Private assets: returns, diversification, and sustainability

Change is a powerful force in the world of investment. The long-term changes we face now can best be represented by the powerful themes underlying the Age of Transformation: climate change, demographics, and innovation. However, we are also in the midst of shorter-term changes that can have huge repercussions on our investment choices: inflation, an energy shock, tighter monetary policy, to name a few.

These changes are taking place at a time when public markets are not looking quite so attractive for investors. Conventional asset classes either offer next-to-no yield (bonds) or are priced close to perfection (equities).

Amid so much uncertainty, and with a need for yield remaining a key challenge, many investors are now taking a closer look at private markets.

Private assets can offer investors a real alternative to public assets. Historically, private assets have delivered diversification, stable income streams and consistent premium returns over liquid and traditional debt, with modest drawdowns over the long term.

As private assets are not traded or issued in an open market, they tend to offer less liquidity than publicly traded assets, but this is generally compensated by an illiquidity premium as such assets are often held to maturity. Clearly, this means they are best suited to investors that don’t have strict liquidity requirements.

The private investment universe is increasingly broad, presenting opportunities across corporate lending, real assets such as infrastructure debt and private equity. It also spans a wide set of sectors and provides further diversification potential through how the assets are structured.

In an environment of persistently strong inflation and rising interest rates, private debt can be particularly attractive as it tends to focus on floating rather than fixed rates, meaning investors are primarily exposed to credit risk rather than interest rate risk. That said, there are still risks and in the current climate any exposure to commodity prices is something to watch closely.

Growth is particularly robust at present as an explosion in merger and acquisition activity is fueling financing needs, particularly for small-to-mid capitalisation businesses which are not always well served by traditional lenders. In addition, the need for infrastructure related to the energy and digital transition is huge, so private assets can specifically target environmental, social and governance (ESG) themes.

Commercial real estate debt (CRE debt) exhibits many of the aforementioned qualities. Aside from offering a steady income stream, CRE debt is one of the few assets that performs well in an inflationary environment as it offers an indirect inflation-linked income stream, which is typically 100-160 basis points higher than public-market debt with a similar credit worthiness.

Rising interest rates are not a danger as loans are set and adjusted in line with changes to the base rate. And as with other mortgage-type products, there is a 0% floor on interest payable, which means that negative yields are not a possibility. Given negative yields are a reality for a lot of publicly traded paper, it is clear that there is extra value in this illiquidity premium.

CRE debt is also fully collateralised – a particular strength of investing in bricks and mortar. However, it is not suited to all investors as the span of a CRE debt investment is typically ten years.

Investors can take comfort from that fact that CRE debt offers diverse levels of diversification.

Firstly, it’s worth noting the scale of the CRE debt market at around EUR 1.2 trillion in Europe alone and annual financing amounts to around EUR 200 billion¹. This means there are abundant opportunities from both a geographic and sector perspective. In fact, CRE debt funds typically have exposure to over 2,000 tenants across hundreds of properties in different jurisdictions and industries meaning revenue is spread across a large array of income sources.

Relative value also presents an opportunity to diversify and improve return potential. When providing a loan to a company or infrastructure project, lenders can choose from different parts of the capital structure, seeking out the most attractive on a risk/return basis. Junior debt is one such segment that is growing quickly and is a part of the capital structure that can offer a lot of relative value for investors.

The consequences of the corona virus pandemic were challenging for many commercial real estate sectors, hotels, and real estate in particular. However, logistics real estate has proven to be a fast-developing sector that continues to offer good value. In 2021, the amount invested in logistics increased by 53% versus just 8% for offices².

The trend for logistics is not just a pandemic-fad and should benefit from the ongoing restructuring of retail distribution, while goods of all kinds increasingly need to be moved rapidly from point to point. That said, the meteoric rise in value of logistics is a good reminder of the need to be prudent in the selection of acquisitions to fund. Full risk assessments and due diligence must be conducted on both the equity owner and the underlying tenants, rather than merely the buildings in which they sit. Additionally, covenants to mitigate income impairment from borrowers or, indirectly tenants can further strengthen lending, meaning CRE debt can be considered a reliable and defensive investment proposition.

The built environment has a poor record on decarbonisation – it is responsible for 39% of carbon emissions stemming from the energy used to heat, cool and light buildings (operational emissions) and the emissions associated with the materials and construction processes throughout the lifecycle of buildings (the embodied emissions)³. Yet, CRE debt can be an important driver of change.

With the right sustainability mindset, lenders can assess all potential projects in terms of their net environmental contributions, which evaluates properties based on their construction and operations, and can use this information to either influence change, particularly for new builds, or walk away from unsatisfactory prospects.

Given the need to rapidly transition the built environment, incorporating a bias towards sustainability can be a positive security selection tool, signifying the quality of a project and helping to rule out unsuitable investments.

These days, most investors have three main investment prerequisites: returns, diversification, and sustainability. Private assets, including CRE debt, easily fulfil these requirements for those investors with longer-term horizons that can absorb less liquidity.

Of course, not all opportunities are the same, some offer more value than others – particularly when it comes to sustainability – so sourcing matters.

At BNP Paribas Asset Management, we not only believe in making a thorough assessment of any potential borrowers, but we also seek to measure the net environmental contribution of all projects to determine their suitability for investment. This requires significant resources and a tailored approach for each asset. While this can be a more labor-intensive process than investing in public companies – which have a duty to report regularly on aspects of their business – we believe this is the best way to identify borrowers with the strongest sustainability credentials while keeping credit risk at manageable levels.

In this way, we’re helping our clients finance a better economy for tomorrow.