A real assets portfolio may include allocations to real estate, infrastructure equity, and other physical assets such as commodities and natural resources (e.g. timber and agriculture). Allocations within this bucket are said to be tangible investments with intrinsic value due to their physical properties.
Investors may include private subordinated infrastructure debt in a real assets allocation as they share similar attributes such as:
- Physical assets with intrinsic value
- Can serve as a hedge against inflation
- Low correlation with traditional asset classes (equities and bonds)
- Long-term horizons
- Liquid asset class
These characteristics drive the overall asset allocation to real assets, which is generally a decision based on risk/return trade-offs and liquidity profile. The risk/return profile of the real assets can range widely depending on whether it is an equity or debt investment.
Additionally, the illiquid nature of this strategy may make private subordinated infrastructure debt an appropriate fit as investors would be taking a long-term view (seven to 10 years or more) in these investments. Subordinated infrastructure debt would be driven less so by macro-economic conditions than property investments, which tend to be more cyclical and sensitive to market environment.
Another benefit of private subordinated infrastructure debt in this allocation is its low correlation with the other real asset investments as well as with the broader multi-asset portfolio. From this perspective, we believe that private subordinated infrastructure debt provides diversification benefits and is an attractive complement to the real asset allocation and the multi-asset portfolio.
As explored in a 2016 paper from AMP Capital, ‘Subordinated Infrastructure Debt – The Time is Now’, some investors may decide to separate their Infrastructure allocation from their real assets allocation. Within an infrastructure portfolio, which typically is mostly infrastructure equity investments, subordinated infrastructure debt can serve a variety of roles depending on an investor’s existing portfolio and investment strategy. For those investors who are seeking the low volatility, high-yielding cash flows of core infrastructure assets, but who find difficulty deploying capital at attractive return levels in the current highly competitive environment, subordinated infrastructure debt presents as an alternative.
Annual yields in subordinated infrastructure debt are around eight to 10 per cent with total net returns in-line with or even exceeding those of core equity1. For those with exposure to higher returning value-add infrastructure equity strategies, subordinated debt can complement and drive cash yield across the portfolio on a blended basis. Value-add infrastructure equity funds will typically target lower cash yields in the first part of the fund’s life as capital is reinvested to drive business growth. Pairing such an investment with a high-yielding infrastructure debt strategy can help ensure the portfolio is highly cash generative from the outset.
Adding infrastructure debt to an infrastructure equity allocation can also serve to help balance the risk profile. Infrastructure debt tends to have much lower volatility (albeit due to lack of mark-to-market) than infrastructure equity investments and can offer more defensive characteristics to the portfolio. In a stressed market environment, subordinated debt ranks ahead of equity and will be less impacted by market shocks. Therefore, an infrastructure debt allocation can be a nice and more balanced complement to an infrastructure equity allocation.
Adding infrastructure debt to an infrastructure equity allocation can also serve to help balance the risk profile.”
Alternatives can be a ‘catch-all’ category that encompasses all assets that are unlisted and illiquid. A typical alternatives allocation can comprise of hedge funds and private equity investments, but it can also include infrastructure and private debt. The role of an alternatives allocation is to provide diversification relative to traditional asset classes (equities and bonds) and deliver attractive absolute risk-adjusted returns.
Investors who look to their alternatives allocation to be a diversifier, could consider private subordinated infrastructure debt as a defensive allocation due to its low correlation and low volatility characteristics. It can be grouped with more defensive hedge fund strategies that are relative value in nature and alternative beta type of strategies.
On the other hand, investors who are seeing high risk-adjusted returns from their alternatives allocation may look at private subordinated infrastructure debt for its higher yield and illiquidity and complexity premia. These types of alternative investments may include ‘growth’ strategies including private equity, mezzanine debt, leveraged buyouts and directional hedge funds. These strategies typically target mid to high-teen returns in which case, private subordinated infrastructure debt may fall short of these risk/return expectations.
The benefit of including private subordinated infrastructure debt within an alternatives allocation, is the low correlation compared to other alternative strategies within the bucket, and compared to the broader diversified portfolio. We think private subordinated infrastructure debt should be considered a ‘defensive’ alternatives investment whose main purpose is to help diversify the alternatives allocation as well as the broader multi-asset portfolio.