Thematic investing is key to unlocking value
Coming out of the sharpest contraction since the Great Depression, the world continues to adjust to a new economic reality. While the initial recovery has been strong, we believe there are still clouds on the horizon, including inflationary pressures and more modest growth prospects. To navigate this environment, we maintain strong conviction in our transformational investing approach, which combines thematic sourcing with hands-on value creation.
Private markets outlook
Consumers and businesses continue to adjust to a new normal after the pandemic. The strength of the recovery has started easing from exceptionally strong levels as government support measures have run out and pent-up demand is being released. Certain constraints, however, are still unfolding. Supply constraints are proving to be stickier than initially thought. Labor shortages and delivery delays are limiting output in select industries. Commodity prices are running high. The COVID-19 pandemic and its repercussions are blurring the economic picture, making forecasting and policy decisions highly challenging. In our economic base case, we expect modest mid-term growth, higher inflation, and a relatively accommodative policy backdrop. We expect nominal rates to rise and real rates to remain low. But the scope for policy error is immense.
Central banks, and the US Federal Reserve (Fed) in particular, face a narrow and ever-shrinking runway to achieve their goal of moderately higher inflation combined with a smooth landing for the economy. After living through a period of highly benign financial market conditions that saw valuations rise to record highs, the macroeconomic environment is tightening. Investors should brace themselves for more volatile times. Broad market return expectations need to adjust to this changing tide.
As economic uncertainty continues to rise, corporate fundamentals remain solid. For now, earnings growth is surging, corporate profit margins are strong, and M&A and private markets investment activity is thriving. Valuations in many sectors have increased further over the course of 2021. Credit spreads have also tightened.
We focus on assets with a strong market position, supported by sustainable secular growth, and stress-test our underwriting returns against the impact of higher inflation and lower growth. We heavily scrutinize the resilience of demand for the products and services our portfolio assets produce and for the properties that we build and lease. Pricing power is of utmost importance. Furthermore, through our thematic investing approach, we ensure high conviction in our underlying growth assumptions – at the sub-sector and asset levels – to justify current valuations.
Three giga themes guide our thematic investing approach:
Digitization & Automation
The main force driving the transformation of businesses across technology, services, and production
The reshaping of consumer preferences and habits in areas such as nutrition, healthcare, leisure, and learning
The largest ever global energy infrastructure and effectiveness program in history, touching on all economic sectors
We focus on assets with a strong market position, supported by sustainable secular growth, and stress-test our underwriting returns against the impact of higher inflation and lower growth.
The private equity market has staged an extraordinary comeback since the early shocks of the pandemic. Outside of hospitality and leisure – sectors that Partners Group has very limited exposure to – companies under private equity ownership have shown great resilience. This is especially the case for sectors benefiting from transformative trends that have been amplified by COVID-19, such as digitization, and that are driving above-average growth. Across all sectors, tech-enabled companies that are embracing the shift towards a more automated, digitized and cleaner world are positioned to gain market share and are especially sought after. As a result, valuations for these attractive companies have further increased, and 2021 has been shaped by pre-empted sales processes and shorter due diligence periods for these businesses.
Year-to-date 2021 investment and exit activities have been exceptionally strong and both are on track to beat record 2007 levels. And despite busy fundraising in 2021, private equity buyout dry powder in terms of years of investment volume has fallen to a 14-year low.
Dry powder in terms of years of investment declined in 2021
This market buoyancy comes with challenges and risks. While many companies have learned to successfully navigate COVID disruptions, there are now new clouds on the horizon. Supply chain constraints, delivery delays, inflationary pressures and the prospect of higher rates all provide potential headwinds for growth. With extremely short processes and high valuations having become the norm, the only way to prudently invest in this environment is to adopt a targeted sourcing approach, building strong conviction in those investment themes that will continue to generate sustainable growth, regardless of economic dynamics. This typically requires multi-year preparation and research work before a target company within an attractive segment becomes available for investment. Today, only a few firms have the resources, commitment and long-term view to implement this strategy.
The only way to prudently invest in this environment is to adopt a targeted sourcing approach.
At Partners Group, we pursue 40-60 investment themes at any given point in time across our four private equity sector verticals – Technology, Goods & Products, Health & Life, and Services. Across our portfolio, many of the transformative trends reshaping the way we operate lie at the heart of our thematic investing approach and were accelerated by the pandemic. This careful selection of themes, combined with our hands-on work with portfolio companies, has guided our portfolio during the pandemic, resulting in a 2020 EBITDA growth of over 10% and a more than 25% increase for the twelve months until June 2021.
COVID-19 has served to further demonstrate the essential nature of infrastructure, with fundamentals for the asset class having strengthened during the pandemic. Investments in infrastructure assets with highly contracted revenues or higher expected growth rates have been left unscathed or have even outperformed – renewable generation and communications assets, for example. Conversely, the crisis has highlighted the risks inherent with macro-sensitive sectors and, in particular, those exposed to travel demand such as airports. We had consciously avoided these sectors in favor of investing along long-term structural trends, which contributed to the resilience of our portfolio during COVID-19.
As economies have reopened and government restrictions on movement have eased, investment activity in the infrastructure space has picked up and showed an over 30% volume increase through Q3 compared to last year. Valuations have also recovered to pre-pandemic peaks or above, as in the case of brownfield wind and solar power assets.
Throughout the pandemic, some structural changes became accelerated and the opportunity to invest in a next generation of infrastructure has arisen for private investors. These developments include new consumer consciousness around sustainability, emerging themes such as industrial decarbonization, a focus on underinvested areas (e.g. rural connectivity, water sustainability, roads, and bridges), and expansive government support (e.g. EU Green Deal, US Infrastructure Bill). Infrastructure spending features prominently in recent government initiatives. However, government stimulus alone is not enough to meet the estimated USD 3.7 trillion of annual global infrastructure investment required through 2035.
The post-pandemic environment is uncertain. Rising rates will cause headwinds to valuations. Highly priced core infrastructure, more sensitive to interest rates, could underperform. That is why our approach revolves around thematic investing in next generation infrastructure and hands-on, platform-based value creation strategies aimed at protecting returns against economic instability. With rising uncertainty on the horizon, this approach has never been more relevant.
Our approach revolves around thematic investing and hands-on value creation strategies aimed at protecting returns against instability.
Private real estate
Following the unprecedented economic disruption caused by the COVID-19 pandemic, global real estate transaction activity increased in H1 2021 compared to the same period in H1 2020 as travel restrictions within the US and Europe started to loosen, allowing for investors to perform on-the ground due diligence.
The pandemic has accelerated the bifurcation of investor appetite, with capital flowing increasingly away from office and retail, and towards residential and industrial. While certain measures taken during the pandemic are expected to be transitory, we believe that the behavioral shifts toward working from home part-time and shopping online will be more permanent. As people spend less time in the office and more time at home, demand for larger, amenity-rich residential units is increasing, while that for older vintage office space is decreasing. Similarly, e-commerce retailers and industrial tenants will drive demand for industrial space commensurate with the growth in online sales, while traditional retailers will continue to reduce the number of their stores.
As people spend less time in the office and more time at home, demand for larger, amenity-rich residential units is increasing.
As demonstrated in the chart, which illustrates global investment volumes by sector, the residential and industrial sectors saw a relative increase in capital inflows compared to office and retail. This level of investor demand, coupled with resilient occupier demand, may somewhat insulate the industrial and residential sectors from cap rate expansion, even in a rising interest rate environment. Lender appetite broadly matched equity investors’ appetite with a preference for residential and industrial, although overall loan-to-value ratios remain lower than prior to and during the Global Financial Crisis.
Global investment volumes and share by sector
Debt markets have continued their upward move since last year, quickly rebounding from pandemic lows, with secondary pricing now sitting above pre-pandemic levels. Accommodative central bank policies and low rates globally fuelled a move upward, as investor demand for income-producing assets strengthened. Spreads have tightened notably and, while equity contributions remain high in a historical context, we have seen some compression. Borrowers have taken advantage of the low rate environment and issued a record amount of debt. With a global loan market size of USD 1.5 trillion and high dry powder for buyout and M&A activity, private debt offers ample investment opportunities.
Global loan market size
Implied default rates estimated last year proved to be overly pessimistic as the global economy and corporate earnings rebounded faster than expected. Realized defaults are currently close to historic lows. The level of distressed debt has fallen and the ratio of upgrades to downgrades is now positive for the first time in the last five years.
The outlook from here is mixed. We expect buyout and M&A activity to remain strong. However, we also expect rising headwinds to corporate profits and a period of higher inflation and rates. As opposed to fixed-income credit, private debt, with its floating-rate nature, shields investors from duration risk and falling prices in a rising rate environment. Profit margins however may come under pressure as input prices and financing costs increase. With spreads at or close to all time tights, there is a good chance they could widen from here.
Our roots as a private equity investor strongly influence our due diligence process, as we take the perspective of an owner.
We do not foresee a fundamental alteration in our investment approach but believe that caution is the byword and we are moving up the capital structure in our direct lending, with a greater focus on senior secured debt, such as first lien unitranche. We will avoid investments where the level of return is not commensurate with the level of risk, both first and second lien, and where the necessary covenants are not offered. This conservative investment philosophy is implemented with an in-depth due diligence process in order to focus on resilient sectors, such as technology, services, software and healthcare, which have lower relative exposure to COVID-19 challenges and commodity price-related industries, in a broadly diversified portfolio.
To illustrate how we implement our relative value views, we have presented both a return-focused and a yield-focused private markets portfolio. Both portfolios maintain an overall diversified approach and consider technical factors such as investment flow, the breadth of asset classes and incremental risk-return factors.
The return-focused portfolio combines private markets asset classes and asset types with the potential for capital appreciation. In the current environment, we place special emphasis on control investments in private equity and private infrastructure, where we see the best return potential driven by thematic investing combined with value creation. Real assets provide a degree of inflation protection, which is highlighted by the sustained outperformance in the stagflation scenario compared to a 60/40 public markets portfolio.
Return-focused portfolio allocation in our base case
The yield-focused portfolio focuses on income-oriented opportunities and consists of private debt instruments and yielding private infrastructure equity investments. Real estate debt is a clear underweight given tightly compressed spreads. The floating-rate nature of private debt investments leads to continued outperformance under the stagflation scenario.
Yield-focused portfolio allocation in our base case
An increasingly uncertain macroeconomic outlook poses significant challenges to investment
decision making. For all asset classes, our underwriting remains prudent and we continue to
factor in multiple contraction over our expected hold period.
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