Private assets views Q4 2023: selectivity is key

The latest update from our private assets business highlights new investment opportunities arising from global themes of decarbonisation, increasing deglobalisation trends, evolving demographics, and the AI revolution.

17/10/2023
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Authors

Nils Rode
Chief Investment Officer, Schroders Capital

The global themes of decarbonisation, increasing deglobalisation trends, evolving demographics and the ongoing AI revolution continue to create new opportunities across the spectrum of private asset investments.

At the same time, we are witnessing a general slowdown in the fundraising cycle across private asset strategies. Likewise, transaction activity is also slowing down and valuations are adjusting to varying degrees across strategies.

With uncertainty and change, investors face changes in actual portfolio allocations, required returns or liquidity needs and are now reviewing their allocation and commitment plans. While the potential for economic slowdown or a recession may be a concern, cycles bring opportunity. Historically, attractive opportunities for equity owners and lenders have emerged during times of recession. Likewise, policy changes, and implementation of new regulation for traditional capital providers, like banks, also creates inefficiencies that can benefit alternative capital investors.

We believe that the confluence of new thematic tailwinds, the current cyclical slowdown, and limitations on traditional capital providers present an attractive opportunity for investors who apply a forward-looking approach. Below are some guiding principles we consider important to navigating investments through this cycle.

Seek tailwind from the 3D Reset and the AI Revolution

Powerful long-term trends such as decarbonisation, deglobalisation, and demographics (the “3Ds”), alongside the ongoing AI revolution, will drive a markedly different economic and geopolitical environment over the next decade and beyond. Considering the importance of longer-term trends to many private assets investments, these themes are particularly significant. We see attractive investment opportunities in areas such as sustainability-and impact-aligned investments, renewable energy, generative AI, and investments in India.

Focus on less correlated investments

With uncertainty, volatility, and new market dynamics, the benefit of diversification is significant. In this context, identifying less correlated strategies can be a risk mitigating advantage. We see attractive opportunities in less volatile or less correlated assets, as well as investments in sectors where capital provision is inefficient. Real assets offer protection from inflation, insurance linked securities are uncorrelated to macro-economic risks, microfinance and private credit offer income with lower volatility with additional opportunity present in small and mid-buyouts (particularly in certain industry sectors such as healthcare) and also in seed and early stage venture capital investments.

"Rethink the re-up" – selectivity is key

Many new investments involve "re-ups" with general partners (GPs), with whom investors have existing relationships. In this dynamic environment we advise investors to question whether past success will continue. Assessment of partners and strategies in light of the impact of key trends of decarbonisation, deglobalisation, demographics, and the AI revolution, are critical. Rather than automatically re-upping into similar strategies, we recommend that investors broaden their new investments into opportunities that benefit from these transformative trends, that offer diversification and/or that capture the benefits of inefficiencies.

Our assessment of opportunities by private asset class has remained largely unchanged over recent quarters. We provide a more detailed examination of these opportunities below.

Private equity

We believe that being highly selective in private equity investments is a critical success factor. We focus on opportunities that are aligned with the trends mentioned already and that 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 anticipate that small and mid-sized buyouts will outperform large buyouts, 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 focusing on 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. GP-leds 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-leds should increase.

Private Debt and Credit Alternatives

Income is now very attractive in most markets. Rising interest rates have combined with a pullback of 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. For example through tangible asset backing, combined with contractual or ‘pass-through’ links to inflation. Some sectors offer structural opportunities, such as infrastructure debt, while other sectors offer more selective opportunities, like commercial real estate. We remain cautious with regard to real estate debt, and focus our lending where fundamentals are strong. For example, we believe that 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 (ABS), and collateralised loan obligation (CLO) sectors. Over the last decade, for these sectors and for MBS, the Federal Reserve and US banks have been among the largest buyers. Their withdrawal has created a very attractive opportunity in the highest quality securities. These investments offer diversification to tradition corporate credit. As well, 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, high selectivity 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 an attractive option for investors seeking alternative sources of income.

Infrastructure

Within infrastructure, we see renewables as a particularly attractive due to their strong link to inflation and secure income characteristics. They 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, which were reinforced by the ongoing war in Ukraine. Furthermore, the cost of living crisis has also brought focus to energy affordability, and 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, which will play an important role in enabling the decarbonisation of industries such as transport, heat and heavy industries.

We also see attractive opportunities in other infrastructure areas related to digitalisation and other essential infrastructure. These investments offer similar opportunities around the ability to generate inflation-linked and often stable returns.

Many of the most attractive sustainable infrastructure investment opportunities can be found in Europe and in North America in our view, but we also see opportunities in emerging markets on a highly selective basis.

Real Estate

Real estate markets have repriced significantly as a consequence of the new higher interest rate regime, inflationary pressures, geopolitical shifts, equity and debt market movements impacting investor allocations, 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 the real estate 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 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 nearshoring/ friendshoring of supply chains.

Logistics and urban industrial assets, convenience retail formats, mid-market multi-family housing, budget and luxury hotel formats, and self-storage are the sectors offering absolute and relative value.

The transition to a higher interest rate 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 which will mean capital expenditure will also have to increase to meet evolving regulatory and shifting tenant requirements.

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Authors

Nils Rode
Chief Investment Officer, Schroders Capital

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