Real estate remains a core asset for many institutional investors, and rightly so. The manager universe is broad and established with a transparent track record and the market continues to offer an array of opportunities that generate attractive risk-adjusted returns. However, investors should also be considering other asset classes within the private markets sphere that offer strong returns and opportunities to match investments with long-term liabilities.
This article highlights why infrastructure and corporate direct lending should not be overlooked and shows how to successfully navigate these relatively young institutional asset classes.
The crisis of 2007–2008 led to a significant evolution in real estate investment markets across the globe. In the United States, we saw a very aggressive approach to writing down assets, with valuations reduced by up to 45 percent over an 18-month period, creating a significant opportunity for investors to benefit from investing into opportunistic funds. The result was up to 100 new players and funds, each deploying typically between $500 million and $1 billion (€450 million and €899 billion) of capital during the period. This generated a far greater level of recapitalisation in the US market compared to the United Kingdom and continental Europe, where institutions — which are traditionally far more risk-averse, particularly in Europe — deployed significantly less fresh capital into the market.
Finding your niche in real estate
In the United Kingdom and Europe today, selecting attractive niche markets in real estate, whether by region or by subsector, has become increasingly important. In London, yields have reduced significantly in certain areas, including prime location high-end residential and commercial office developments, and for many investors these assets are not generating their required returns. That said, the continued migration of both domestic and international companies into the British capital is driving demand for work space, and investing in office developments in some of the more peripheral areas of the capital is proving an attractive choice for investors.
Likewise, the private rented sector in the United Kingdom, while still far behind the United States and European countries like Germany and the Netherlands, is seeing growing levels of institutional investment. We are witnessing an increasing number of developers moving into this sector, looking to capitalise on the growing demand from tenants for high-quality rental accommodation, and with government initiatives supporting growth the sector is becoming increasingly attractive for institutions to invest in.
Similarly in Europe, we are seeing specific pockets of the real estate market offering strong returns. In France, the office market in Paris rebounded strongly last year, with transaction volumes in the first nine months of 2014 up by 39 percent year-on-year. With other economies such as Spain now predicting economic growth of 2.8 percent in 2015, we are seeing this translate into an increasingly attractive real estate market. Ultimately, tapping into these niche areas relies on managers having robust local knowledge, a deep understanding of their subsectors and experience in the implementation of capital into these markets to ensure the most successful outcome.
Despite the strong opportunities in real estate across the United Kingdom and Europe, investors should be considering alternative opportunities in sectors such as infrastructure and corporate direct lending, both on the equity and the debt side. These asset classes can offer attractive returns that can fill a key area of an investment portfolio.
Infrastructure; matching long-term liabilities
Despite growing rapidly, infrastructure is still a relatively new asset class for institutional investment. The manager universe is in its infancy, dominated by a small, focused selection of around 200 players globally. Over the past three years, we have seen institutional asset allocations in infrastructure rise to as much as 10 percent of overall portfolios; this increase in capital has come from a mix of fresh allocations as well as reallocations predominantly from fixed income and equities.
For institutions such as pension funds, which need to invest in long-term, inflation-linked assets to match their liabilities, infrastructure is a highly attractive asset class. Similarly, infrastructure funds have become increasingly important for investors seeking to benefit from the low correlation with traditional asset classes, ie. equity and bond markets, and who are also keen to reduce risk by diversifying their portfolios. Sounds familiar? Yes, it is broadly the same investment thesis as for core real estate.
The opaque nature of infrastructure funds can be challenging for investors. While the number of managers entering the market is growing considerably, understanding how to maximise your investments in this asset class is a big consideration, especially when many fund managers have a limited track record. To combat this, a thorough review of the manager universe is essential to help establish which managers have a strong background in infrastructure and which are likely to be the most experienced in deploying capital into this market.
In contrast to real estate, infrastructure is more of a global market and knowledge of operating and investing in one specific region can be more easily transferred to other locations across the world. Therefore, working with managers that have a strong track record in one location but that are looking at diversifying their infrastructure allocations geographically should not necessarily be viewed negatively. One criticism of infrastructure funds is that the amount of leverage is too high, sometimes up to 80 percent to 90 percent. This is another element that investors need to consider when choosing allocations; seeking independent investment advice can help ensure that institutions are making fully informed decisions, which is particularly important when the market is so opaque.
Corporate direct lending
With banks across the United Kingdom and Europe still deleveraging and the level of available finance for businesses continuing to fall, there is a growing need for investment from alternative lenders. In the mid-market particularly, the need for liquidity among corporates remains strong, and we are seeing the emergence of direct lending funds, which is helping to open up the market for these companies to access debt capital from institutions, including pension funds and insurance companies.
For investors, direct lending strategies offer attractive risk-adjusted returns and an opportunity to generate yields where other asset classes are failing to fulfil requirements. Over the past three years, we have seen institutional investors becoming increasingly focused on corporate direct lending and as investment consultants we have deployed €5 billion of capital for our institutional clients, mainly since 2011.
Similarly to infrastructure investments, there are many new funds launching in this area, and navigating the field and selecting the right manager can be challenging for even the most sophisticated institutions. We expect the number and scope of direct lending funds to continue to grow over the next few years. While we expect the track records of many managers to become more established and transparent, the manager universe will also become more complicated as funds look to differentiate their strategies.
The challenge for many institutions is taking that first step away from well-known asset classes and considering alternative areas where they may have far less, or even no, experience of investing. While this can be daunting, our markets are continuing to evolve and sectors that previously offered attractive risk-adjusted returns have now changed. Therefore, it is essential to review different opportunities to maximise the efficiency and success of your capital allocations and seeking independent investment advice is vital.
Working with an investment consultant can help to mitigate risks and ensure that all aspects of investment strategy are being considered, from investment manager search and selection to strategic implementation and analytics and monitoring. There are many viable strategies in real estate, but these should be examined in the context of opportunities in infrastructure, private debt and corporate lending.