Perspective

Outlook 2021: Private assets


The recent vaccine breakthroughs are at last allowing investors to cast their attention beyond the current pandemic, to the long-term opportunities and prospects for private markets.  

While comparatively resilient, private markets were not immune to the wider slowdown triggered by Covid-19. The numbers so far point - quite understandably - to a dip in fundraising across the industry in 2020. We do expect further economic pain in coming quarters. However, our experience and expectation is that many private market segments will display characteristic stability, while new opportunities for value creation will emerge.

Our own research, conducted in the midst of the crisis, indicates that investors still plan to allocate more capital to private markets next year. Indeed, over the next five years, private markets are expected to almost double again in size.

As 2021 begins we are convinced that there is room for this expansion. We expect the return generation that attracts investors to private markets will persist, albeit increasingly driven by areas of private markets which are harder to access and demand in-depth expertise.

As we look to 2021 (and beyond) experts across Schroders private markets business offer their views on emerging and persistent concerns, as well as the challenges and opportunities that define their area.

Private equity

Nils Rode, Chief Investment Officer, Schroder Adveq:

Private equity demonstrated its stability during the Global Financial Crisis in 2008/09 and has done so again during the Covid-19 crisis. While global stock markets corrected by more than 20% in Q1 2020, buyout investments only corrected by about half that amount. Venture capital valuations demonstrated even greater resilience, remaining little changed even as stock markets corrected sharply.

As 2021 approaches, and vaccine breakthroughs mean a return to normality looks to be in sight, how will private equity fare post-Covid? Despite the distractions of such a unique 12 months, it remains important to take the long-term view that is appropriate for this asset class.

Over the long-term, the world is moving at very different speeds in terms of demographics and growth. Private equity is well-suited to this type of backdrop, given a broad range of different return drivers, which can create value in a variety of ways that we will touch on later.

This is especially important in an environment of zero or low real interest rates, which is likely to remain the case for a long time. Private equity is also well positioned to capture secular – or non-economically sensitive – trends, before they are accessible through listed stock markets.

Last, but not least, due to the controlled nature of the investments and the often lengthy due diligence process, private equity is well positioned to achieve increasingly important ESG and impact-related objectives in addition to financial objectives.

Despite all of these factors that support private equity investments, there is one big risk: too much capital.

As more and more investors are willing to accept and are even actively seek illiquidity, it is safe to assume that the illiquidity premium is reducing, even though this is hard to measure.

As such, we believe it will become even more important to capture what we call the “complexity premium”, which can be found in more specialised and harder-to-access private equity market segments. These are areas that reward investors for participating in investments that are hard to replicate.

Examples include:

  • Small buyouts
  • Emerging managers
  • Co-underwriting for direct/co-investments
  • Specialised secondaries
  • Turnaround
  • Seed and early stage technology and biotechnology investments
  • Early growth investments in Asia and Chinese onshore RMB investments.

As long as investors keep these changing market dynamics in mind - and position their private equity portfolios across a broad range of return drivers – we think investments in the asset class remain highly attractive in 2021.

Impact investment

Philipp Müller, Chief Executive Officer, BlueOrchard:

Emerging markets ultimately fared better than many feared through the Covid-19 pandemic. The initial concerns were that, combined, the hit to trade and tourism, weaker commodity prices and slowing foreign direct investment (FDI) could prove disproportionately damaging for developing economies.

However, overall, emerging market (EM) responses to the pandemic proved effective. Lockdowns were consistent in most countries. Fiscal measures such as tax deferrals, public sector loans or capital injections into businesses were supportive. A weakening USD and monetary policy manoeuvres – from policy rate reductions, special liquidity facilities and relaxed reserve requirements - limited the immediate fallout. As we head into 2021, global demand is recovering swiftly, and we expect emerging economies to rebound. Macroeconomic forecasts suggest positive GDP growth in 2021 in EMs compared to 2020.

Even so, the pandemic will have a lasting effect, having increased the global poverty rate and caused considerable damage to developing labour markets. Despite encouraging developments in vaccines, distribution of them in emerging markets – where access to refrigeration is less dependable - remains an unresolved issue.

The way asset management chooses to respond, as the world returns to normal, will be crucial to how lengthy the after-effects of Covid-19 are to EMs. We think there are a slew of opportunities from which investors can benefit while supporting small investees in developing economies.

Many institutions we work with have endured the crisis much better than we anticipated at the beginning of the pandemic. We expect well managed microfinance institutions (MFIs) should be able to maintain required liquidity and capitalisation levels. In some markets, such as India, better performing MFIs may be able to increase market share as demand picks up. In addition, a weaker US dollar may ease debt burdens for countries who borrowed in dollars.

We also believe impact bonds continue to look attractive (better value) relative to investment grade credit in developed markets. As ever, finding that value depends on being selective, but as the market in social, impact and green bonds continues to grow, the range of potential outcomes is widening.

Given the limited opportunities for growth and delayed collections, many microfinance institutions will enter 2021 with lower cash reserves than desired. They will, in some cases, require capital injections to achieve targets and this creates an especially supportive environment for private equity investments. There are risks associated with the short/medium-term impact of Covid-19 on business models, but attractive pricing is on offer, where we think risks are manageable and understood. 

Finally, the Covid-19 pandemic has not diminished the importance of longer-term themes; chief amongst them the ongoing fight against climate change. The world’s population continues to grow and each of us are consuming more. Beyond the coming year and (hopefully) a revitalised global economy, investment in infrastructure development is one of the main drivers of sustainable growth in the emerging markets.

The energy sector, in particular renewable energy, remains in focus for investors. Emerging market populations already make up 65% of the global total, and are growing rapidly. This creates considerable demand for the development of infrastructure which must be met sustainably, for all of our sakes.

European Real Estate

Mark Callender, Head of Real Estate Research:

The development of effective vaccines means there is real hope that Covid-19 will be brought under control by the middle of 2021. It would be a mistake however, to assume that European real estate markets will simply return to how they were at the start of this year.

Inevitably the pandemic affected big gateway cities such as New York, London and Paris most severely, which has led to speculation that urbanisation will now go into reverse. In the 1920s, following the Spanish Flu, some people moved to the countryside. However, they were quickly replaced by others moving in. We believe this could happen again, particularly if housing becomes more affordable. 

Cities will retain their advantages in terms of transport connections, leading universities and hospitals and major cultural and leisure attractions.  That suggests that cities will continue to attract highly skilled people and businesses which gain from clustering together (e.g. finance, IT, professional services).

Covid-19 has clearly fast-forwarded the growth of on-line shopping and supply chain disruption means that manufacturers and retailers are likely to hold more stock of essential goods. This year is likely to see near-record levels of warehouse lettings in Europe, at around 25 million square metres. However, we also anticipate a wave of retailer insolvencies, a further 3-5% increase in vacancies and a 10-15% fall in rents in non-food retail schemes. We think this divergence will continue for several more years.  Given that prime logistics yields in Europe have fallen to 3.5-4.25%, the critical question for investors is: “at what point are expectations of further warehouse rental growth too optimistic?” 

The impact of Covid-19 on future office demand is more ambiguous. On the one hand, the pandemic has de-stigmatised working from home, and staff like the flexibility. Companies can save money by cutting office space.

On the other hand, employers will need to retain a large amount of space if most staff choose to be in the office three, or four days a week. There are also concerns that remote working will inhibit innovation and training and damage productivity in the medium term. We expect that office rents will fall by around 5% in most European cities over the next 18 months. However, we expect that demand for good quality offices in city centres and close to universities will recover from 2022 onwards. We are more cautious about back-office space, where demand is likely to be undermined by new technology. 

Finally, we think one of the most important lessons of Covid-19 is that real estate investors need to fully understand that all real estate is “operational”.  Relying on (long-term) lease contracts, where the landlord-tenant relationship does not stretch beyond the quarterly invoice is myopic.

It has become clear across all sectors that when a tenant’s business is changing, or a market structurally not performing, this is not just a problem for the party paying the rent. Understanding this inherent operational risk should teach investors to be better aligned for future performance. Investors with an intimate understanding of their clients’ business can ultimately drive better outcomes for all parties, whether in hotels, retail, office as well as living and logistics. Investors embracing this “hospitality” approach across all sectors are likely be the first to benefit from recovery.

Infrastructure

Jerome Neyroud, Head of Investments, Infrastructure Debt: 

Covid-19 has magnified and accelerated key themes for the last few years, including decarbonisation, digitalisation, and the zero-rate environment ,that have supported infrastructure investments. Engaging with the transition to a decarbonised economy and a more general ESG-conscious investment approach have become a must.

Infrastructure will play a significant role in new investment in renewable energy and electric mobility (e.g. electric vehicle charging stations). More than this, infrastructure has a key role to play in “improving” existing infrastructure, making more efficient and “smarter” networks, as well as a fit-for-purpose digital infrastructure.

Covid-19 has laid bare that investment in digital infrastructure is essential, especially if the post-Covid normal is of more working from home. Digital infrastructure is no longer a “nice to have” but has become as essential as water or electricity for everyone’s day-to-day life.

The digitalisation and “virtualisation” of the economy is also having an impact on how we travel. Airport infrastructure has been hit by the coronavirus.  However, it has suffered less than other players in the value chain (airlines, airport service providers, caterers, travel agencies). 

Infrastructure, with its long investment terms of around 20 years, can sustain bumps in the road better than businesses with five year cycles, which may not survive Covid-19’s disruption. Another effect of Covid-19 is ballooning debt, and risk free rates are close to zero or even negative. In 2021, we believe infrastructure (be it senior debt, junior debt, or equity) will still offer attractive, predictable and regular cash flows to yield-starved investors.

Insurance-linked securities (ILS)

Stephan Ruoff, Head of ILS:

For most people, 2020 will be remembered as the year of Covid-19. For those in the business of insurance risk transfer though – like us in ILS - it was also the year of a record number of named storms in the Atlantic, a great many wildfires, severe connective storms in the US and typhoons in Asia.

There was some impact from coronavirus-related claims to ILS, especially for business interruption and mortality risk. However, the impact was generally small. ILS remained, as expected, largely immune from the pandemic. Indeed, despite the addition of a very high number of natural catastrophes, to date the asset class overall performed well and within expectations. In fact, in spite of the high number of US storms amongst the Atlantic number, none made landfall in heavily populated areas.

The 2021 outlook for ILS is positive. Re-insurance markets globally are undergoing fundamental corrections that we expect to continue in 2021 and beyond. Recent years saw exceptionally high natural catastrophe activity; the largest loss year ever fell in 2017. This ultimately meant that for some reinsurers and ILS managers, reserves to cover losses were not high enough. This knocked on into 2018.

Root causes for the prolonged “loss-creep” were poorly modelled exposures to perils that are most impacted by climate change. This triggered a trend towards improved pricing conditions. These challenges were proactively addressed by the market, through revised terms and structures. Rates were increasing as 2020 began, and have continued to rise, due to the additional impacts of the Covid-19 pandemic limiting the availability of capital.

Weakened balance sheets, through this loss-reserve development, and a lasting low interest rate environment reducing investment income for (re-)insurance companies have resulted in rating agencies taking a negative view on the outlook for the industry. This has put even more pressure on insurers to improve returns. With strong actions taken, new capital flowing in and improving underwriting terms, we see ILS moving to the most attractive yield levels in nearly a decade.

This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

All data contained within this document is sourced from Cazenove Capital unless otherwise stated.