Private infrastructure: emerging markets infrastructure: risk, returns and current opportunities
The current market environment is characterized by low yields, intense competition for assets and increased regulatory volatility in many countries previously considered to be stable. This poses a significant challenge for capital deployment in general and investments in infrastructure in particular.
We believe that an allocation to emerging markets private infrastructure is an accretive addition to a private markets investment portfolio, especially based on three megatrends: (i) the need for energy, (ii) the “production – consumption disconnect” (a persistent and growing distance between centers of consumption of natural resources and mining areas) and (iii) increasing urbanization and mobility.
These trends offer attractive infrastructure opportunities in energy, commodity and urban infrastructure. While these segments show differing characteristics in terms of size and level of regulation, in our view, the end user’s willingness to pay for an infrastructure-related service represents a key criterion for sectorial and regional assessment.
The potential tangible improvements to a country’s economic efficiency through infrastructure reward investors in emerging markets accordingly and offer a compelling proposition with long-term outperformance potential. Such investments – particularly those in countries demonstrating solid economic fundamentals which offer country premiums which more than compensate for the increased risk – can generate highly attractive returns for investors. Furthermore, renewable energy investments in particular constitute an interesting relative value play.
We believe that a global emerging markets approach based on the flexible use of different investment instruments, such as equity, preferred equity and mezzanine, can be an effective way of accessing the emerging markets infrastructure opportunity. The implementation of this approach is more complex than executing on “plain-vanilla” bond-like infrastructure investments in mature markets. A global network, advanced skillset and well-resourced platform are important prerequisites to deliver on the strategy, combining the best of both worlds – solid returns for the investors with tangible economic and social impact.
Portfolio management: the tale of the mattress
Given the current low yield environment, pension funds will struggle to reach the target returns required to meet long-term payment obligations to pensioners. In addition, a typical pension fund’s current tendency to allocate the majority of their portfolios to low yielding investments could be characterized as “keeping their money under their mattress” rather than putting the capital to work.
Picking up the mattress metaphor, we examine the implications of putting part of one’s money under one’s mattress in an overall portfolio context. While it is naturally to be taken with a grain of salt, the mattress experiment demonstrates in a very intuitive way how something that might feel safe in the short term by lowering volatility, actually increases the risk of missing long-term return targets.
Accepting that the traditional approach of allocating the portfolio to equities and bonds is unsuitable from a forward-looking standpoint, it is argued that a new asset allocation paradigm is needed in order to adapt to today’s market environment of asset inflation. A superior risk/return profile is achievable by 1) putting capital to work (reducing the allocation to defensive assets such as bonds with limited return potential and an asymmetric risk profile) and 2) investing for the long term by considering the whole liquidity spectrum, including private markets.
Private real estate: why a global approach outperforms
While real estate investors have traditionally invested in domestic core properties, over the past few years we have observed a rapidly increasing trend in the market to gain exposure to real estate globally.
One driver is investors seeking better diversification in their real estate portfolios. They recognize that their domestic portfolios are typically highly correlated, and diversification across geographies can provide significant benefits. Furthermore, while Europe and the US continue to be the main source of real estate investment opportunities for institutional investors, demographic trends point to a shift in the balance of real estate opportunities towards Asia-Pacific that is already underway and which many investors are interested to exploit.
The second key driver is the attractive risk-adjusted returns that a global real estate investment strategy can deliver. An analysis of real estate returns from the Partners Group Thomson Reuters Private Real Estate Index provides evidence that investors can achieve long-term outperformance through a global approach. Given both the frequency and amplitude by which global portfolios have outperformed, this research flash aims to raise awareness of the increasing benefits of going global and demonstrate why a global approach should outperform “home-biased” or regionally focused portfolios.
Private debt: analysis on loss rates in the European mezzanine market
In an environment characterized by uncertainty, weak GDP growth and record-low interest rates, investors are in search of yield. European mezzanine investments, as an asset class, offer investors attractive floating base rates that address their need for yield, while at the same time protecting them from an inflationary interest rate environment.
This paper investigates the loss rates of European mezzanine investments as well as the year-over-year volatility of those loss rates. We analyzed transaction data from a comprehensive set of 439 mezzanine investments that were fully realized on or prior to 31 December 2012. All 439 investments were made between 1989 and 2009, a 21-year time period that covered several economic and market cycles (referred to herein as the “Observation Period”).
The analysis yielded several conclusions: (i) loss rates for European mezzanine investments during the Observation Period were relatively low overall at an annualized rate of 1.8%, (ii) however, a meaningful year-over-year volatility did exist, (iii) by building portfolios that spanned multiple investment years, the volatility of both loss rates and returns may have been meaningfully reduced with minimal impact to returns, and (iv) the returns, in aggregate, were never below 1.0x for any vintage year, with a total pooled investment multiple of 1.59x of invested capital from the 439 European mezzanine transactions.
Private real estate: the real estate secondary market - enhanced returns with lower risk
Real estate secondary transactions represent the purchase of interests in property portfolios and/or single assets from existing investors. These transactions are often consummated at a discount to the net asset value (NAV) of these assets and therefore provide investors with some unique advantages.
Whereas a typical real estate portfolio owns ten or more assets, a real estate secondary investment strategy generally provides investors with broader diversification from owning hundreds of assets. Given that you are buying in at a later stage, investors will have less duration risk as capital and profits will be returned sooner than if they were invested in a blind pool at inception.
Furthermore, in contrast to a blind pool investment program, buying into an existing portfolio allows the investor to substantially mitigate the risk of a J-curve. To the extent you can buy into non-core real estate assets that are four to five years into their typical ten-year life, your entry is at a point in time when a substantial portion of the value creation is largely complete and where the assets therefore possess more core-like attributes. By acquiring such assets at a discount to NAV, you can often generate significant cash-on-cash returns to your equity and a return profile more akin to a value-added strategy, but with core-like property risk.
Private real estate: a new tool for private real estate performance measurement
Over the past 20 years, Partners Group’s real estate team has invested over USD 30 billion in private real estate. Historically, Partners Group has collected and maintained proprietary industry-wide real estate data for in-house use and research projects.
In order to leverage these insights, in 2010 Partners Group teamed up with Thomson Reuters to develop an index for private real estate investments.
The Partners Group Thomson Reuters Private Real Estate Index is a consistent and high quality database that provides significant value-add for users and the broader investment community. The data verifies several of the anecdotal claims and observations about the private real estate asset class.
- The data highlights the benefits of the asset class which has outperformed public equity markets by over 8% since 2000.
- Private real estate investments have continued their strong rebound, generating over 10% during 2011 despite a challenging economic environment in the second half.
- The data suggests that careful selection of managers is even more important in private real estate compared to private equity, where from 2000-2010 none of the vintage years shows a negative median IRR.
- Investors with a contrarian view, investing into a market with increased uncertainty are typically rewarded with better performance relative to investments made during a positive market environment (that typically exhibit higher fundraising). The PGTR data highlights that vintage years with higher fundraising volume tend to underperform ("money chasing deals"); a phenomenon already documented for private equity investments.
Private equity secondaries: key component of value creation
Developing a comprehensive investment strategy in private equity secondaries is about much more than the simple notion of buying "good" assets at a discount to the stated net asset value or perceived intrinsic value.
Secondary buyers need to cultivate specialized skills that contribute to various aspects of the investment process. Without these skills, it is difficult to build a portfolio of secondary investments that will outperform over time as significant value is derived from integrating these elements into the investment process on a daily basis. These skills include:
- A targeted, global sourcing effort;
- Persistence in investment development and flexibility in structuring;
- Enhanced due diligence capabilities;
- Deep knowledge of investment partners; and
- Strong closing and execution capabilities.
As a result, an integrated platform that can support a secondary investment program with a broad array of resources is essential for global secondary investors to be able to operate efficiently and effectively in the market.
Private debt: the debt hangover and its impact on debt markets
As traditional providers of debt financing are still struggling with the aftermath of the financial crisis, structural shifts in the composition of global debt markets are opening up appealing opportunities.
With collateralized loan obligations (CLOs) acting as the other “traditional” source of capital for leveraged buyouts (LBO) in recent years, the current low issuance of new CLOs as well as the looming expiration periods of existing CLOs leave a gap, thus creating opportunities for credit funds and other providers of private debt. At the same time as funding from CLO vehicles is becoming scarcer, banks are in the midst of the deleveraging process, especially in Europe where the banks face huge refinancing requirements for an estimated EUR 1.7 trillion of maturing debt over the next three years. Morgan Stanley expects European banks to shrink their balance sheets by EUR 1.5-2.5 trillion over the next 18 months, of which a large proportion is likely to be the result of restricted lending activity.
In the midst of this situation, we expect to see continued investment activity and sustained demand for LBO debt. The current “dry powder” of roughly USD 400 billion in private equity funds is expected to lead to potential demand for debt financing of nearly USD 500 billion, assuming a market standard equity contribution of approximately 45%. As another prominent driver for strong loan demand, European corporates will be forced to find refinancing solutions for EUR 63.4 billion of loans due to mature between 2012 and 2015.
We conclude that the private debt market, specifically the senior secured loan and mezzanine markets, will exhibit a supply/demand imbalance over the coming years. This dynamic will offer well-capitalized investors opportunities for achieving attractive risk-adjusted returns.
Private infrastructure: building an infrastructure portfolio
Partners Group’s latest research report discusses the key factors for successful portfolio construction for the infrastructure asset class.
In Partners Group’s view, the foundation for successful portfolio construction in this private market asset class is based on understanding 1) the drivers behind infrastructure returns, 2) the non-standard return distribution of infrastructure investments, 3) the high proportion of non-systematic risk within the asset class and 4) the underlying inflation assumptions.
- Portfolio construction: Partners Group’s research report describes how systematic diversification in the portfolio construction process can significantly improve the risk/return profile of an investor’s portfolio. Three factors are identified as driving optimal portfolio construction, namely, 1) the unique non-standard return distribution, 2) the risk/return relationship of individual assets and 3) the correlation of returns between these assets. In order to sufficiently diversify an infrastructure portfolio, Partners Group believes it is necessary to allocate investments across five main parameters. These five parameters are 1) stage, 2) country, 3) sector, 4) vintage years and 5) single asset weights. Each is discussed in detail in the report.
- Inflation protection: for this analysis, Partners Group describes how it classifies infrastructure investments and how important it is to understand the impact of different drivers of inflation sensitivity (e.g. regulated tariffs, contractual indexation, pricing power). The composition of the portfolio will determine how immediately an infrastructure portfolio will react to changes in inflation and consequently the inflation protection it offers.
Private equity: understanding private equity's outperformance in difficult times
Many studies confirm that private equity investments have consistently outperformed public equity markets. A common prejudice is that this superior performance is attributable to the higher risk that private equity investors take.
Therefore, private equity is viewed as an unattractive asset class during difficult macroeconomic environments. We have looked at this hypothesis from various angles and found evidence that it is not justified:
Private equity investments beat public equities and offer an attractive risk profile at the same time. This is proven correct especially in a challenging macroeconomic environment. Private equity’s outperformance over public equities increases further while volatility still remains lower:
- Since 2000, private equity investments have outperformed the respective public equity indices by 5% in North America and 9% in Europe per annum
- In the aftermath of the burst of the internet bubble (Q2 2000 to Q1 2003), private equity investments outperformed public markets by 6% in North America and 20% in Europe on an annualized basis
- During the financial crisis from Q3 2007 to Q1 2009, private equity investments beat public market indices by 19% in both North America and Europe on an annualized basis
These results imply that private equity is a particularly attractive asset class in times of high economic uncertainty.
Private equity: Private equity under Solvency II - Evidence from time series models
From the beginning of 2013, the existing Solvency I regime for European insurance companies will be replaced with Solvency II, an updated framework for determining the regulatory capital requirements.
- Solvency II, an updated framework for determining the regulatory capital requirements for European insurance companies, is expected to come into effect at the beginning of 2013.
- The Solvency Capital Requirement (SCR) is based on a Value-at-Risk (VaR) measure calibrated to a 99.5% confidence level over a 1-year horizon covering all risks that an insurer faces (insurance, market, credit, and operational risk).
- Under the standard formula, private equity investments are captured in the sub-module ‘Other Equity’ for which a stress factor of 49% is applied. This stress factor is calibrated by using the LPX 50 as underlying data. Partners Group strongly disagrees with using this index as a proxy for a portfolio of unlisted private equity investments.
- Partners Group advocates using an index for unlisted private equity from Thomson Reuters to calibrate the stress factor for unlisted private equity. In contrast to standard public market data, this data exhibits auto-correlation.
- Time series models allow analyzing data series with auto-correlation. Standard auto-regressive moving average processes (ARMA) provide for a good fit and allow calculating appropriate capital requirements.
- Calibrating a stress factor for private equity using time series models suggests a significantly smaller stress factor. Depending on the actual portfolio composition, data suggests a stress factor of not more than 30%, a reduction of at least 40% (!) when compared to the stress factor suggested by the standard model.
- Results on the aggregation parameter of private equity and ‘Global Equity’ indicate that the proposed parameter of 0.75 under the standard model is too high and that a coefficient of 0.6 provides a good approximation. This should further increase the diversification benefits of private equity for an insurance company.
Private equity: Latin America - reaching out to untapped opportunities
With a population of more than 570m and an expected combined GDP of USD 5.3 trillion for 2011, Latin America is “nobody’s backyard”, as recently pointed out by the Economist.
- Latin America’s political and regulatory framework, the positive economic outlook and rising consumer purchasing power as well as the low private equity penetration make the region an interesting destination for private equity investments.
- Public equity markets in Latin America do not adequately reflect the sweet spot of economic growth - which has consumer-related sectors (consumer services, consumer goods, education and healthcare) at its center. Instead, public equity markets are often skewed towards the more volatile commodity companies and financials.
- Latin American countries are highly diverse in terms of GDP composition, natural resource endowment and institutional and political stability. Therefore, a local presence, local market knowledge and an extensive network of local players are key for making successful investments in the region.
- Partners Group has a positive outlook on private equity opportunities in economies characterized by political stability and strong macroeconomic fundamentals. In particular, Partners Group overweights Brazil, Chile and Colombia. While the Brazilian private equity market is becoming more crowded and valuations in the large cap space are rising, the country still offers compelling long-term opportunities in selective sectors and should continue to be the main private equity market in the region. Partners Group is slightly cautious on Peru on the back of the presidential election outcome and is taking a wait-and-see approach in the short term. Mexico is attractive on an opportunistic basis. Despite its strong macro-economic fundamentals, Mexico has a high correlation to the USA, which ties the economy to the recovery of the advanced world. Fundamentals in Argentina have improved; a regime change in the upcoming elections may create a more favorable investment environment.
Private equity secondaries: Value-based secondary investing across market cycles
The private equity secondary market underwent significant changes over the last decade and in particular over recent years as a result of the global financial and economic crisis.
Based on Partners Group’s experience as an active investor in the secondary market since the late 1990’s with over USD 7bn invested to date, this paper highlights how the global market for private equity secondaries is linked to economic development and which factors need to be considered in order to successfully create value at different stages of the cycle.
Hereby, the concept of value-based secondary investing will be introduced in order to derive the relevant investment strategies based on the major sources of return which can be identified at the different stages of the cycle.
Manager selection together with a fundamental understanding and tracking of underlying portfolio companies, business models and sectors are key prerequisites for assessing the return potential of secondaries at any point in the economic cycle:
- In the downturn, this allows investors to benefit from the market dislocation by buying at trough valuations from liquidity-driven sellers without taking excessive downside
- In the upswing the approach helps to identify and select the portfolios that offer the highest fundamental value creation potential, often with near term realization prospects
while customized solutions can be used to bridge a potential pricing gap.
By following such a value-based approach, investors are well positioned to achieve attractive returns, thereby fully capitalizing on the current secondary market opportunities arising from the continued strong deal flow, the ongoing recovery of underlying portfolio companies postrecession and the full re-opening of exit markets.
Private real estate: Asia-Pacific real estate - local approach in a diverse market
The Asia-Pacific region contributes approximately a third to global gross domestic product (“GDP”) and is growing at more than double the pace of the United States (“US”) and Europe. However, it has yet to receive its proportional allocation of real estate investments from institutional investors.
Asia-Pacific is an extremely heterogeneous market. Its approximately 50 countries are different from each other in terms of stage of development, governance systems, transparency in real estate markets, tax regimes, and official languages used. In terms of size, the region is vast, covering eight different time zones from India in the west to New Zealand in the east.
Given the diversity in the Asia-Pacific region, Partners Group views the region as a collection of distinct local markets and broadly classifies them into two categories: developed markets and emerging markets. On the following pages, we present our views on the current real estate landscape across Asia-Pacific, with a focus on the markets where we see attractive opportunities in the medium to long term.
Private equity: What is the optimal allocation to private equity
Determining overall asset allocation is one of the first and major challenges an investor faces, well before actual investment decisions are made.
- Although it is hotly debated, modern portfolio theory still represents a major tool for portfolio construction. Today, there are data providers that track the private equity market and two decades worth of quarterly data is a sound statistical basis for portfolio optimization.
- Data is based on the valuation of private companies and corresponding cash flows. Private company valuations typically reflect fair asset values rather than actual transaction values. Although similar tools are used to value public and private companies, the frequency and focus of valuations vary significantly. As a consequence of private equity valuation mechanics, return series exhibit auto-correlation, which, if not corrected for, may distort the results of portfolio optimization.
- Based on historical data series adjusted for auto-correlation, modern portfolio theory suggests an optimal private equity allocation in the range of 10-30% for an unconstrained investor depending on risk tolerance.
- Modern portfolio theory neglects important parameters such as investment selection, liquidity and regulations. Profound investment selection skills and access to top quartile managers are key given the significant return dispersion in private markets. Uncertainty over cash flows of private markets investments requires sophisticated modeling techniques for both risk management purposes as well as portfolio and liquidity management. Last but not least, regulation substantially limits degrees of freedom in asset allocation.
Private debt: Mezzanine Investments - Stability Through the Storm
Mezzanine debt is often used in leveraged buyouts to enhance equity returns. In a company’s capital structure, mezzanine debt is subordinated to senior debt obligations, but ranks ahead of preferred and common equity.
Partners Group has observed through its investment experience that the asset class has exhibited remarkable resilience through the recent financial crisis.
Partners Group is convinced that mezzanine currently represents an exceptional investment opportunity. As an introduction we observe:
- Mezzanine debt in Europe outperformed nearly all asset classes during the financial market crisis from 2007 to 2009
- The peak to trough drawdown of the asset class during the crisis was 11% compared to many other asset classes in the 50-60% range highlighting the relative stability of mezzanine loans in the crisis
- With 50% recovery rates given default, a mezzanine lender can realize default rates on over half its portfolio and still not experience a loss of principal. This is due to high historical recovery rates and high contractual coupon payments that generate significant interim cash flows
- With historical default rates peaking in the 12-13%1 range in 2008, and projected default rates in the 2-4%2 range going forward, mezzanine currently represents a very attractive risk/return profile for investors regardless of market direction
- Relatively low leverage and historically high equity cushions in the capital structures of leveraged buyouts today enhance the risk characteristics of an already stable asset class
- High contractual coupons offer investors steady cash flow margins over variable base rates (in Europe), as well as enhanced return potential through payment in kind interest
- The performance of mezzanine throughout the market crisis, as well as the prevailing attractive characteristics the market exhibits, suggest that mezzanine is currently one of the most attractive asset classes
Private equity: Feeling the pulse of private equity
Against the background of raising complexity and uncertainty, private markets investments, conducted by a leading global integrated investment manager, can provide significant long term benefits across economic cycles.
Realizing private markets investments across the cycle requires an in-depth assessment of the different segments from a top-down and bottom-up perspective. Investment managers have to be able to attract the most compelling investment opportunities along all phases of the economic cycle to the benefit of their clients.
Key findings of our research study comprise:
- Considering the link between the economic environment and private equity realizations, a significant pick-up in distributions is strongly linked to a recovery of economic growth
- Although this period of low realization activity did and will further cause issues for some investors ("liquidity perspective"), other investors appreciate investment managers to realize their investments in a less risk-averse post-crisis exit environment at a higher multiple ("return perspective")
- Many investment managers have only limited reserves for further investments (especially the ones who invested at an aggressive pace in 2006-2007) and will need to invest remaining dry powder in existing portfolio companies instead of allocating it to new investment opportunities
- We expect a consolidating business environment where investors are looking for quality managers with solid track records and a global integrated approach. Some players in the industry may have to go out of business
Private equity: Waiting for the tide to come in
The real estate markets in developed countries appear to be at an inflection point. One asks has the hemorrhaging finally stopped? Are we languishing in the doldrums? Or has the tide actually turned and will capital flow back into the sector? There is considerable speculation as to the directional movement of the real estate markets. What is the market telling us?
As we look forward to the next 12 to 18 months, Partners Group has a strong conviction that the tide not only is coming in, it is coming in far faster than many believe.
- Partners Group believes substantial capital that has been sitting on the sidelines will flow into what is perceived to be the least risky sector of real estate – trophy, core properties.
- Capital, not fundamentals, will bolster prices in the core, trophy sector. Investors will mistake this for a recovery across the asset class.
- Consequently, core real estate assets may actually be riskier than the market perceives due to the abundance of capital.
- Partners Group's view is that investors should target those opportunities where capital is most constrained to obtain the highest risk adjusted returns.
Private equity: Private equity allocations under Solvency II
Starting in 2012, European insurers will be required to comply with Solvency II, a new European Union regulatory framework with solvency capital rules applicable to insurance companies.
Executive Summary (copy 1)
Under these rules Insurers will have to calculate their solvency capital requirement either using a standard model or their own internal models. Based on the current proposal, investments in private equity1 would be subject to a stress factor of 55% under the standard model2. Analyzing the impact of private equity on an insurer's capital requirement suggests however, that even under the standard model, private equity is accretive to an insurer's portfolio both within the overall equity allocation and within the overall allocation. The diversification benefits leave the capital requirement largely unchanged as long as the allocation to private equity is not higher than 35% of the overall allocation to equities.
The relatively high capital requirement for private equity will incentivize insurance companies that aim to diversify their balance sheets to build internal models. Particularly for a specialized asset class such as private equity, asset managers like Partners Group have an important role in increasing their clients' understanding of the available private equity data and supporting the development of the relevant components of internal models. Based on the prevailing data, Partners Group expects the capital requirement for private equity under internal models to be significantly lower compared to the coarse standard approach. In our opinion, data suggests a stress factor for private equity in the range of 25-35%.
Insurers will analyze structural solutions to help them tailoring the capital requirements. With Solvency II emphasizing substance over form, many of the "plain-vanilla" solutions are unlikely to be able to reduce capital requirements. In order for a structuring solution to effectively reduce capital requirements, it must entail a change of the risk-return profile of the investments by way of transferring the risk from the insurer to a third party.