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Understanding how to succeed in private investing includes understanding all asset classes and what they are trying to achieve in your portfolio.  In our previous article, you learned about the capital growth-focused world of private equity, famous for its high risk as well as its potential for high returns in the form of buyouts and venture capital.  Now, let’s tackle the remaining asset classes: private credit, infrastructure, and real estate.  Here again is a chart outlining each private investment asset class and its corresponding investment objectives:

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Private Credit

One of the fastest growing asset classes, private credit allows investors to invest in loans to smaller, less mature companies and private real estate with negotiated terms usually including higher return levels to compensate for assuming higher risk.  By structuring the terms of the loan in a way that offers a level of protection should the company or real estate building default or go bankrupt, the amount of risk is potentially mitigated.

Like most asset classes in the private market universe, there are different options to meet your portfolio’s needs, from stable income to capital growth.  Those looking for consistent returns without as much risk can be involved in direct lending in businesses and stable real estate deals.  Direct lending involves extending loans and credit to small and mid-market companies without financial institution oversight or regulation.  The terms of the lending can be more flexible than traditional banks, but with higher returns for the lender than conventional financial institution loans.

Those looking for higher returns and capital growth opportunities in the private credit space can turn to mezzanine debt and distressed debt as options to suit their needs.

Mezzanine debt is used a lot in acquisitions of companies and buyout funds because it operates as a hybrid of both bonds and equity. Mezzanine debt is technically a loan that is subordinate – junior in importance and hierarchy – to senior debt obligations. If a company goes bankrupt it pays senior debt first, making it much riskier and unlikely for subordinate (junior) debt to be paid out.

However, mezzanine debt contains warrants – options to exercise demands – where the debt can be turned into equity (stock) in the company. Therefore, we find mezzanine debt is usually subject to volatility more comparable to stocks than bonds. Mezzanine debt’s most attractive feature is the option to convert to stock.  As an example of the potential for return, imagine owning mezzanine debt in Apple or Facebook before they went public.

On the capital growth end of private credit, we find distressed debt.  Distressed debt offers the highest level of potential returns within private credit while also assuming the highest levels of risk.  As the name implies, distressed debt targets companies who may have defaulted on loans or declared bankruptcy while looking to restructure.  Think of distressed debt like being a debt collector: scooping up debt for pennies on the dollar that no one else wants and re-structuring it to enhance returns.

One of the biggest issues with distressed debt is the low level of supply available, particularly in strong economies as evidenced by the chart below.

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During economic downturns such as the Great Financial Crisis of 2008-2009[1], distressed debt can be a huge opportunity as companies begin to default and go bankrupt leading to outsized returns. The most recent default cycle was in 2015/2016 with energy companies defaulting on their debt, creating opportunities within this asset class. Be on the lookout for higher levels of supply in the distressed debt space due to COVID in the coming months and years.

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Infrastructure: A New Option in Private Markets

Global infrastructure made up over 14% of global GDP for a total of $9.5 trillion dollars in 2015[1].  The rise in global population and ailing infrastructure around the world leads McKinsey & Company to believe that another $3.7 trillion[2] will need to be pumped into global infrastructure annually through the year 2035 to keep up with demand.

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Due to the sheer size of the problem, countries are getting creative and incorporating private money into infrastructure projects to ease the financial burden on their wallets.  Private money is happy to oblige as they find these deals attractive for their potential recurring revenue opportunities.

The two main private infrastructure asset classes are broken down between greenfield investments and brownfield investments. Greenfield investments involve new projects built from the ground up while brownfield investments are focused on re-positioning old infrastructure assets for new uses.

Greenfield investments are considered riskier due to the higher need for construction and larger reliance on commodities to build the project (timber, cement, steel, etc.) If commodity prices are high at the time of the project, it can create risks for the overall profitability of the investment. In fact, greenfield investments are normally about 1-2% riskier than brownfield investments specifically because the risks associated with more intensive construction costs[1].

Brownfield investments are more focused on investments that occur after construction has already happened and recurring revenue is already in place. Since there is lower risk associated with these types of investments compared to greenfield, the potential returns of this asset class are lower as well.

Besides the growing need for infrastructure projects and potential for large future returns, infrastructure is so unique because it is the least correlated asset class of all private investments to public stocks as the below chart indicates.  In terms of portfolio value and function, infrastructure provides the largest level of diversification from core public stock and bond holdings than any other asset class without sacrificing much in terms of potential investment returns.

 

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Private Real Estate

The beauty of private real estate is the ability to potentially accomplish many investment objectives. If you’re looking for a boost to the income portion of your portfolio, core real estate is a great option.  Opportunistic equity or value-added equity can be an ideal place for capital appreciation. In past articles, we’ve also spoken of how private placement real estate could be an income replacement for bonds.

Core real estate is the most popular of all the private placement real estate options. Since the early 2000’s, core real estate has had as much capital flow into it as value-add real estate and opportunistic equity combined[1]. Its attractiveness comes from the lower risk characteristics associated with core real estate investments. Typically, core real estate investment strategy is based around finding solid grade-A properties with long-term, high-credit tenants already in place.

While real estate is normally known as an investment that uses a lot of leverage to enhance returns, core real estate commonly has a very low loan-to-value (LTV) of 0%-30%[2]. This strategy can make investments in core real estate typically more predictable as the investment is more focused on income generation from current rental income, rather than relying on potential future appreciation.

Value-add and opportunistic real estate focus on the development and construction of real estate to create investment return. While core real estate has low levels of leverage – below 30% — opportunistic real estate typically involves higher levels of leverage – close to 60%+ LTV. Normally, this type of riskier investment play is focused on the purchase of land and development of projects without tenants already in place.  All of these uncontrolled variables create higher risk than core real estate, but this increased risk also creates potential future higher levels of return.

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To give you a visual, this graph shows the high correlation between value-add and opportunistic real estate. The main difference between the two is that value-add normally repositions an investment – turning a vacant grocery store into a gym and office space – while opportunistic real estate normally involves construction from the ground up. While both investment strategies drive strong returns, opportunistic real estate also historically has delivered higher returns than core real estate or value add real estate if you’re willing to assume the higher risk.

 

Conclusion

Each asset class of private investing has sub-asset classes that may accomplish different objectives within your portfolio, and all aid in diversifying your holdings outside of the public markets.  Understanding each of these opportunities is key to moving forward successfully with private investments.

Next in the Series

In our final installment in the series, we’ll cover what you need to consider about private investing’s present and future before moving forward with your own investments. CLICK HERE to access the next article.

 

CITATIONS

[1] Blackrock Private Markets 2020 Report p.21
[2] Mckinsey Global Institute Bridging Infrastructure Gaps 2017 report p.1
[3] Mckinsey Global Institute Bridging Infrastructure Gaps 2017 report p.2
[4] Blackrock Private Markets 2020 Report p.17
[5] Blackrock Private Markets 2020 Report p.25
[6] Blackrock Private Markets 2020 Report p.25
Post Disclaimer

The information contained in this post is for general information purposes only. The information is provided by Asset Classes Deep Dive: Private Credit, Infrastructure and Private Real Estate and while we endeavour to keep the information up to date and correct, we make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability or availability with respect to the website or the information, products, services, or related graphics contained on the post for any purpose.

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