How can real asset investors build an all-weather portfolio?

There is continual demand in infrastructure, but what are the investors focused on? Andrea Echberg, Partner at Pantheon, joins us for a deep dive into investor appetite for infrastructure and portfolio-building tips you should employ to succeed in the world of real assets.

What are the key sectors and geographies LPs are focusing on in real assets within private equity at the moment?

We see continuing strong investor demand for infrastructure exposure and expect 2018 to have been another record year for fundraising. The five-year CAGR for private infrastructure is 16% and many groups have been increasing their fund sizes meaningfully^[1]. Data shows that the majority of capital raised in 2018 is intended for investment in developed markets, predominantly North America and Western Europe.

Investor appetite for core infrastructure, where fund managers and direct investors (select SWFs and institutional investors) are competing for so-called “trophy” assets in stable regulatory environments, has increased pricing and may soften potential projected equity returns. The competition for core infrastructure assets has resulted in groups moving up the risk/return spectrum; one consequence of which that we have high on our radar to monitor is whether groups are being adequately compensated for the additional risk. Further, in this environment we find the definition of infrastructure is also expanding – and thus we remain focused on the basic tenets of infrastructure investing which includes evaluating competitive positioning, revenue stability, counterparty risk, and return drivers, in addition to capital structure and entry valuations.

In contrast to infrastructure, natural resources fundraising, which historically has been dominated by energy, has fallen at a CAGR of 20% in the past five years.^[2] Key themes in this shift away from upstream energy include environmental considerations and a desire to reduce volatility. We are finding that the reduction in capital for conventional energy is presenting a compelling, contrarian environment for nimble investors to build exposure to the sector.

The universe is much smaller in asset-backed strategies although private capital is looking to fill the void, left by banks, in leasing strategies.

What strategies are LPs employing to construct an optimum real asset portfolio?

Investors in private real assets typically make commitments to closed-ended or open-ended commingled funds. Open-ended funds lend themselves to core or super-core infrastructure investments that generally have a more conservative risk/return profile and require longer hold periods. The closed-ended fund structure, ubiquitous in private equity, is common in real assets for core plus, value add, or opportunistic strategies where returns are typically generated through growth, operational improvement, or risk reduction. It is also common for investors to build an allocation to real assets through publicly-traded securities and then transition to private investments as capital is called down.

Pantheon’s platform is designed to maximize the number of opportunities we see by investing through primary fund commitments, secondary investments, and co-investments. We believe this generates the highest quality deal flow and makes the “top of funnel” as wide as possible, allowing our team to identify what we consider to be the most attractive risk-return opportunities. Not all investors have the necessary scale and size to source a wide set of opportunities. While certain institutions have built in-house co-investment execution capabilities, there are still very few that have the resources, incentives, and processes to evaluate deals in the time-frame expected by GPs.

Pantheon tends to focus on secondary investments and co-investments. We believe these strategies can offer access to the full real assets spectrum through attractive entry points. Secondary positions may offer the opportunity to acquire assets at effective discounts with shorter hold periods and greater visibility into near-term portfolio movements, which have enabled us to build exposure to certain sub-sectors where the equity returns would ordinarily fall below our target, such as social assets, timber, and renewable energy. Co-investments/directs, in turn, can offer a fee-efficient option to deploy capital in sub-sectors that may typically exhibit expected equity returns > 10%, and we have also been able to access opportunities in emerging sectors like communications and aviation, where we wouldn’t typically see secondary opportunities owing to the depth of the market.

Are pure-play or diversified funds a better fit for your portfolio? Why?

Pantheon’s approach is to build diversified exposure to the asset class. As a guide, we would generally target portfolio position bite sizes of up to 5% in a co-investment and up to 10% in a secondary deal, with the bite size generally driven by the number of the holdings, and the risk profiles, in the underlying portfolio.

We employ a barbell approach across real assets, seeking specialists for certain sectors and sub-sectors, such as upstream energy or telecom infrastructure, and generalists, albeit with teams of sector specialists, in other parts of the portfolio, like infrastructure and energy infrastructure.

We recently examined the performance of renewable energy investments, comparing generalist funds with pure-play renewable energy managers from 2004 to 2016. We identified groups of our highest conviction pure-play renewable managers and top generalists who invest in renewables. All managers had invested multiple funds, and we compared their performance across vintage years as measured by net IRR and net multiple, to a private infrastructure peer group ultimately assigning a quartile-ranking. ^[3] The dataset suggested that generalist managers had a higher likelihood of achieving top quartile net IRR and net multiple performance. Our reasoning is that pure-play renewable managers may be forced to deploy capital into this sector and this sector alone, while generalist managers may have the opportunity to invest in renewables when the relative risk/return exceeds other sectors and vice versa.^[4]

How can investors mitigate volatility in their real assets portfolios?

Real assets can be a valuable portfolio diversifier because they have historically exhibited a low correlation with public equities and fixed income^[5]. We believe that the best way to mitigate volatility within a private real assets portfolio is to diversify, as it has also been evidenced that real asset sub-sectors have a low correlation to one another^[6]. It’s our approach to seek diversification by geography, by sector, by deal type, by partner, and by vintage year.

Real assets are generally considered to offer potential downside protection for investors.^[7] Pantheon’s approach is to target returns through both yield and capital growth, focusing on opportunities where reliable income streams from regulated entities or high-quality counterparties have historically been generated. In our experience, volatility in the performance of real assets programs is typically driven by exposure to investments that we asses to be over-levered or exposed to commodity price movements.

What are the threats and opportunities of the macroeconomic environment and outlook for this asset class?

Real assets, specifically infrastructure, saw large capital inflows as central banks tightened interest rates following the financial crisis and investors have searched for yield in the years following. The impact of future interest rate increases on the performance of real assets investments is uncertain, depending on whether any increase in revenues offset higher debt repayments, although we would expect asset valuation to face downward pressure, as the implied discount rate increases with interest rates.

Interest rates generally increase in response to greater inflationary pressures. Many sub-sectors in real assets, such as infrastructure, have contracts with inflation-linkages/protections built-in, providing a natural hedge against higher inflation. For example, tariffs on regulated utilities are usually indexed to inflation and contracts between owners of transportation assets (airport, ports, and toll roads) and third-parties, such as airlines and shipping lines, typically include some form of inflation indexation. Moreover, in periods of high inflation, natural resources have historically also provided higher returns than stocks and bonds. In examining most recent high inflation years (2004, 2005, 2007, 2011), when inflation was above 3%, natural resources produced an average annualized return of 19.5% relative to U.S. stock and bonds which produced 5.8% and 5.4% annualized returns respectively over those same time periods.^[8]

As a secondary buyer, macroeconomic headwinds that result in real assets sub-sector dislocation can offer an attractive opportunity to acquire assets as distressed, or just fatigued, sellers/opportunities come to market and investors look to generate liquidity and reduce exposure. Likewise, a co-investor may be able to move quickly to acquire assets in periods of volatility.

What are the implications of a transition to cleaner energy for investors?

The dynamic shift in fuel sources may have ramifications for our everyday lives – from the ways our homes are lit to the way businesses power operations. The latest Energy Transition study conducted by McKinsey shows an accelerated take-up of renewables that will result in peak global carbon emissions by 2024.^[9] This is likely to have significant implications for real assets investors.

We view the transition to cleaner energy as gradual and certain. Existing sources of energy, such as natural gas, will be important fuels during this period. Indeed, natural gas is the only fossil fuel expected to continue to grow its market share in the coming years.^[10] We continue to favour proven, developed, and producing (“PDP”) upstream and midstream natural gas opportunities, targeting well capitalized assets that are generating yield, through strong free cash flow, that allows the potential to de-risk the investments over time.

In the next five years it is expected that new-build wind and solar projects will reach cost parity with conventional power and after 2035, it is projected that renewables will comprise >50% of total energy generation.^[11] Our approach is to source and diligence investments that may benefit from improving cost curves and renewable adoption. Identifying compelling returns on operational wind and solar assets in developed markets has proved challenging recently. Consequently, we look beyond conventional renewables to emerging opportunities in energy efficient and sustainable technologies. Improvements in energy storage, battery technologies, and electric vehicles may also offer investment opportunities in the future.

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Under the spotlight: Andrea Echberg