The Zero: Why zero rates are increasing the appeal of private assets
The Zero: Why zero rates are increasing the appeal of private assets
Through unparalleled fiscal and policy support, the global economy has survived the initial trauma of Covid-19. However, it is too early to say that economic damage has been entirely averted, nor even that it can yet be quantified. Much like emergency surgery, the economy has simply been given the time to repair, but there are many battles left to fight in the pandemic.
In line with most major central banks, the Federal Reserve’s response is cautious. The US central bank has said that the most likely timing of the next increase in the federal funds rate is 2024. Our economics team believes tightening may be closer to 2023, with President Biden’s fiscal boost plans taking shape, but that’s still a long time off.
You wouldn’t know it to look at markets. Equity indices could scarcely be more upbeat. The speed of the 2020 equity market rebound has no equal in living memory. Similarly, in corporate bond markets, all of the initial spread widening that we saw at the start of the pandemic has disappeared.
Schroders' Head of Research and Analytics Duncan Lamont recently said of equities that “at face value, the bad news is that everywhere looks to be at nosebleed-red levels of expensiveness”.
Headline equity multiples and benchmark spreads do not, of course, tell the whole picture, and can at times be distracting. Active equity and credit managers have numerous tools to drive returns. Even so, it is a challenging environment, especially for those chasing returns targets set in less troubled times.
As Schroders’ Head of Securitised Credit, Michelle Russell-Dowe put it: “Policy dependence has brought us here, and with very little yield in traditional fixed income, with crowding in traditional “risk assets” like equity, and with correlations pulling together, traditional asset allocations may be in for a reconsideration.”
Adding more tools to your portfolio
The difficulty in generating sustainable returns in traditional asset classes, focused on public markets, is a key reason that private assets continue to attract capital.
Research that Schroders undertook in April 2020, when the pandemic was at what may be considered “peak uncertainty”, indicated that institutional investor allocations to private markets continued to rise. The private equity market today is already twice the size it was in 2009.
Private markets offer a wide variety of value-creation tools. These include the so-called “illiquidity premium”, whereby investors are rewarded for locking up their capital. But there are many more.
Importantly, these tools are typically used independently of the policy or market back drop. Some relate to the structure of the instruments, others to their esoteric nature. From this, investors can earn a “complexity premium”.
Built to withstand The Zero
The structural elements that defend private assets against The Zero are found in most private debt instruments. It is not uncommon, for example, for contractual base rate floors to be built into the instruments themselves.
Publicly traded debt prices are often linked to either Treasuries, -IBOR or “mid-swap”. There is no such widely accepted market practise in, for example, infrastructure debt.
Nicole Kidd, Head of Private Debt, Australia, says: “For privately negotiated loan agreements it is common to floor the reference rate at zero, or occasionally even a rate greater than zero. As a result, the more negative rates move, the greater the effective coupon you would be receiving on this particular loan (being the difference between base rates and your received margin).”
In other words, the value of the base rate floor becomes more impactful the further into The Zero we go, either in terms of rates falling further from here, or how long the policy environment lasts.
The impact of a zero floor using senior infrastructure debt as an example
There are other factors at play. Steadily rising bank liquidity requirements – a secular trend that preceded both the Covid-19 and Global Financial Crisis - have played into the hands of private debt investors. Credit spreads have risen for direct lenders that have stepped into the gaps left by retreating bank lending. Banks do remain active as infrastructure debt lenders, but for similar reasons, the wider trend of falling lending and the declining supply streams resulted in comparatively attractive spreads commanded by non-bank infrastructure lenders.
It would be simplistic to suggest it is merely supply and demand though. Speed of execution, whereby capital can often be delivered more quickly by private lenders than large banks, can further add to the negotiated return.
In some cases the base rate is a factor, but other determinants of return are more important.
Insurance-linked securities (ILS) are, notionally, floating rate instruments. Part of the coupon paid is based on money-market return. However, the coupon is reset quarterly, meaning shifts in monetary policy make little difference to the instrument’s value. Furthermore, the bulk of the coupon is based upon the risk premium. The modelled likelihood of the relevant insured event occurring and – particularly in the case of privately negotiated ILS instruments – the illiquidity premium, are more important. Around a third of the ILS market is tradeable; the bulk is not.
Finally, and debatably more a technical factor, it is worth noting that private debt instruments are not eligible for central bank bond buying programmes. As a result, private debt is not exposed to the same spread compression driven by quantitative easing.
The “complexity premium” – the rewards for hard work
Historically, a key motivating factor for investors allocating capital to private markets has been to secure the “illiquidity premium”. But with more and more investors willing to accept it, and some even actively seeking illiquidity, it is safe to assume that the illiquidity premium is reducing.
What is still a very meaningful driver of return is what we might call the “complexity premium”. Complexity premium refers to excess returns driven not by sacrificing liquidity, but by the level of engagement needed both in sourcing a deal, and the skills and work needed to make it a success. The complexity premium can be found in more specialised and harder-to-access areas. Delivering complexity premium requires in-depth knowledge of specific areas, extensive networks of localised counterparties and ongoing engagement.
In the private equity world, co-investments and secondary transactions can be of real merit in this environment. They can provide limited partners (LPs; those who invest in fixed term closed-ended funds) with valuable agility and flexibility.
With co-investments, LPs can flexibly target the most attractive sectors, geographies and business models at any given point in time. Secondaries, in particular GP-led transactions, give incoming investors the ability to invest alongside GPs in a select group of companies in their fund portfolio. We discuss these more here.
However, increased competition for investment opportunities means secondary managers increasingly need to prove their sophistication to participate. They may be favoured if they can offer insight, the ability to handle complex situations, dependability, speedy response and capital deployment to general partners (GPs); that is, the managers of the private equity fund/limited partnership.
We also believe that a huge number of opportunities are emerging in China private equity just now. That said, restrictions on foreign access to the full local currency (RMB) market mean many investors in the US, UK and Europe, can’t access the most compelling deals.
These are just two examples. There are a range of value-add strategies in private equity that could fall under the “complexity” bracket.
One of the most important lessons of Covid-19 was the need for real estate investors to fully understand the operational risks they are exposed to through their tenants. All real estate is “operational”. Relying on (long-term) lease contracts, where the landlord-tenant relationship does not stretch beyond the quarterly invoice, is myopic.
Through the pandemic, Schroders’ real estate managers have confirmed that levels of engagement with tenants went through the proverbial roof. When a tenant’s business is changing, or a market structurally not performing, this is not just a problem for the party paying the rent. During the pandemic, managing this risk meant balancing client interests with the safety and wellbeing of tenants.
Schroders' Head of UK Real Estate Investment Nick Montgomery experienced this first-hand. “The unprecedented level of tenant engagement supported higher rent collection rates compared with industry averages. Furthermore, it created mutually beneficial opportunities to change lease structures to drive future performance.”
The road less travelled
The problem of The Zero is unlikely to go away in the short or medium-term. There are arguments for financial repression via policy to persist for much longer, even as rates lift from zero or negative. Participants in all markets alike will need to consider diversifying sources of return beyond traditional markets, or traditional thinking. The world of private assets offers a wide variety of tools to investors facing such challenges.
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