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Unravelling the opportunities of unlisted assets

INVESTMENT

21 May 2021

 

Historically the domain of institutional players like superannuation and endowment funds, more and more investors are now awakening to the potential benefits provided by unlisted assets.

Dampened volatility, returns linked to inflation and access to the illiquidity premium on offer, are just some of the benefits unlisted assets may provide. Once considered mysterious and inaccessible, unlisted assets are now considered an important component to a well-diversified portfolio.

These benefits do however bring with them key risks, namely illiquidity and complexity. Reason enough to work with experienced investment professionals who can help research and identify ‘best in breed’ managers, actively manage and monitor these investments over time and help to appropriately size the exposure to unlisted assets as part of an overall portfolio.

In this article we examine why investors are attracted to allocating capital to this space, the advantages which unlisted assets may provide and why consideration needs to be given to the appropriate sizing within portfolios.

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The market backdrop

Divergent views on financial markets are a given. However, there is one thing that the vast majority of multi-asset managers can agree on - future investment returns are unlikely to be as strong as they have historically (Chart 1). Unfortunately, the COVID-19 market crash in March 2020 also brought about some new market dynamics. Diversification, the only free lunch when it comes to investing, was brought further into question. While equities fell sharply and volatility spiked at all-time highs, U.S. Treasury yields (a safe haven) rose at the peak of market meltdown. In layman’s terms, correlations increased as nearly all assets headed in the same negative direction (at least for a couple of days). Diversification was hard to find at this time and questions have been raised for the future.

Therein lies the dilemma for investors; where to allocate? Certainly, there are options to cope with this environment. In the first place, we believe that higher strategic allocations to equities and overweights to government bonds vs. cash may be necessary in order to sustain a certain level of portfolio return while not running excessive risk. The key however may lie in allocating to an asset class, long-utilised by pension and sovereign wealth funds - unlisted assets. Unlisted assets are an integral part of a well-diversified investment portfolio due to their relative return stability, better risk adjusted returns and the long-term focus of these asset classes.

 

Chart 1: Return expectations for traditional investments are at record lows

 

Source: LGT Capital Partners, Robert J. Shiller, Refinetiv, Morningstar. Date range: 31 January 1871 to 31 December 2020.

So what are unlisted assets?

Put simply, unlisted assets are investments that are not listed on an exchange. They can include infrastructure (e.g. roads, airports, pipelines, telecommunications networks, ports and power grids), property (e.g. office buildings, industrial parks, distribution centres, housing and shopping centres), private equity (private companies, including everything from start-ups to mature businesses), agriculture and private debt.

Although unlisted assets are often categorised together, there are significant differences between the types of unlisted assets and their role in a diversified portfolio.

 

Infrastructure

Infrastructure investments provide capital to develop or maintain assets that are essential services or facilities such as airports, toll roads, ports, telecommunications, water, sewage and power services. These assets are considered essential services in developed countries and can improve living standards and economic potential in developing countries. Infrastructure projects often rely on substantial initial investments. Infrastructure funds typically offer risk and return expectations which are higher than private credit funds, but lower than private equity funds.

 

Property

Property investments involve directly acquiring property assets such as residential properties, shopping centres, office buildings, industrial parks and distribution centres. Returns comprise both income generated from rental yields, and capital appreciation due to demand dynamics and through improvement/development of the asset.  Return and risk expectations for property funds vary significantly, from core to higher-return seeking opportunistic assets, owing to the broad diversity of strategies globally.

 

Private equity

Private equity investments provide capital for private companies that are not listed or publicly traded. The most common categories of private equity include venture capital, growth capital and leveraged buyouts. Private equity investments require specialist fund managers to identify and source investment opportunities then drive capital appreciation through governance, financial and operational management. Many global technology companies including WhatsApp, Facebook, Twitter and Snapchat were identified and invested in at the venture capital stage by funds which operate in this space.

 

Private Debt

Private debt is a general term that describes non-investment grade debt such as corporate loans, infrastructure debt and real estate debt.  These funds are generally income generating in nature, with the ability to meet return targets hinging on the capability of fund managers to ensure underlying borrowers repay their principal and interest as agreed.

Why should I consider investing in unlisted assets?

While there are numerous reasons why investors invest in unlisted assets (Chart 2), we have highlighted some key reasons why we believe they can play a valuable role in portfolio construction. The below chart is for illustrative purposes only but provides a good framework for how unlisted assets could be considered as part of your portfolio construction and the benefits typically derived from each asset class.

 

Chart 2: Typical benefits derived from the primary unlisted asset classes

 

 

Source: ANZ CIO. The above diagram is for illustrative purposes only and is intended to demonstrate the typical characteristics associated with each asset class. These may vary from product to product and the above should not be relied upon for portfolio construction purposes.

Diversification

Over recent years the correlation between equities and other classes has shifted materially higher (Chart 3). While every investor has their own investment preferences, necessity for income, tolerance for volatility, expected returns and investment time horizon typically frame portfolio construction considerations. When considering a multi-year strategy, allocating to multiple asset classes with lower correlations to one another creates a greater chance of achieving return outcomes with a lower level of risk. Generally, unlisted asset returns have a low correlation to listed assets due to the fact that they can be uncorrelated to the business cycle, leaving them less exposed to short-term listed market volatility. The use of unlisted assets to diversify returns through market cycles can provide a ballast to a portfolio during listed share market downturns, potentially resulting in increased stability of portfolio returns.

 

Chart 3: True diversification is more difficult than in the past as correlation across assets has increased

Correlation between MSCI World Index & other indices

 

Source: LGT Capital Partners, Bloomberg. As at 31 January 2021. Equities represented by the MSCI World Index, Investment Grade Bonds represented by the Bloomberg Barclays US Aggregate Bond Index, High Yield Bonds represented by the Lehman US Universal High Yield Corporate Index, Commodities represented by the Reuters Commodities Index, Listed Real Estate represented by the NAREIT Equity Index.

Premium on returns

Unlisted assets have high barriers to entry which can provide a return premium over listed assets. The return premium is derived from the complexity as well as the illiquidity of the fund or underlying assets. Investing in unlisted assets requires specialised expertise and is often associated with large transaction costs. Having sufficient resources to analyse and evaluate unlisted opportunities, as well as negotiate and implement contractual terms, requires adequate scale to justify the allocation of resources in order to execute at a reasonable cost.  These factors may provide an illiquidity return premium and subsequent overall superior return for patient investors that can allocate long-term capital to invest in unlisted assets (Chart 4). Robust due-diligence on unlisted funds and their underlying assets, is even more important than for liquid listed assets, because they generally can’t be exited quickly if things go wrong.

 

Chart 4: Historical Private vs Public Market Returns (% per annum)

 

Source: StepStone. Note: As of January 1, 2005 – December 31, 2019. Past performance is not indicative of future results and there can be no assurance that the investment will achieve comparable results or avoid substantial losses. For illustrative purposes only. Historic annualized returns from January 1, 2005 – December 31, 2019.

Better risk-adjusted returns

Unlisted assets have historically generated superior risk-adjusted returns when compared to many other asset classes, such as equities. When considering investment returns, risk is a critical component. Every investment return should be considered with respect to the amount of risk taken to achieve that return. Historically, most core unlisted assets have been positioned on the risk/return curve between fixed-income investments and listed shares but with a superior risk/reward pay-off.

 

Inflation linked

Real assets, such as unlisted property and infrastructure, have return streams which are often linked to inflation. For instance, in the case of infrastructure, toll road prices are indexed to inflation and for property, rents are set in relation to increases in inflation. As an investor with objectives linked to inflation (CPI+), this is an attractive benefit.

 

Long-term focus

The longer-term investment horizon for unlisted assets is aligned with the long-term time horizon of multi-asset portfolios. Unlisted infrastructure, property and private equity or debt investments are generally held for the long-term. This enables asset managers to make longer-term decisions which benefit the long-term value of unlisted assets. In contrast, listed boards tend to have a shorter time horizon which can affect longer-term asset value.

Sounds interesting but what are the risks?

While the benefits of unlisted assets are easy to see, like any investment there are always risks. In addition to the added complexity these investments typically bring, we have identified 4 key risks which are most prevalent in unlisted assets.

 

Complexity

Unlisted asset strategies are typically more complex than traditional assets like equities and bonds. A higher level of due diligence is required to be successful and investors may need more time or resources to gain comfort with investing in more complicated strategies, or delegate this function to others they trust.

 

Liquidity risk

Unlisted assets are typically illiquid given they are not traded on an exchange and therefore it can be harder to trade or find buyers willing to transact at a given price. Often an investor will not be able to sell an asset at its fair value for many months or more. Additionally, in some situations, the valuation of unlisted assets can change sharply as they are typically valued infrequently, relative to listed instruments such as shares which are valued daily. During distressed market environments, it may not be possible to sell unlisted assets at a fair or reasonable price. Hence why investors need a long-term time horizon, which will generally be rewarded by what is known as the illiquidity risk premium – the reward for investors for tying up their capital.

 

Physical risks

An asset’s geographic location can make it susceptible to risks such as physical changes in the environment caused by climate change. Events such as cyclones, floods and bushfires or the impacts of longer term shifts in climate patterns such as rising sea levels are physical risks.  Likewise, this can also manifest in country-specific risks including geopolitics, which are not necessarily as inherent when it comes to listed assets.

 

Regulatory risks

This type of risk exists where a change in government policy can jeopardise the investment thesis of an asset. Such changes can increase business operating costs or change the competitive landscape (in the case where a monopoly exists).

 

Transition risks

Technology and consumer behaviour are constantly changing as the economy shifts. An example is less reliance on fossil fuels for a lower-carbon intensive economy. In this example, a shift to electric cars and an increased penetration of renewable power generation may impact a business. This represents both an opportunity and a threat for investors and asset managers.

Accessing the right unlisted assets

The higher complexity and implementation challenges in getting exposure to unlisted assets mean that investors need to be savvy about how access this space.

For many investors, investing in unlisted assets through a ‘fund of fund’ structure may be the most practical and convenient way to gain access.  These structures often allow exposure to a broad range of unlisted assets and managers in a single fund.  Investment minimums tend to be lower and in some instances they may provide some degree of liquidity.

For investors with larger amounts of capital, investing directly into private markets assets may be viable.  However, this may also require the need to meet capital calls and manage cash-flows directly from the assets.  These investments can remove a layer of fees; however, they typically have little or no liquidity.

Investment selection is arguably more important in unlisted markets than in traditional assets.  This is because the dispersion between the best and worst managers tends to be far greater.  This is why partnering with skilled professionals may make the difference between a successful and unsuccessful venture into unlisted assets.

Who’s investing in this space?

Unlisted assets have typically been the domain of institutional investors. With superannuation and pension providers, sovereign wealth and endowment funds typically holding much larger allocations to these assets than individual investors (Chart 5).

 

Chart 5: Exposure to alternative assets by investor type %

 

Source: Willis Towers Watson Global Pension Study 2020, NACU Business Owners TIAA Study, 2018, International Forum of Sovereign Wealth Funds, 2016 Money Management Institute, 2017. Averages are dollar weighted exposures.

 

Access to these opportunities, as well as expertise and an understanding of their complex nature has often been the reason for this. However, as return expectations continue to decrease and as more investors are seeking alternative sources of return, fund managers are now providing more readily accessible opportunities for individuals to access this asset-class.

How much should I allocate?

Investors need to carefully consider their investment time horizon, income requirements and other constraints and objectives before investing in unlisted assets. Professional advice is recommended whenever you are considering any changes to your portfolio.

For most investors with a long-term investment horizon, an allocation to unlisted assets of between 10%-15% may be appropriate. For some investors with very long investment timeframes, higher risk appetites and a high level of comfort and familiarity with these assets, a higher allocation, up to 30%-40% may be acceptable within portfolios. The exact amount will depend on your investment time horizon and how much capital may need to be liquidated throughout different periods.

 

Summary

Unlisted assets can provide portfolios with increased diversification, inflation-linked revenue streams and the potential for greater returns. However, investors need to ensure they understand the risks associated with these strategies (primarily illiquidity and complexity) and ensure that any investment is appropriately sized in their overall portfolio, and in accordance with their objectives and liquidity needs.

Professional strategic asset allocation is critical for ensuring this is done appropriately, avoiding concentration risks and diversifying intelligently.

To find out more about unlisted assets and how these may be able to play a role in your investment portfolio, including the current opportunities available via ANZ Private, please contact your ANZ Private Banker or Advisor.

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ANZ Private Bankers are representatives of Australia and New Zealand Banking Group Limited ABN 11 005 357 522 (ANZ), the holder of Australian Financial Services Licence number 234527. This document ("document") is distributed to you by ANZ and may not be reproduced, distributed or published by any recipient for any purpose.

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