High and Low
Fundraising in 2023 has unquestionably been difficult, and for good reason. Elevated interest rates and inflation (which remains sticky) have been top of mind, all in a context where the denominator effect has dampened LPs’ enthusiasm for additional capital commitments.
Challenging times are expected for some managers launching funds when 2024 begins, with investors capped out from real estate allocations. There are fewer distributions being made by existing funds as a result of the slow pace of transactions and the decreased amount of capital that is being deployed. As a result, there is less money available to be invested in new funds.
A recent survey conducted by Goldman Sachs Private Markets, which included more than 200 LPs and GPs, revealed that the most significant obstacle for GPs remains fundraising. At the same time, LPs consider track record to be the most important factor when evaluating GPs, which makes it more difficult for new GPs to break into the market.
It is macro concerns, not market factors, that are at the focus of perceived dangers, according to Goldman Sachs. Respondents ranked a recession (48%), geopolitical conflict (46%), inflation (43%), and interest rates (37%) as their primary concerns
Real estate is the top choice for decreasing allocations among LPs (28%). “With real estate assets in the process of repricing, and with a more than $2 trillion wall of maturities over the next three years likely to force more revaluations, its unsurprising that some LPs remain cautious about their real estate allocations,” said Jim Garman, partner and global head of real estate investing at Goldman Sachs. “We expect more dislocation ahead as the market adjusts to the new economic reality.”
Enter Infrastructure
As inflation remains elevated and likely to sit at levels that are unsettling for the Federal Reserve, real assets have garnered fresh attention as potential inflation hedges.
Infrastructure projects, according to global multi-investment behemoth KKR, can be considered as an effective “modern-day” inflation hedge. In addition to the natural inflation protection provided by tangible assets, infrastructure investments frequently include contractual or regulatory inflation protection on earnings.
Some investors might think that now could be the time to begin to pull back on commitments to real assets. That view, however, is not one that KKR holds.
As the firm recently wrote in a research note titled, “Regime Change: The Changing Role of Private Assets in a ‘Traditional’ Portfolio,” infrastructure has performed well in lower-inflation environments as well. The research showed infrastructure’s potential benefit to a portfolio as an “all-weather” allocation, particularly as inflation has now pulled back.
KKR modeled the annual real return for infrastructure from 2004 to 2021, using the Burgiss Infrastructure Index. The results showed a return of 7.7% in a low inflation (1.9%) environment and a 6.7% return in a high inflation (3.5%) world. Meanwhile, the return for real estate from 1978 to 2021, using the NCREIF Property Levered Index, revealed a 6.8% return during a low inflationary (3.1%) period and a 5.1% return when inflation was high (5.9%).
It should be noted that, while inflation has slowed, it has not disappeared. KKR believes it will remain above Fed targets for the foreseeable future, owing to significant structural shifts in demography, supply chains, housing availability, fiscal deficits and the energy transition.
A few layers of protection against inflation and volatility are provided by private infrastructure. First, infrastructure, like other real assets, has a tangible underlying asset. During periods of high inflation, physical assets often retain or even increase in value. This is especially true with infrastructure.
In the sphere of digital infrastructure, for example, rising global data usage and connectivity demand are propelling growth in fiber optic networks, mobile towers, and data centers. Data center leasing activity and rental growth have been robust across the U.S., and increased adoption of artificial intelligence, cloud-based computing networks, and other trends are increasing demand for digital infrastructure.
This large structural change has implications for asset allocation, as bonds are expected to be less effective as a portfolio “shock absorber” than they have been in previous cycles, according to KKR. Other traditional shock absorbers, such as REITs, TIPS, and gold, have all performed poorly in this cycle.