Outlook 2024: Private assets in the age of the 3D Reset

Private assets are on the cusp of a new era driven by seismic global themes. But which private asset classes are best positioned to benefit?

19/12/2023
Private Assets

Authors

Nils Rode
Chief Investment Officer, Schroders Capital

The flow of liquidity in private markets has shifted dramatically over the past 18 months. Geopolitical and economic tumult has ended a long phase in which investors have not needed to make many strategic adjustments. Interest rates and inflation were low, liquidity abundant and value chains had grown longer as a result of globalisation.

But that has started to change. Investment strategies that have been successful for a long time may face new headwinds.

In the short term, fundraising in private assets has slowed dramatically from an especially robust period in 2021. As borrowing costs have risen, the environment favours those able to provide liquidity.

We believe we are now entering an era we’ve labelled the “3D Reset”.

The 3D Reset is a shift in market structure. It describes how the dynamics of decarbonisation, demographics and deglobalisation are altering the shape of the investment landscape. To these three themes we can add technological advancement – specifically the artificial intelligence (AI) revolution. This is being driven by venture capital for now and will, we believe, completely reshape our lives.

Here we break down each of these themes, the implications for private assets over the long-term and outline how best we believe investors can channel them into growth. We will also look at the shorter-term outlook, and how it might affect more tactical allocations.

Decarbonisation

Decarbonisation will happen at different speeds in different places. We expect decarbonisation to yield a deep, rich seam of investment opportunities for decades to come.

One of the most visible signs of decarbonisation is the evolution we are witnessing from combustion engine cars to electric cars. Indeed, decarbonisation will touch daily life in many ways, from what happens when we turn on a light, to how buildings behave around us. It comes down to how energy is produced, used, and preserved.

Energy, and its production, is transforming entirely. There are decades worth of investment still ahead of us.

The transition to renewable energy sources involves not just the development of additional renewable energy generation from new wind and solar capacity. The infrastructure needed to deliver the energy to source also requires large amounts of investment to avoid problems like “grid congestion”. It will require buildings to be overhauled to more efficiently use energy in heating, cooling and lighting our offices, shops and homes.  

The push to decarbonise also means a fundamental change in how we produce and consume goods, from linear “take-use-discard” to a circular “re-cycle” economic model. The value of natural capital, and its role in preventing climate change and the associated costs, will also yield new opportunities.

Focus asset classes for decarbonisation

Infrastructure investments, both equity and debt, offer the most direct play on the theme of decarbonisation. The investment case is also especially compelling for the current, challenging investment environment.

Renewables assets (wind farms, solar, hydro, biofuel, biomass and geothermal) are predominantly contracted assets with secure income and inflation-linked cash flows. They are generally either regulated, or under a power purchase agreement (PPA) contract, which renders them highly immune to macroeconomic shocks.

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.

In real estate, sustainability and impact considerations mean capital expenditure will also have to increase to meet evolving regulatory and shifting tenant requirements. More demand for sustainable buildings aligned with tenants or owners that have their own carbon reduction targets will drive capital needs. Given the major role banks have traditionally played in real estate finance, the needs for capital, coming at the same time that banks must meet higher capital requirements, means tremendous opportunity for private markets to step in with sustainable financing alternatives.

Demographics

Demographic trends and the expected effects on investment opportunities vary greatly around the world.

There are several emerging economies – foremost among them India - where populations are growing, and where the younger populations will contribute to robust economic growth in the next 20 years. India is the world’s most populous nation, with over 1.4 billion people and a median age of 29. Its favourable demographics combined with a burgeoning middle class, are set to boost domestic consumption and growth over the next decade.

This youth stands in stark contrast to the ageing demographics of most other large nations, where fertility rates are falling and life expectancy rising, leading to a top-heavy age distribution. This can cause working populations, and consequentially economic output, to fall. That said, artificial intelligence is expected to enhance productivity meaningfully in the near future, which could diminish the effect of top-heavy age distribution.

Focus asset class for demographics

Real estate. Various types of living formats that cater to the needs of people at various stages of their lives will be needed to meet the demands of rapidly changing demographics.

Ageing in populations in developed markets is driving increased requirements for purpose-built age-restricted housing and care homes that provide the requisite amenities and facilities.

At an earlier stage of the lifecycle, there remains continued demand for purpose-built student accommodation in certain places. There is also a broad-based undersupply of affordable and mid-market rental housing segments, most notably in Europe.

These living segments deliver contractual or indirect inflation protection and enable the application of operational skills to drive sustainable medium-to-long term income and value.

Where the average age of a country’s population is rising, so too is the anticipated healthcare burden. This creates opportunities in healthcare-related investments across private assets.

Deglobalisation

The Covid-19 pandemic, as well as the recent rise in geopolitical tension, have brought supply chain resilience and security to the fore. In some key sectors – most notably, semiconductors - it has prompted “nearshoring” initiatives that see supply chains being brought closer to home. We believe this will continue as the world becomes increasingly “multi-polar”.

In terms of its economic weight measured as global share of GDP, the US has been the dominant for over 50 years, but China is snapping at its heels. We expect India to follow suit and become another economic powerhouse. It has risen to become the fifth-largest economy in the world and is expected to be the third largest by 2030.

Focus asset class for deglobalisation

India private equity.  India's private equity market is rapidly maturing with an expanding ecosystem of local fund managers. India’s startups are harnessing the nation’s digital revolution to reshape industries, with consumer, financial services, and IT at the forefront of this transformation. Non-tech companies are also set to reap benefits from growing e-commerce adoption, a growing middle class, and diversification from China.

India has witnessed the creation of more than 100 unicorns, which are privately held startup companies valued at over $1 billion. This places it third in terms of unicorn creation, behind the US and China. The digital revolution in India has played a significant role in the emergence of these unicorns. However, their presence across a wide array of sectors, consumer and retail (39%), financial services (22%), industrials (16%), enterprise technology (12%), media and entertainment (9%) and healthcare and life sciences (3%) illustrates the breadth of the Indian private equity opportunity.

Real estate debt. As reshoring, friendshoring and nearshoring take place, there is fiscal spending dedicated to building new plants and facilities. The CHIPS Act in the US is an example. This creates the need for facilities, such as industrial properties. With debt financing, particularly for commercial real estate, less readily available, this is an area with strong fundamental support. What’s more, de-globalisation may be inflationary, so the higher loan rates associated to the floating-rate debt, along-side the inflation protection real estate can afford, is attractive.

Technology

Artificial intelligence has moved from the conceptual to the practical, and is being used in many valuable ways, from diagnostics in healthcare to fraud prevention and data analysis. We believe we are at the cusp of the fifth industrial revolution. However, this fifth revolution differs to previous ones in how machines are being used and the pace of technological progress.

While the first four industrial revolutions were characterised by machines helping humans with “physical” labour, the artificial intelligence-led fifth wave is the first time machines are able to help humans with “cognitive” labour.

Where previous industrial revolutions took decades to create large scale impact, AI-first companies are registering that impact in months. For instance, ChatGPT took two months to reach 100 million users compared to five years for Uber to reach the same scale. At this pace of innovation, some believe that by 2040-50, the artificial intelligence boom will culminate in “technological singularity” – where a smartphone will have the same cognitive processing power as all humans on the planet combined.

Focus asset classes for technology

The new frontier technology driving the current wave of artificial intelligence is “generative AI”. Companies like OpenAI and Cohere create the foundational technology, but many more startups and more mature companies build on what that base technology can do.

Initially, this is a topic for venture capital and growth capital, but over time, on the private equity side, this will also become a topic for more mature businesses and buyout investments that adopt artificial intelligence to change or enhance their business model.

We believe generative AI will make existing technology and software “smarter” and will create a secular trend impacting all industries. We expect the impacts of AI to have second-order impacts on the real estate and infrastructure markets.

For instance, the boom in AI focused start-ups in tech hubs like Silicon Valley might create office space demand in some place, as in potential new tech hubs like Toronto, Paris, and other regions. At the same time, it might, over time, reduce demand for office space in others.

The substantial data processing requirements is also re-invigorating demand for data centres, creating tailwinds in this area. Furthermore, AI’s massive compute appetite needs substantial energy resources, that we see as an opportunity for infrastructure investments, particularly in renewable energy.

A private markets slowdown

Despite the long-term trends creating tailwinds for private markets, they are currently seeing a slowdown in terms of fundraising, investment activity, and for some strategies, valuations. This slowdown is not uniform across all private asset classes, with some areas experiencing more significant corrections than others. The slowdown follows a period of strong private asset markets during the pandemic in 2020 and 2021 and is largely a return to pre-pandemic levels. However, the persistent high rate environment we are now in means some private market segments are overshooting into the other direction, creating opportunities for new investments.

Considering these long-term trends and short-term challenges, we have three recommendations:

Focus on long-term trends

Investments with long investment horizons should be guided by the long-term trends of the 3D Reset and the AI revolution. These trends will provide tailwinds for well-positioned private assets.

Diversify

As the world transitions from one historic era to the next and goes through a post-pandemic slowdown, diversification of a private assets portfolio is especially important. Adding less correlated assets, such as insurance-linked securities and microfinance, can provide more stability. Finance secured by assets, such as homes, buildings, claims, or equipment can offer a diversity across regions, as well as across fundamental drivers. Infrastructure debt, meanwhile, offers stability and defensive characteristics with good inflation protection.

Rethink past strategies

Investors should not automatically continue with what has worked in the past. Instead, strategies and investments should be evaluated for their suitability for the new world we are entering.

In conclusion, this is a time to be forward-looking and thoughtful. The 3D Reset, the AI revolution, the private markets slowdown and higher global interest rates mark a new era for private assets investment. By focusing on long-term trends, diversifying portfolios, and rethinking past strategies, investors can navigate this new era successfully.

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Authors

Nils Rode
Chief Investment Officer, Schroders Capital

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