Interest in private markets has grown rapidly among investors, particularly within an environment of historically low interest rates and market volatility. This is an investment category offering investors access to a spread of strategies, some of which may be relatively illiquid, but bring the potential for sustainable and enhanced returns, reduced volatility and tail-risk protection. In addition, they often have low correlations with other asset classes, such as equities and bonds. This enables the construction of portfolios that can mitigate sharp movements in these core asset classes.
There are numerous categories of private markets, including real estate, infrastructure, private equity, private credit, natural resources and more. Each of these sub-asset classes has its own characteristics, from risk/return profile and level of inflation linkage, to volatility and income orientation
Commercial property covers a wide range of assets, including offices, retail (e.g. shopping centres and retail parks) and industrial buildings (e.g. distribution warehouses). More recently, opportunities in property have widened to include student accommodation, residential housing, logistics, and development assets. For investors, all these assets offer the potential for capital appreciation over the long term, combined with a regular income from rents.
There are also property sectors that are less closely tied to economic conditions, such as social housing funds, which provide affordable accommodation to citizens with lower income or disabilities. Typically backed by governments and involving long-dated contracts, the key driver of returns is the rental income these properties generate. Government backing adds an extra layer of stability to this investment option.
Infrastructure projects generate the sort of stable cashflows that are hard to find in traditional bond markets. Infrastructure covers a number of essential services, such as social infrastructure (hospitals, schools), core infrastructure (transport assets) and renewable infrastructure (wind farms, solar parks). Many projects are backed by governments and benefit from state subsidies. Such investments are often natural monopolies and have built-in inflation escalators. As such, infrastructure is valued for its ability to generate predictable returns over the long term.
Increasingly, infrastructure programmes are being financed via listed funds, run by managers who can oversee planning, construction and site management. While they have sensitivity to power prices, their revenues are largely independent of economic factors.
Private equity is fundamentally about creating value through the transformation of companies. The average private equity fund will own a company for five to seven years, allowing management teams to drive through operational or strategic improvements in order to maximise revenue and increase profits. Unlike venture capital, which invests in fledgling start-ups, private equity tends to look for more mature, revenue-generating companies.
The popularity of private equity has exploded, with fundraising at its highest in 10 years. This, however, has left global private equity firms (GPs) holding around $1.7 trillion of unallocated capital (or ‘dry powder’). With more money at their disposal, managers are under increasing pressure to deploy that capital, leading many to pay a premium to secure their targets. According to consultancy firm Preqin, private equity managers were paying up to 11/12X average EBITDA in 2017, while leveraged deals were 6X EBITDA. These are the highest multiples since the peak in 2007.
Elevated prices will naturally affect the returns investors can expect. However, these prices tend to be focused in the upper end of the market, where many large GPs deploy their capital. By contrast, there is much stronger return potential from buying at lesser entry multiples at the lower mid-market. GPs are increasingly looking at new and expanding markets. This includes China, where private market returns better reflect the nation’s strong GDP growth than their public market counterparts. So, while valuations are undoubtedly elevated at the upper end of the market, there are still plenty of opportunities elsewhere that should enable GPs to continue to deliver superior returns.
Private credit is another way to expand investment opportunities. While regulatory constraints have curtailed the amount that banks have been willing to lend to businesses and projects, the provision of debt from the private sector has seen substantial growth. Private credit offers a diverse array of strategies and a number of advantages, particularly in a low return environment. Target return, risk and liquidity are among the most important considerations, offering the potential to achieve different objectives.
One burgeoning area of private markets is natural resource, which includes forestry, agriculture and energy production. These give investors the opportunity to directly invest in timber, agriculture, oil & gas and commodities managers – providing exposure to investments that are hard to source, hard to access and hard to perform due diligence on. Given their importance to a well-functioning society, these assets can provide attractive, stable and predictable long-term returns.
Although the benefits are clear, investing in private markets is not without its challenges. There can be issues around valuations: given that private assets are not listed on the stock exchange, there is no daily pricing. Investors must be happy to hold asset for the longer term. However, private market managers can help mitigate these challenges, offering the wide range of expertise required to successfully take advantage of, and implement, the many strategies that the asset class offers.
Author: Jonathan Borland, Associate Investment Specialist, Private Markets at Aberdeen Standard Investments. To find out more about Aberdeen Standard Investments contact your financial adviser
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
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