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Illiquidity premia in real assets: Q2 2022

Our real assets research team crunch the data to see whether the effects of rising inflation and interest rates are being reflected in private market returns.

Read this article to understand:

  • How the effects of macroeconomic factors on real assets varies by sector and transaction type
  • Why long-income real estate is demonstrating resilience in the high-inflation environment
  • Why forced selling could present opportunities in the asset-backed securities market

Figure 1: Illiquidity premia in private markets

Illiquidity premia in private markets

Note: Illiquidity premium required for private real estate equity transactions reflects the time it takes to sell and achieve a fair value. Indicative time period: 3 months.
Source: ICE BoA Merrill Lynch, Bloomberg, Aviva Investors. Data as of June 30, 2022

Historically, illiquidity premia in real asset markets have been compressed during market downturns, with private debt generally repricing at a slower rate than public market equivalents. On the other hand, they are often at their widest in the aftermath of a recession, as public markets rebound faster while private market investors maintain their discipline over a longer period. 

Our latest data suggests that, while there has been some compression in illiquidity premia over the last quarter, this varies by sector and the specific nature of a transaction. For example, in infrastructure debt, private spreads have remained stable during a period when public spreads have widened significantly, causing the illiquidity premium to decline.

While a fall in average illiquidity premia remains applicable to real estate finance, long-income real estate and private corporate debt, illiquidity premia have varied at a transaction level. Overall, given the time lag associated with changes in public markets being reflected in private markets, it remains to be seen how soon private market pricing will reflect public market volatility.

Given that illiquidity premia vary by sector, identifying appropriate liquid benchmarks is key in enabling cross-sector comparison. Due to this differentiation, broad public benchmarks can be misleading. We assess illiquidity premia by analysing sectors on a comparable basis, using liquid benchmarks appropriate for each asset class.

Real estate debt

Within real estate, liquidity remains steady in debt and equity, though the approach among lenders has become more cautious.

Sectors previously out of favour have seen less of a pricing impact

Pricing has moved outwards, although not yet significantly. Sectors previously out of favour, such as retail, have seen less of a pricing impact, but there has been a cooling in sentiment towards better-performing sectors, such as logistics.

Overall, there is widespread uncertainty given the inflationary environment. The impact is likely to vary between different sectors.

Real estate long income

Investors continue to see the benefit of long-lease real estate let to investment-grade companies and public sector counterparties, with secure contractual cashflows rising with inflation. While they present greater risk, assets tied to sub-investment grade covenants look attractive on an opportunistic basis.

Higher demand in the healthcare and student accommodation sectors continue to sharpen pricing in these sectors

Despite the recent steep rise in construction costs, forward-funding structures remain attractive as raw material prices are expected to gradually stabilise. Higher demand in the healthcare and student accommodation sectors, combined with low stock and significant gilt volatility, continues to sharpen pricing.

Over the next year, we expect to see margins and illiquidity premia restored, as investors become more price-sensitive given rising gilt yields.

Infrastructure debt

Investment activity in the infrastructure market is likely to maintain a strong focus on renewable energy and digital infrastructure, such as fibre broadband. Progress is also being made to develop business models for sectors such as carbon capture and storage, hydrogen and nuclear energy. With the most recent contract-for-difference auction for offshore wind taking place in July, the focus now is delivering tangible progress towards net zero.

Inflation-linked assets will likely be impacted more positively

While inflation presents a real risk, its impact on infrastructure is mixed. Inflation-linked assets will likely be impacted more positively, with the significant rise in energy costs also benefiting assets exposed to prevailing power prices.

In markets such as green energy, excess liquidity is beginning to depress pricing. Public spreads have widened but private spreads remain stable. Time will tell whether private market pricing will start to reflect pressures in public markets.

Structured finance and private corporate debt

The market for private placements continues to present strong relative value, with a significant increase in investment activity and rising spreads. Conversely, market uncertainty has resulted in the relative unattractiveness of mid-market opportunities within the sub-investment grade universe.

Opportunities appear more attractive in floating-rate loans

While non-cyclical and defensive sectors may remain resilient, selectivity is critical. With lending costs rising, export credit agency financing continues to be competitively priced. Opportunities appear more attractive in floating-rate loans given the rise in rates. We also see significant value in asset-backed securities as spreads widen, with forced sellers needing to cover collateral costs.

Key risks

Investment risk

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency and exchange rates. Investors may not get back the original amount invested.

Illiquidity risk

Where funds are invested in real estate / infrastructure and illiquid private assets, you may not be able to switch or cash in your investment when you want because real estate in the fund may not always be readily saleable. If this is the case we may defer your request to switch or cash in your units.

Valuation risk

Investors should bear in mind that the valuation of real estate / infrastructure is generally a matter of valuers’ opinion rather than fact.

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