O Brave New World

We ask whether private assets remain attractive as interest rates rise…by Thomas McMahon

Private markets could be the next big opportunity for investors. Over the summer we have been running a series of articles looking at the key private markets that are seeing rapid growth in the investment trust space. Bringing our series to a close, here we consider some idiosyncratic trusts broadening out into highly specialised asset classes and thus widening the options that investors have access to. Given the strengths that private assets bring to a portfolio, we expect to see more new developments like these emerge in the future. We conclude by discussing the outlook for private assets in the light of current market developments and long-term trends.

Shipping

Taylor Maritime Investments (TMI) offers direct exposure to merchant vessels, real assets at the heart of the globalised economy. It is the second investment trust in this space, following the launch of Tufton Oceanic Assets (SHIP) in 2017. TMI is distinguished by its focus on the segment of the market relating to handysize vessels (smaller ships up to 50,000 tonnes), which manager Ed Buttery believes is significantly undersupplied. As vessels have long construction times and yards are limited, industry experts can have pretty good visibility on supply coming down the pipeline and the scope for it to be expanded. In Ed’s view, it will take some time for a backlog in the handysize segment to be cleared, with other structural factors supporting the value of high-quality modern ships. One key factor is environmental regulation, which creates ever higher requirements for fuel economy and limits on environmental impact thus increasing the price differential between new and old vessels. A relatively specialist and opaque market like shipping places a premium on experience and connections, and Ed and his team stand out in that regard. Ed’s own long experience builds on the connections he has through his father, who is a veteran of the industry and founder of Pacific Basin. Ed and his team have personal professional relationships with many of the key players in the industry – such as shipbuilders and ship contractors, amongst others – which should help them have an edge in buying and selling these assets and negotiating advantageous charters.

Shipping is a cyclical industry with economic sensitivity via volumes of trade. In this it deviates from some other real asset sectors such as infrastructure. However, it delivers some of the other key attractions of private markets: diversification, the ability to add value in an inefficient market, and potentially high returns for taking liquidity risk. TMI’s returns have been exceptional since its 2021 launch, with NAV total returns of 81.3% to the end of March, illustrating the potential rewards of investing in a riskier area which needs a specialist to navigate. Additionally the trust has a well-covered dividend, and has already raised its dividend from 1.75 cents a quarter to 2 cents, after paying a hefty special. There is some inflation protection too, as vessel owners are able to pass on costs to charterers, although any recession caused by inflation would potentially lead to falls in charter rates. TMI trades on a double-digit discount, which we think reflects some profit-taking after a strong start as well as the unfamiliarity of the asset class. We published a full research note on TMI in June.

Forestry

Last year saw the launch of Foresight Sustainable Forestry (FSF), the only listed fund offering exposure to UK forestry. This is a relatively obscure market with data being hard to come by, but it has some clear attractions. Historically, land has been a good investment over the long run, while timber is a basic commodity which brings a link to inflation. Additionally, the net-zero commitments of the UK government have led to a few recent developments which should support an investment in forestry. Firstly there is a growing impetus behind onshoring production of various commodities in various industries, which should support the growth of the domestic timber supply, which has been growing at a rate below demand growth. Secondly, planting new forestry sequesters carbon from the atmosphere, and FSF’s investments in many cases could be viewed as offsetting emissions elsewhere. This is gaining formalisation through the growth of the carbon credit market, which has the potential to add meaningfully to FSF’s returns as it develops.

FSF is managed by a specialist team at Foresight Group who devote considerable resources to investing in a relatively small and inefficient market. While it is a hard market to assess quantitatively due to the lack of data, we think it should offer diversification versus equities and bonds, although like other commodity-exposed trusts it will have some link to economic cyclicality. Dividends are not expected to be a material part of returns. In the early results the NAV has seen significant write-ups, as we discuss in detail in our recent note.

Song royalties

Hipgnosis Songs (SONG) is well established in comparison to TMI and FSF. It was launched in July 2018, meaning it has just completed its fourth year of operations. SONG purchases the rights to music catalogues from artists, aiming to squeeze value out of them by promoting the songs in order to benefit from the growing globalisation of pop culture and growth of streaming services. SONG should deliver an uncorrelated yield, although there is obviously a link to the economic cycle as music is a consumer good, so its consumption will likely fall when consumers are poorer. However, the base case for the shares is that we are living through secular shifts in demand and consumption which should see strong long-term growth in the value of the catalogues. If so, then this secular uptrend should see higher highs and lower lows as economic cycles wax and wane.

SONG has raised a lot of money since launch (it now has gross assets of £2.1bn). This may have contributed to a widening discount over the past year, although general risk aversion is likely to have played a role too. The discount has come in over the past month from c. 20% to c. 12%, and this is likely in part a reflection of a bounce in markets, with SONG behaving like a risk-on investment. One worry the market has had is the debt situation: SONG has gearing worth 27% of NAV for which it pays a floating rate, meaning that it is exposed to rising base rates. The trust’s manager has successfully securitised a catalogue it runs for Blackstone, which may have shown the route to resolving this situation and reducing the interest burden, thus potentially relieving the pressure on the rating in the future.

Oh, wonder! How many goodly creatures are there here! How beauteous mankind is! O brave new world, that has such people in’t! – The Tempest

Conclusion – the appeal of private assets

Private assets are diverse, with the number of options available to the average investor having grown considerably in recent decades. Private equity and property are arguably the two best-established sectors, while infrastructure and renewable infrastructure have become critical allocations in many portfolios over the past decade. These have been added to in recent years with many other asset classes such as private debt, growth capital, shipping, forestry and royalties. One reason cited for the growth of private assets has been the low interest rate environment. This raises the question of whether the appeal of private assets will diminish if rates continue to rise and stay at elevated levels compared to those of the past decade and a half. In our view this is unlikely to be the case. It may be that the yields available on these sectors look less attractive versus conventional bonds in future, which could mean premiums being lower on average. However, there are a few reasons we believe demand will remain high.

Expected returns on conventional asset classes, chiefly equities, are lower than achieved historical returns. This can be seen across the forecasts of those making such projections. One reason for this is the low base rate, which is changing, but there are others. For example, equities should compensate us for taking the extra risk involved in investing in them over bonds. In other words, their returns can be broken down into the base rate plus an equity risk premium. One way of thinking about the equity risk premium (ERP) is to think about it as the earnings yield, i.e. the inverse of the P/E. If the ERP is the long-run growth in earnings, then we can also think about it as long-run GDP growth, meaning earnings growth in the whole market should track growth in the economy (using some simplifying assumptions). In other words, our expected returns from equities should be inherently linked to our expected GDP growth. While we may be seeing base rates lift, this does not presage a shift in the economic regime from low to high growth in the developed world. The key factors behind economic growth are demographics (growth in the labour force) and total factor productivity (TFP – basically technology and organisational efficiencies). Demographics in the developed world are poor, which means that if we are going to see a shift to a structurally higher-growth world it will have to come from breakthroughs in technology or institutional organisation, which will first have to offset any negative effect from deteriorating demographics. This is not impossible, but the base case has to be that it will not occur. As a result, we should expect GDP growth to remain low, keeping equity returns low by historical standards. Many private assets have the potential to do better than equity markets, earning a premium for illiquidity and complexity, and offering the opportunity to add alpha in structurally inefficient markets.

Another reason we expect demand for private assets to remain high is diversification. One way of responding to low growth in UK or US equities would be to allocate more to fast-growing nations such as those in Asia – or even perhaps to Africa over the next 20 years. However, global equity markets tend to share key sensitivities: to the global base rate (the Federal Funds Rate), to the dollar, to global trade and to major political and economic events. Infrastructure, song royalties or forestry could provide some respite, although they will never be entirely isolated from common risk factors. Investors who use investment trusts will find some correlation through the share prices (in the short term, at least). As these asset classes become more visible and understood, we expect them to become an increasing feature of well-diversified portfolios.

We also think part of the reason for the growth of private assets in the investment trust space is progress, and would argue it was previously institutional and technological reasons which were holding these assets back in the institutional space. The internet has produced an incredible democratisation of knowledge, while developments in hardware and software have opened up sophisticated ways to track, organise and communicate information. To some extent people will invest in private markets simply because they can; these asset classes were not overlooked in the past but simply had not been made available to most people (in some cases they barely existed in an institutional form). In a more sophisticated, knowledge-based economy in which investors expect better and cheaper service from the financial services sector and greater control over their investments, knowledge of, and interest in, private assets should continue to grow.

Disclaimer

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.