Are private markets suited to a changing economic environment?

Private markets have enjoyed steady growth in the years since the global financial crisis, largely because they filled the yield vacuum for institutional investors who were willing and able to accept the asset class’s longer timelines and reduced liquidity.

But in 2022, economic conditions are shifting. Investors now face the twin challenges of higher inflation and rising interest rates – an environment that has seen fixed income yields rise dramatically. If investors can obtain reasonable yields from traditional fixed income assets, will there still be a market for private assets?

Institutional investors are finding there is more to this relatively new asset class than its liquidity premium.

Riding the inflation wave
While yields may be higher this year, sustained inflationary pressures have stoked uncertainty – and consequently volatility – across traditional markets, sending both equities and bonds trending lower. This period of positive correlation for equities and bonds has been damaging to investors, who need access to assets that are less correlated and can provide effective protection against inflation and rising interest rates.

Private assets have the ability to provide some inflation protection, without investors having to compromise on yield or returns. This resilience partly stems from the fact that private debt offers a broad range of risk profiles and covers a diverse set of investment strategies including private equity; loans to corporates, small-to-medium sized enterprises (SMEs) and other organisations; as well as infrastructure, corporate real estate, and forestry and timber. Within each of these strategies, further diversification comes in the form of geographical, industry and currency exposure.

Infrastructure: weathering the economic crosswinds
Infrastructure has proven to be a particularly stabilising asset, even during the volatile economic environment of recent years.

Infrastructure deals tend to finance essential services and straddle several different sectors, including transport, energy, renewables, water, communications, education and healthcare services. These defensive sectors are especially attractive during periods of higher inflation, or recession — as demand is likely to remain constant, regardless of any economic downturn. In other words, when times are tough, people will still need to use broadband services, rail networks, energy to heat and light their homes, and have access to education and healthcare.

Infrastructure investment opportunities are long-term in nature and offer their backers a reliable income stream over many years. Usually they are backed by real assets, while debt agreements typically offer some form of indexation meaning they provide an effective inflation hedge for investors.

Building a greener future
Another material attraction of private assets is their integral role in the global shift towards a low-carbon economy.

Firstly, there is a clear need to build new infrastructure to support a greener economy. This will range from renewable energy generation – be it solar, offshore wind or tidal; improved transport systems, including higher-speed rail links and the infrastructure to support the adoption of electric vehicles; as well as faster broadband solutions and the implementation of 5G to meet the growing demand for data mobility.

Secondly, these transitions aren’t just ‘nice to have’ aims, many governments have made legal commitments to deliver net zero goals within a set timeframe and so infrastructure transformations need to happen relatively quickly.

The OECD estimates that the infrastructure needed to meet global climate and development commitments requires an additional annual investment of around USD 2.5-3 trillion1. Private finance will need to support public spending, much of which will likely be supplied by direct lending, rather than traditional bank finance.

These twin tailwinds should not only help sustain demand for the asset class during the next decade but also ensure it remains a compelling investment solution.

An alternative ESG option
There has been a raft of new regulations introduced across many developed markets requiring pension companies, insurers, asset managers and institutional investors to identify key environmental social and governance (ESG) risks, and support and promote more sustainable investment themes, be they the energy transition, impact investing or net-zero goals. Such regulations are expected to be broadened out to include biodiversity and social impact, alongside climate change in the not too distant future.

Given private assets’ ability to move the dial on both environmental and social sustainability projects – as well as the provision of essential services like water and waste treatment – the asset class is well positioned to offer investors an alternative option for sustainable investing that will also help them meet their financial targets.

Push / pull dynamic
Unlike publicly-listed assets, there is less scrutiny of ESG risks among private assets and few standardised processes monitor these risks across strategies and products. Ultimately, it is down to the asset managers, or providers of private finance, to implement their own customised framework for the assessment of ESG factors, that not only identifies potential project risks but also ensures that sustainable growth opportunities are prioritised.

It is here that private asset managers have a real opportunity to drive forward sustainable ideas and affect genuine change within their portfolio companies as they can use their influence to encourage companies to adopt better environmentally or socially responsible approaches to their business plans.

There is a push /pull dynamic at work here. On one side, investors are looking for more diverse, sustainably-orientated investment options, especially those featuring attractive risk-return profiles; on the other, businesses are keener to take on flexible and innovative lending streams and are therefore often willing to accept specific sustainability criteria to secure lending. Essentially, both parties are increasingly aware that limiting the extent of climate change and implementing better social policies are in everyone’s best interest as they are fast becoming imperatives of business and investment success.

A stormy weather investment option
Private markets have already proven their ability to adapt, develop and thrive. Having emerged as a more accessible investment option in the aftermath of the global financial crisis, the asset class prospered during the yield drought and can now be seen as a compelling solution to weathering the oncoming economic storms, as well as having the added benefit of strong ESG credentials.

At BNP Paribas Asset Management, we believe private markets are well suited to meet the full range of complex investment demands of today’s market. Not only can they deliver robust long-term performance, but the asset class will play a vital role in the transition to a more sustainable world.

With this in mind, our comprehensive ESG framework not only applies to listed investments, but also includes a whole range of private market investments. We are continually striving to develop and improve our proprietary tools to ensure all relevant ESG risks are being properly assessed and managed, and we also endeavour to maximise any sustainable growth opportunities to the benefit of our clients and the wider world.

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