UK alternative investment companies: the opportunity for long-term investors

We have long believed that UK alternative investments companies merit a place in private client portfolios. Firstly, they offer a convenient way to access private markets, with more liquidity and lower minimum investment sizes than is traditionally the case. This lets investors tap into long-term growth areas, such as infrastructure and renewables, that may not be easily accessible elsewhere in public markets. Secondly, the profits and dividends provided by these assets are often underpinned by long-term, predictable cash flows with a link to inflation. While inflation is coming down from very high levels, we expect it will remain a challenge for some time.

Both factors have contributed to significant growth in the investment company market in recent years. It now accounts for around a third of the value of the FTSE 250, up from 20% five years ago.

The share price of these companies can be volatile. In general, they move by much more than the companies’ net asset value (or “NAV”). This figure reflects the price at which the underlying assets could theoretically be sold in a private transaction. As a result of this volatility, there may be times when the share price of an investment company is above NAV - and others when it is significantly lower.

Recently, many sub-sectors of the UK alternative investment company market have been trading at a material discount, sometimes more than 25%. We haven’t seen discounts at this level since the Global Financial Crisis of 2008/9.

The key reason has been the rise in UK and global interest rates, starting in late 2021. In general, as interest rates rise, the income from equities and alternative investments looks relatively less attractive compared to the yield on cash and government bonds. However, we think that investors may be placing too much weight on changes in short-term interest rates – and not enough on the more stable, long-term rates that better reflect the nature of these underlying assets. The market is also overlooking the implicit and explicit inflation-linkage of some assets. Lastly, alternative investment companies have been caught up in the negative sentiment surrounding the UK: as their weighting in UK indices has increased, they have suffered as institutional investors reduce their exposure to – and sometimes even bet against – UK shares.

This has created some interesting opportunities in the space. In many cases, we believe that investors are overlooking the healthy outlook for long-term cash flows, which ultimately drive returns. Performance may improve as investors become more confident that interest rates have peaked. By contrast, the sector could come under more pressure if inflation starts rising again and central banks further increase interest rates. This is not our base case.

Under pressure: UK investment companies in a rising interest rate environment

FTSE 350 Closed End Fund Index* vs FTSE 250 and FTSE All Gilts Index

^{*Investment companies are often referred to as “closed end” funds. These funds issue a fixed number of shares, unlike “open end” funds which can issue new shares on an ongoing basis.}

We own investment companies within our Diversified Alternative Assets and Sustainable Alternative Assets Funds, which are held by many of our UK clients. To give you a flavour of what these funds invest in, we provide snapshots of two of the companies that we hold.

HICL Infrastructure

What’s the strategy?

HICL aims to offer investors sustainable income and capital growth from a diversified infrastructure portfolio that is critical to the functioning of society. The company makes private investments in assets such as hospitals, roads and schools that benefit from a protected market position and resilient, inflation-correlated cashflows. The portfolio is diversified by geography, infrastructure sector and revenue structure.

What’s the opportunity?

HICL sees a fundamental global need for infrastructure investment, driven by demographic shifts, increasing urbanisation, aging infrastructure, technological advancement and climate change.

What are the challenges?

As the owner of essential infrastructure, HICL interacts with governments and faces risk from political and regulatory change. The challenge is offset by governments’ need for the support of private partners to finance and operate infrastructure. Diversification across jurisdictions also reduces the risk.

The market environment is another challenge. A disconnect has opened up between the valuations applied by public and private markets to infrastructure assets. In public markets, share prices are often trading at discounts to NAV despite transactions in private markets supporting NAV valuations.

Supermarket Income Reit

What’s the strategy?

Supermarket Income REIT (SUPR) is the only listed company dedicated to investing in “omnichannel” supermarket property. Omnichannel supermarkets provide in-store shopping - but also operate as online grocery fulfilment centres for both home delivery and click and collect. This flexible, low-cost model accounts for over 80% of all online orders.

SUPR aims to provide secure and growing income with potential for long-term capital growth.

Why supermarkets?

Grocery is a defensive sector which has seen revenue growth of over 30% since SUPR’s IPO in 2017. SUPR’s tenants include the UK’s leading and largest grocery operators. The strength of tenants and “mission critical” nature of the real estate has led to 100% occupancy and 100% rent collection for SUPR since it listed.

The stores that SUPR invests in are key revenue centres for supermarkets, with turnover of the biggest exceeding £80m per year. This, coupled with scarcity of alternative locations, drives occupancy. Many of SUPR’s sites have been grocery locations for over 30 years.

SUPR’s leases have a weighted average unexpired term of 13 years, are predominantly inflation linked (either to RPI or CPI) with an average cap of 4% annually. In the current inflationary environment, the company is benefiting from the inflationary uplift, while the caps ensure that rents remain affordable for our tenants.

What are the challenges?

Interest rate rises have resulted in higher borrowing costs for companies, impacting the value of real estate assets and share prices for listed real estate businesses. However, the non-discretionary nature of grocery spending ensures that despite challenging macroeconomic conditions, SUPR, its tenants and the wider grocery sector remain resilient.

SUPR has a robust balance sheet, with a current loan to value ratio of 34%. It has fixed 100% of its borrowing costs at 3.1%.

The securities mentioned in this article are for illustration purposes only and are not a recommendation to buy or sell. Past performance is not a reliable indicator of future results.