Playing the long game in private assets
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Private assets are at an interesting juncture in their evolution as a more accessible asset class. While structural shifts driven by decarbonisation, deglobalisation, demographics and AI create investment opportunities, we are seeing a general slowdown in the fundraising cycle across private asset strategies. Likewise, transaction activity is relatively muted and valuations are adjusting to varying degrees.
To some extent, these recent trends are to be expected; with uncertainty and change in economies and markets, plus the lingering threat of recession, investors are revisiting portfolio allocations, required returns and liquidity needs.
At the same time, cycles bring opportunities to equity owners and lenders. Likewise, policy changes as well as the implementation of new regulation for traditional capital providers such as banks, create inefficiencies that can benefit alternative investors.
We believe investors who apply a forward-looking approach can capitalise on the confluence of new thematic tailwinds, the current cyclical slowdown and limitations on traditional capital providers.
With this in mind, there are some guiding principles that we consider important to navigating investments through today’s cycle.
1. Seek tailwinds from the “3D” reset and AI revolution
Powerful long-term trends such as decarbonisation, deglobalisation and demographics (the “3Ds”), alongside the ongoing AI revolution, will forge a markedly different economic and geopolitical environment over the next decade and beyond. Further, these themes are particularly significant given the importance of a longer time horizon for many private asset investments. As a result, we see attractive investment opportunities in areas such as sustainability-and impact-aligned investments, renewable energy, generative AI and investments in India.
2. Focus on less correlated investments
Amid uncertainty, volatility and new market dynamics, diversification is increasingly important. In this context, identifying less correlated strategies can create a risk mitigating advantage. In line with this, less volatile or less correlated assets, as well as investments in sectors where capital provision is inefficient, are appealing. For example, real assets offer protection from inflation and insurance-linked securities are uncorrelated to macroeconomic risks. Further, microfinance and private credit offer income with lower volatility plus additional opportunity present in small and mid-buyouts (especially in industry sectors such as healthcare) and also in seed and early-stage venture capital investments.
3. Be selective by rethinking the “re-up”
Many new investments involve "re-ups" with general partners (GPs), with whom investors have existing relationships. However, in our view, the current dynamic environment requires investors to question whether past successes will continue. It is critical to assessing partners and strategies in light of the impact of the 3Ds and the AI revolution. Rather than automatically “re-upping” into similar strategies, we recommend investors to broaden their new investments into opportunities that benefit from these transformative trends, offer diversification and/or capture the benefits of inefficiencies.
Getting the right private asset exposure
Our view of opportunities by private asset class has remained largely unchanged over recent quarters. We believe it is important to reflect on these.
Private equity
Being highly selective in private equity investments is a critical success factor. We focus on opportunities that are aligned with the latest market trends and that we believe these could have the potential to capture a complexity premium. That is, those requiring the deployment of unique skills to drive both organic and inorganic growth in portfolio companies.
In the coming quarters, we expect small- and mid-sized buyouts to outperform larger ones, driven in part by a more favourable dry powder environment resulting in lower and more stable entry valuations for smaller transactions. Similarly, we expect seed and early-stage disruptive investments to be more resilient than later-stage or growth investments, owing to the same dynamics.
By sector, we are particularly drawn to opportunities in healthcare. Regionally, we continue to see North America, Western Europe, China and especially India as attractive. GP-led transactions are likely to rise further in prominence. These types of deals also allow favoured portfolio companies to be retained and developed further by the same management team. With IPO markets closed, we anticipate a reduction in M&A exits, so GP-led deals should increase.
Private debt and credit alternatives
Income is now attractive in most markets. Rising interest rates have combined with a pullback by some traditional capital providers to create a combination of attractive coupon, lower leverage and more favourable terms.
Investments that offer variable interest rates and strong security are especially attractive, in our view. These include, for example, tangible asset backing, combined with contractual or ‘pass-through’ links to inflation. Some sectors offer structural opportunities, such as infrastructure debt, while other sectors require a more selective approach, like commercial real estate. We remain cautious about real estate debt and focus our lending where fundamentals are strong. For example, we believe the deterioration of fundamentals in offices has not yet fully played out, while areas like rental housing and student housing remain attractive from a lender’s perspective.
Floating-rate securities are the majority of the asset-backed securities (ABS) and collateralised loan obligation (CLO) sectors. For the last decade, the US Federal Reserve and US banks have been among the largest buyers of both ABS and CLOs, along with mortgage-backed securities,. As these investors have withdrawn, we see attractive opportunity in the highest quality securities that also offer diversification from traditional corporate credit. In addition, the increase in regulatory capital requirements for banks will fuel growth in this segment.
The leveraged loan markets have shown resilience. Yields benefit from higher base rates and considerable yield spread; however, loan prices are high. In general, default rates remain low and risk has been more idiosyncratic, but default levels have begun to rise and recoveries on defaulted loans have historically been low. With the uncertain macro backdrop and the risk of an upcoming default cycle, being highly selective is key.
Insurance-linked securities offer valuable diversification in any fixed income portfolio due to their lack of correlation with traditional assets. Beyond this, yields are reaching historic levels due to natural catastrophes and insurance market dynamics.
Microfinance also offers diversification and lowly correlated returns, making it another attractive option for investors seeking alternative sources of income.
Infrastructure
Within infrastructure, we see renewables as particularly appealing due to their strong link to inflation and secure income characteristics. These assets also contribute to diversification, through their exposure to differentiated risk premia, such as energy prices and weather.
In addition to the decarbonisation trend, renewable energy is benefiting from heightened concerns about energy security and the need to reduce reliance on fossil fuels, reinforced by the ongoing war in Ukraine. Furthermore, the cost of living crisis has also brought energy affordability into sharp focus. In many areas around the world renewables are now the cheapest source of electricity production that can be built.
We also see opportunities in adjacent technologies such as hydrogen, heat-pumps, batteries and electric vehicle charging – areas expected to play an important role in enabling decarbonisation across transport, heat and heavy industries.
We also see attractive opportunities in areas of infrastructure related to digitalisation and other essential services. These investments offer similar potential around the ability to generate inflation-linked – and often stable – returns.
From a sustainability perspective, we see many of the most compelling infrastructure investment opportunities in Europe and North America, and on a highly selective basis in emerging markets.
Real estate
Real estate markets have repriced significantly due to the new higher rates regime, as well as inflationary pressures, geopolitical shifts, volatility in equity and debt markets, and ever-growing sustainability considerations.
Occupational markets continue to show resilience and while demand has softened, tight supply conditions (given elevated construction and debt finance costs) and the scarcity of high-quality sustainability-compliant space is likely to fuel renewed growth into the medium-term.
Given the extent and uneven pattern of the repricing so far, we view real estate as an asset class to be in the early phase of a broader cyclical buying opportunity, alongside existing and newly emerging opportunities from structural change. The most immediate opportunities can be found in markets that have experienced the fastest repricing, such as the UK and the Nordic region, followed by the US and other Continental European markets. In Asia Pacific, cyclical opportunities are centred on markets that align with China’s recovery or can provide alternatives in the near-shoring / friend-shoring of supply chains.
The sectors offering absolute and relative value are logistics and urban industrial assets, convenience retail formats, mid-market multi-family housing, budget and luxury hotel formats, and self-storage.
The transition to a higher rates regime has made financial engineering less feasible going forward, with performance centred on the delivery of efficient operational management across sectors, and on providing contractual or indirect inflation protection.
Sustainability and impact considerations should be prioritised, in turn meaning capital expenditure will also have to increase to meet evolving regulatory and shifting tenant requirements.
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IMPORTANT INFORMATION
Investment involves risks. This material is issued by Schroder Investment Management (Hong Kong) Limited and has not been reviewed by the SFC.