowing private credit managers to underwrite financing
for large borrowers that used to rely on high yield bonds or broadly syndicated leveraged loans (BSL).
With respect to existing private credit vintages, a lot depends on how positions underwritten during the credit
frenzy are impacted by higher rates. The second chart shows the increase in private credit coupon payments
using BDCs as a proxy14. According to Cliffwater, trailing loss rates (i.e., default rate net of recovery) for private
credit were 0.7% in mid-2023 compared to ~2% for BSLs. Separately, Proskauer Rose estimated a ~2% private
credit default rate in July 2023, up from ~1.5% at the end of 2022. While both sources suggest that private
credit stress is low so far, we’re hearing about more private credit modifications such as equity injections by
sponsors, covenant relief and a shift to payment-in-kind interest. It’s hard to track in real time; private credit
interest coverage has probably deteriorated in line with leveraged loans as shown on page 5.
Did private credit lenders negotiate for stronger protections than BSL lenders over the last few years when
underwriting standards weakened? First, let’s review how institutional lenders surrendered to borrowers by
2020 by sacrificing covenant protections, which is illustrated in the third chart. Note that middle market BSL
lenders did not embrace covenant lite15 loans nearly as much as larger lenders.
Global private credit market Private credit: BDC coupon payments rising
US$, billions Percent
$1,400 14%
Unrealized value 90th percentile
$1,200
Dry Powder 12%
$1,000

$800 10%
$600 Median
$400 8%

$200
6%
$0
10th percentile
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15
Dec-16
Dec-17
Dec-18
Dec-19
Dec-20
Dec-21
Jun-22

4%
2013 2015 2017 2019 2021 2023
Source: Preqin, June 2022 Source: GS Global Investment Research, November 2023

Lender surrender in the BSL market Covenant-lite mostly a feature in larger BSL market
Loan covenant score, 5 = weakest covenant quality % of loans by category
5 80%
2007 2019-20 Large middle
4 70% market ($500mm +)

3 60%

50%
2
40%
1
30%
0
Middle
covenants

incurrence
Restricted

investments
Overall

liens & structural

Asset sales &

payments

20%
assignments
Financial
score

Subordination:

mandatory

market
Voting &
prepays
Debt

Risky

10%

0%
'11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22 '23
Source: Moody's. 2020. Source: LCD, Pitchbook, JPMAM, Q2 2023

14
BDCs are the most transparent form of private credit lender and make up 20%-25% of direct lending
15
Cov-lite doesn’t mean no covenants, but typically restricts them to an “incurrence basis” meaning that they
only apply when the borrower chooses to incur additional debt
17
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Since Q1 2021, private credit markets have remained open while BSL markets have been mostly closed. This
suggests that private credit is taking advantage of scarcer credit conditions, but the ultimate experience of an
investor in a loan fund depends on ex-post performance of these mostly single-B rated credits. Observations
from market participants suggest that private credit underwriting standards are tighter than in the BSL
market, although as larger private credit firms compete for market share, their standards are declining16. In
other words, larger private credit loans are becoming commodified as they compete with BSLs. Loss experience
during a default cycle will be the best arbiter of how private credit compares to BSLs and HY bonds.
Private credit: open for business Loss rate estimates on BSLs and private credit
# of loan transactions, quarterly Trailing 12-month loss rates
100 10%
Private Credit Private credit, lagged 1Q
90
Broadly syndicated loans Broadly syndicated loans
80 8%
70
60 6%

50
4%
40
30 2%
20
10 0%
0
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 -2%
2019 2019 2020 2020 2021 2021 2022 2022 2023 2023 2008 2010 2012 2014 2016 2018 2020 2022
Source: Pitchbook, LCD, JPMAM, Q3 2023 Source: Cliffwater, Moody's, GS Global Investment Research, Q2 2023

For a deeper dive, let’s review Moody’s analysis of 28 private credit loans and 15 BSLs made in 202317:
• Moody’s found a correlation between increasing private credit loan size and the loss of maintenance
covenants. While 67% of small private credit loans had “always-on” maintenance covenants, only 7% of
large private credit loans did
• Smaller private credit loans had more restrictive EBITDA add-back allowances than larger ones, and were
way more restrictive than BSLs. These caps on add-backs limit a borrower’s ability to project operating cost
and merger synergies that have not actually occurred; by extension they limit allowable leverage that is
based on multiple of estimated EBITDA
• Similarly, smaller private credit loans had shorter periods over which these fanciful EBITDA projections can
be made (“look-forward periods” of 15-24 months vs 24+ months for larger private credit loans)
Smaller private credit loans tend to favor lenders more Private credit more restrictive than BSLs on EBITDA make-
% of private credit loans with always-on maintenance covenants believe, % of loans by EBITDA restriction cap
70% 60%
Private credit <=$250MM
60% 50% 50%
50% Private credit >$250MM 47%
45%
50% Syndicated loans
40%
40%
30% 27%
30%
20%
20% 17% 17% 17%
20%
10% 7%
10% 5%
0% 0% 0% 0%
0% 0%
<=$250MM $250MM - $500MM >$500MM 20% 25% 30% 35% No cap
Private credit loan amount Cap on EBITDA add-backs
Source: Moody's Investor Services, October 2023 Source: Moody's Investor Services, October 2023

16
“Private credit deep dives”, Proskauer Rose, June 2023
17
“Private credit, syndicated loan protections will converge as competition grows”, Moody’s, October 2023
18
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Moody’s also looked at other covenant comparisons of BSL and private credit markets, finding that private
credit terms offer greater lender protections in some key areas. Warning: this section is geared towards people
who enjoy reading and understanding loan documentation. If you invest in funds that participate in BSLs and
private credit, this arguably should be you.
• Inside maturity sublimits reflect the degree to which existing lenders allow borrowers to take on new debt
with shorter maturities, allowing new lenders to “prime in time”. Lenders with shorter maturities can get
paid out of a potentially troubled credit first and may have more leverage in restructurings that take place
outside bankruptcy
• Reallocation allowances. Restricted payments clauses specify the circumstances under which borrowers
can pay dividends, make acquisitions and engage in other asset transfers. Reallocation allowances permit
borrowers to convert the restricted payment amounts, if they are not made, into additional debt capacity
• Asset sale prepayment step-downs allow borrowers to liquidate collateral and use less than 100% of the
proceeds to prepay debt if certain leverage tests are met
• The 200% contribution clause allows borrowers to take on $2 in debt for every new $1 of equity contributed
• No IP blocker refers to the absence of express provisions preventing intellectual property from being
transferred to unrestricted subsidiaries (often referred to as the “J Crew” provision based on what the
sponsors did in that transaction)
• More call protection. Private credit lenders typically require call protection of 2-3 years with 2%-3% early
call penalties compared to only 6-12 months of call protection and 1% penalties for BSLs
BSL market much less protective than private credit on key covenant features which become even more
important in times of economic distress, Percent
80%
73% Broadly syndicated loans
70% 67% Private credit
67%
60%
60%

50%

40%
33%
30%

20% 14% 14%

11%
10%
0% 0%
0%
Inside maturity sublimits Reallocation allowances Asset sale prepayment 200% contribution clause No IP blocker
step-downs
Source: Moody's Investor Services, October 2023

These clauses will become increasingly important should economic conditions weaken in 2024, leading some
sponsors to try and move assets to unrestricted subsidiaries and to pursue equity-friendly restructurings against
the consent of minority lenders.

19
EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

What would a world with more private credit look like? First, it would probably drive the share of loans
originated by banks to a new post-war low, and increase originations in a less regulated environment. After the
SVB failure, banking system regulation is likely to increase given the Fed’s mea culpa18. A world with more
private credit would almost certainly entail a higher cost of debt. As shown below, we estimate that in Q2 2023
direct lending yields were 11.5% compared to 9.0%-9.5% for leveraged loans, preferred stock and high yield
bonds. This represents a wealth transfer from private equity to private credit lenders.
The “golden moment for private credit” argument is partially based on the notion that new Basel III capital
rules will force banks to curtail lending and other risk-taking activities, driving more borrowers to private
credit. The third chart below shows estimates of possible Basel III impacts: a 25%-35% increase in risk-weighted
assets for Category I and II US banks19. The US proposal applies to banks with more than $100 bn in consolidated
assets and covers global operations of US banks with proposed compliance by July 2025. The comment period
for Basel III has been extended to January 2024, so it’s possible that changes will still be made.
There could be some benefits to private credit; a smaller number of creditors may allow for faster distress
resolution without always having to rely on bankruptcy courts; many private credit borrowers have just 2-3
lending counterparties. I’m also told that there is less “creditor on creditor violence” in the private credit market
than in the US loan market, another byproduct of a smaller lending group. Still, there are concerns about the
systemic risks associated with more non-bank lending, which is addressed in the Appendix.
US non-investment grade yields, Q2 2023 Bank share of loans vs household/corporate debt/GDP
Percent Percent Percent
12% 65% 150%
Banks as % of total loans
140%
10% 60%
130%
55% 120%
8%
50% 110%
6% 100%
45% 90%
4%
40% 80%
2% 70%
35%
US household+corporate debt/gdp 60%
0%
Direct lending
US leveraged US Preferred US High yield 30% 50%
loans YTW 1952 1962 1972 1982 1992 2002 2012 2022
Source: Bloomberg, JPMAM, Q2 2023 Source: Federal Reserve, JPMAM, Q2 2023

Projected increase in Category I and II US bank risk

weighted assets due to new Basel rules, US$, trillions
$10
Current rules Basel 3 Proposal
$9
$8 Credit Valuation
$7 Adjustment
$6 Market Risk
$5
$4 Operational Risk
$3
$2 Credit Risk
$1
$0
Standardized Advanced Basel 3
Approach Approach Proposal
Source: Morgan Stanley, Oliver Wyman, November 2023

18
“Fed admits some of the blame for Silicon Valley Bank's failure in scathing report”, NPR, April 28, 2023
19
Category I and II banks refer include JPM, BAC, C, WFC, GS, MS, BK, STT and NTRS. The next tier of Category
III banks, which are not included in the RWA assessment above, includes USB, PNC, TFC, SCHW and COF
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EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

Appendix: what are the systemic risks of more non-bank lending?

I joined JP Morgan in 1987 when the banking share of loan originations first fell below 50%, as shown in the
chart above. These are complex topics, but this origination shift coincided with a massive jump in US household
and corporate debt as a share of GDP, and has also done little to reduce the volatility of equity markets or the
severity of recessions. Now Basel III is poised to drive more credit creation outside the banking system.
Another form of credit creation moving outside the banking system due to bank capital rules and regulatory
arbitrage: the rise of non-bank mortgage originators. Regulators are still trying to figure out the implications
of non-bank lenders dominating mortgage originations given questions about their special servicing capabilities
and heavy reliance on wholesale funding. Their declining stock prices are mostly a reflection of rising interest
rates so far, but new research and a 2022 report from the Treasury point to possibly inferior loan quality and an
increase in systemic risk. The surge in private credit, like most rapid capital mobilizations, will need to be
navigated very carefully.
Nonbank share of mortgage originations Largest non-bank mortgage lender stock prices vs money
Percent center bank index
70% $30 500
450
60% $25 Money center
banks index (rhs) 400
50% 350
$20
40% 300
$15 250
30% Rocket Mortgage
200
$10 -49%
20% 150
United Wholesale -40% 100
10% $5
Mortgage loanDepot 50
-87%
0% $0 0
2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2020 2021 2022 2023 2024
Source: Inside Mortgage Finance, S&P Global, JPMAM, 2022 Source: Bloomberg, JPMAM, November 28, 2023

On the risks of non-bank lending by mortgage originators

• “Assessing the Impact of New Entrant Non-Bank Firms on Competition in Consumer Finance Markets”, US
Dept of the Treasury Report, Nov 2022: “While new entrant non-bank firms appear to be contributing to
competitive pressures, they are generally not subject to the same oversight for safety and soundness or
consumer protection as insured depository institutions, raising public policy considerations”
• Consumers turning to Fintech lenders are more likely to spend beyond their means, sink further into debt
and default more often than people with similar credit profiles borrowing from traditional banks. Source:
DiMaggio (HBS) and Yao (Georgia State University), 2020
• An analysis of LendingClub found that borrower misinformation didn’t negatively impact underwriting
decisions as it should have, despite the fact that incomplete income verification on the Lending Club
platform on loan applications negatively affected recovery rates. Source: “Fintech platforms: Lax or careful
borrowers’ screening”, Serena Gallo (University of Campania), July 2021

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EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

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EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

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EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN
Ac c e s s o u r 1 3 t h a n n u a l e n e r g y p a p e r h e r e December 5, 2023

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