October 28th, 2008

Alternatives to Alternative Capital

Posted at 8:01 PM ET

David Piebe, Chairman of Global Client Development

(Re)insurers have come to expect that alternative sources of capital will always be available. Private equity funds, hedge funds, and other alternative investment vehicles have contributed copious capacity to risk-bearers since the turn of the millennium, and especially following the 2005 storm season. The well, however, may be at risk of running dry.

For the past decade, records have been set throughout the alternative investment community in terms of both inflows and returns. Venture capital stoked the dotcom fires, and hedge funds found opportunities for gain in the aftermath. A wave of mergers and acquisitions has taken full advantage of private equity coffers and cheap credit, with buyout funds remaining investors’ preferred flavor until only recently.

But, the private equity tide is now ebbing, and (re)insurers will have to reconsider their long-term plans for accessing capital.

The cues in the private equity market are subtle. Greater amounts of previously uncommitted capital are starting to be used in transactions. This “dry powder” is being called up to take the place of leverage that is increasingly hard to come by. As a result, the levels of capital available to private equity funds globally are not changing. Continued aggressive inflows are being offset by the increased consumption of capital to complete deals.

While more investor money is entering the private equity market, the destinations are changing. Distressed debt, mezzanine, and other credit-focused funds are gaining popularity rapidly, largely as a result of opportunities created by the collapse of the subprime mortgage market and subsequent credit crunch.

(Re)insurers should watch these trends closely. We saw alternative investment vehicles contribute to balance sheets richly following Hurricanes Katrina, Rita, and Wilma—which also spurred a period of sustained rapid growth for the alternative asset community. Currently, total assets under management are close to USD3 trillion worldwide—dwarfing the USD165 billion spent on reinsurance in 2006 (the last year for which data is available). Hedge funds add another USD2 trillion to capital markets capacity—at least.

It has been easy to feel as though this vast source of capital would always be available, but pressure on equity valuations and tightening credit markets are taking their toll on the alternative investment sector—as on everyone else. The expectation that private equity funds will rush to replenish carrier balance sheets post-loss may need to be tempered with the realities of today’s far-reaching economic squeeze.

While alternative sources of capital are likely to tighten after a mega-catastrophe, the situation is far from dire…provided that (re)insurers start planning now. A combination of favorable risk transfer pricing, a carefully constructed target capitalization, and the thorough evaluation of portfolio risks will differentiate those that survive from those that thrive following the next disaster. Today’s decisions will define the market’s landscape.

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