Using proprietary data, our private markets research team compares risk and return across sectors.
Read this article to understand:
- How our proprietary data reveals relative value across private markets
- Why equity is positioned for a recovery and the differentiation expected across sectors
- Debt’s continued strength amid a trickier macro environment; plus, new analysis for structured finance
It's a truism that knowledge is power. In relation to private markets, it is particularly apt, as relevant information can help investors make better decisions.
As part of our efforts to provide better data, we use our proprietary methodology to compare risk and return across sectors on a consistent, forward-looking basis, revealing where relative value can be found (see Our approach: Measuring risk and return). Data is gathered across multiple periods, and the view for Q4 2024 is presented here.
This quarter, we introduce two new models to our sector analysis: a structured finance model for the UK and one for Europe. These help illustrate the different opportunity sets available in each market.
Our approach: Measuring risk and return
A common obstacle for investors in private markets is the lack of a transparent pricing history to track risk and return and the factors driving them. Most firms keep transactional data private and buy supplementary market data from external providers who may not have a comprehensive view of the market. To address this, we have developed our own methodology to apply on a consistent, forward-looking basis (see Aviva Investors’ proprietary real assets relative value framework).
This methodology allows us to compare risk and return at sector level using a cashflow profile approach. Moreover, because all the cashflows and simulations are contained within one framework, we are able to examine and quantify the underlying drivers of risk.
When considering risk in a relative value context, we take ex-ante risk (based on a forward-looking view) on the standard deviation of 5,000 internal rate of return (IRR) simulations to measure variation from the mean. As with any idiosyncratic asset class, manager skill and the specific characteristics of the investment strategy make a difference. When considered alongside mean returns from individual assets, these factors could result in outcomes significantly lower or higher than those modelled. Also, note that all the returns illustrated are unlevered. In spite of these qualifiers, we believe the approach allows a level of insight and transparency where nothing else similar currently exists.
With the depth the relative value model offers, we determine correlations between sectors. This information then helps us build portfolios and optimise capital allocation. We can interrogate these portfolios to understand how sectors contribute to overall risk or offer diversification benefits. These capabilities, coupled with a unique understanding of the individual risk drivers in each sector, enable us to identify new opportunities and unlock diversification potential.
We conduct our analysis on a five-year, ten-year and full-life basis, with the flexibility to analyse alternative investment horizons as well. For the purposes of this article, we focus on an investment horizon of five years, as this is aligned with the requirements of a large portion of investors.
Economic backdrop
UK GDP growth surprised positively in the first half of 2024 but tailed off in the second half again. Meanwhile, Europe maintained positive GDP growth for the first three quarters of 2024 following flat GDP growth in Q4 2023. In both the UK and Europe, inflation appears to be under control and heading towards target. It did tick up in October, which was, in part, anticipated as a result of energy costs. However, readings for the coming months will determine the magnitude of the impact of recent political events, such as the UK Autumn Budget and the US elections.
The ECB made its first interest rate cut of 25bp in June 2024
In June 2024, the European Central Bank (ECB) made its first interest rate cut of 25 basis points (bps) after nine months of stable rates. The UK followed in August and the US in September, with an unusual 50bp interest rate cut.
In the second half of the year, political events (namely the UK Autumn budget and US elections) resulted in an uptick in government bond yields which is expected to lead to a moderate slowdown in the pace of rate cuts. However, the economies of the UK and continental Europe continue to move towards a more “normal” environment, one in which we expect “higher-for-longer” interest rates.
The macroeconomic environment is bumpy but remains on (a slightly extended) course
During our last relative value analysis, published in August 2024, we concluded the equity sectors had stabilised while the debt sectors remained attractive (see Relative value in real assets: A spectrum of opportunities).1 This is because, over the past couple of years, while debt sectors were seeing heightened potential as a result of elevated base rates, equity was repricing. As a result, equity screened poorly on a relative value basis.
The potential returns offered by the debt sectors have remained strong
Our view has somewhat evolved since then. The potential returns offered by the debt sectors have dipped slightly in some areas, although they have remained strong and continue to be fuelled by the elevated rates environment. Meanwhile, the equity sectors have seen a strengthened forward-looking expectation, as a result of the general stabilisation seen across the markets. The absolute return outlook is a more positive one now.
In parallel, the risk associated with the debt and equity sectors has remained stable since the previous view, with the exception of private corporate debt and structured finance, which have both seen a slight reduction in risk. On a potential return per unit of risk basis, the debt sectors continue to screen more attractively than the equity sectors, reflective of the lower risk associated with debt. However, the equity sectors have the potential to offer greater upside.
The UK continues to offer slightly greater absolute return potential than Europe
Considering the debt sectors in more detail, the UK continues to offer slightly greater absolute return potential than Europe, as a reflection of their respective markets’ risk-free rates. Floating-rate debt continues to screen more attractively than the fixed-rate sectors on an absolute return basis, although as the macroeconomic environment moves towards stabilisation, this is beginning to normalise. From a slightly different lens, the sub-investment-grade (sub-IG) sectors screen more positively on an absolute return basis than the investment-grade (IG) sectors.
Following the introduction of four new sub-investment grade debt sectors in real estate and infrastructure last quarter, we have introduced two new structured finance sectors to the model, in line with the launch of recent strategies. The two new sectors provide an illustration for both the UK and Europe. The European structured finance sector screens more attractively than the UK, which is representative of the type of opportunities available in the region.
Figure 1: Relative return across sectors (risk verus expected return over five years, in per cent)
Past performance and projections are not reliable indicators of future returns.
Note: Risk is ex-ante, based on the standard deviation of 5,000 forward-looking internal rate of return (IRR) simulations.
Source: Aviva Investors, Q4 2024.
Figure 2: Return/risk: Return per unit of risk
Past performance and projections are not reliable indicators of future returns.
Note: Risk is ex-ante, based on the standard deviation of 5,000 forward-looking IRR simulations. All data for illustrative purposes only. The charts above do not depict specific AI strategies or funds.
Source: Aviva Investors, Q4 2024.
Real estate equity
Over 2022 and 2023, the real estate market went through a period of negative capital growth. As such, the real estate equity sectors struggled to demonstrate relative attractiveness during that time. However, in June 2024, the UK and European real estate markets saw a return to positive capital growth. On a sector-by-sector basis, this story has been a little more differentiated, with industrial, residential and retail real estate participating in this journey, while offices lag and continue to see negative capital growth.
Within the real estate market, one of the key themes playing out has been a focus on quality
The second half of the year saw a slight improvement in sentiment in the real estate market, alongside a slight uptick in activity. Within this activity, one of the key themes playing out has been a focus on quality.
Looking ahead, the trajectory for yield movement looks more positive, with yields expected to be mostly flat or trend slightly lower. We anticipate momentum to pick up in 2025 as yield compression starts to accelerate, although we do not expect yields to return to their previous lows. Overall, with a recovery in sight, the potential returns and relative value offered by the real estate sectors is strong.
Since our previous relative value views, expected returns for the real estate sectors have risen slightly, alongside an increase in the expected return per unit of risk achieved.2 The industrial and residential sectors for both the UK and Europe continue to screen as the more attractive ones, and we expect capital availability will be key to unlocking returns more widely. Meanwhile, with relatively weak expected rental growth, the European retail sector remains the laggard.
Infrastructure equity
Over 2024, infrastructure discount rates generally stabilised, although pockets of expansion still remain. The infrastructure equity sectors we analyse are focused on renewables (such as wind and solar), supporting the activity stemming from the ongoing energy transition.
Since our previous update, the Spanish solar model has seen a change in methodology around power prices, resulting in a slight reduction in expected returns, but the absolute return remains attractive.3
Discount rates have continued to rise slightly in medium-scale wind
In the wind sectors, discount rates have continued to rise slightly in medium-scale wind but have remained stable in utility-scale wind. The increase in the medium-scale wind discount rates reflects the risk associated with potential maintenance costs of geographically dispersed assets.
Taking infrastructure equity as a whole, the returns per unit of risk have typically increased since our previous view but, in keeping with the increased level of risk associated with the asset class, remain slightly lower than in the other sectors analysed (see Figure 2).
Real estate long income
Over the past year, real estate long income (RELI) sectors have repriced to higher risk-free rates and benefited from the stabilisation of the real estate cycle. As such, they are screening attractively on an absolute return basis (see Figure 1).
The general trend for RELI has been an increase in the expected returns over a five-year horizon
On a short-term analysis basis, the general trend for RELI has been an increase in the expected returns over a five-year horizon. The UK and Europe screen comparably on both an absolute return and a return per unit of risk basis (see Figure 2).
Real estate and infrastructure debt
Against a dynamic economic backdrop, rates remain high and opportunities across the debt sectors continue to look attractive. The debt market has seen a general improvement in sentiment over recent periods, alongside an uptick in the level of deal activity and competition.
Real estate and infrastructure debt continue to screen attractively from an absolute basis across both the UK and Europe (see Figure 1). Absolute returns have subsided slightly from the highs seen at the peak of the hiking cycle, but the attractiveness remains. On a return per unit of risk basis, the debt sectors screen attractively when compared to the equity sectors (see Figure 2); however, the debt sectors are inherently lower risk, so with attractive return expectations, this relative comparison would be expected.
For both real estate and infrastructure five-year horizons, the floating-rate sectors screen more attractively in the UK
When comparing the fixed and floating debt sectors in the UK, for both real estate and infrastructure five-year horizons, the floating-rate sectors screen more attractively. However, over a full life horizon, this phenomenon has started to reverse, as both the fixed and floating infrastructure debt sectors screen comparably. For both real estate and infrastructure debt, fixed-rate debt should begin to screen more attractively as rates stabilise.
When considering the UK and European sub-IG debt sectors for both real estate and infrastructure, our analysis continues to reveal greater return potential than for comparable IG sectors. In addition, the sub-IG sectors have a slightly different risk profile to IG, offering diversification benefits.
Private corporate debt and structured finance
Over the course of 2024, the macroeconomic environment has broadly stabilised, and central banks have started to cut interest rates. Private corporate debt (PCD) is quick to reprice to public debt, and as such, it saw credit spreads tighten over the year.
UK mid-market loans have been boosted since our previous view, as a result of rising interest rates (see Figure 1), and the sector continues to screen more positively than its European equivalent.
The return per unit of risk for private placements has remained at a comparable level to our previous analysis
In parallel, while the mid-market loans sectors remained healthy, margins and upfront fees in private placements continued to contract. The return per unit of risk for private placements has remained at a comparable level to our previous analysis, whereas it has improved for the mid-market loans sectors.
As discussed above, we have introduced two new models covering UK and European structured finance. The UK model is indicative of the relative value of a residential mortgage-backed security (RMBS)/ asset backed security (ABS), while the European model reflects the relative value of a collateralised loan obligation (CLO), for which there is less of a market in the UK. As a result, and reflective of the differences in the underlying opportunities, the European structured finance sector screens more attractively than the UK on an absolute return basis.
Conclusion
The outlook from the relative value models is currently constructive on private markets in aggregate. Debt sectors remain an attractive opportunity thanks to high rates, and equity sectors appear to have reached the end of their market cycle. As a result of recent political events, the macroeconomic uncertainty remains heightened. The broad trajectory remains, it just might take a little longer to get there.
Aviva Investors’ proprietary real assets relative value framework
We have developed a methodology to compare return and risk across private markets on a consistent, forward-looking basis. We analyse the fundamentals of each sector to understand the factors driving performance based on a cashflow approach. Some of our underlying assumptions, such as inflation and interest rates, are relevant across multiple sectors, while others, such as credit defaults and recovery rates, are only relevant in specific sectors.
We then craft multiple forecasts for each factor, which feed into the cashflow models at a sector level, and run multiple simulations, pulling in relevant factors to end up with a range of potential returns. The mean of this distribution is the expected return. We also calculate the standard deviation of all calculated returns. We define “riskier” sectors as those with a wider distribution of returns at the end of the holding period, not volatility of returns from year to year, as we believe this is the most relevant measure of risk for most clients.
Our methodology provides a quantitative assessment of the risk-adjusted attractiveness of each sector, which addresses the lack of historical price transparency. We can also identify key risk drivers for each sector to understand diversification benefits. All factors feeding the models are correlated, meaning the return and risk of all sectors are also correlated. This enables us to build portfolios and optimise allocations, bridging the gap between the needs of increasingly sophisticated clients and the opacity of the private market.
The results produced by this methodology allow us to compare risk and return at market level. Manager skill and the specific characteristics of the investment strategy and individual assets mean returns could be significantly lower or higher than those presented.
Our assumptions
Our analysis reflects UK SONIA and European Euribor, five-year gilt and bund yields, inflation assumptions, corporate credit default rates, real estate yields and vacancy levels, among other sector-specific assumptions.
