Emmanuel Deblanc
CIO, Private Markets
14 min read
Key takeaways:
- Private markets have faced challenges due the rise in real interest rates and the decline in M&A activity.
- We see opportunities in the ‘value-add’ and opportunistic areas, particularly real estate and infrastructure, while structured credit looks attractive due to ongoing retrenchment by banks.
- We believe there are grounds for optimism but investors need to have a clear focus and be selective in their approach .
Contents
Significant momentum in structured credit
James King
Head of Structured Credit
The prevailing market consensus is that both interest rates and inflation in developed economies are on an eventual downward trajectory. However, the actual outcome remains uncertain. Amid this lack of clarity, investors are understandably asking where they should be deploying their capital. Structured credit is an area that M&G Investments believes offers rich and diverse opportunities in a variety of market and macroeconomic environments, providing many options for investors depending on their risk/return and liquidity preferences. The market and macro background is important, but the case for structured credit is not dependent on any particular environment and indeed has demonstrated robust through-the-cycle performance.
The structured credit market has seen significant momentum in recent years, driven by both demand and supply-side factors. Notable of these supply drivers has been the pullback by banks from certain lending activities due to stricter regulatory capital requirements which have been brought in following the global financial crisis (GFC). This regulatory pressure has been coupled with episodes of disruption within the global banking sector, led by and large by higher interest rates, which has shone the light once again on bank balance sheets and the critical need to deleverage. Private, non-bank finance has consistently stepped in to fill this funding void to the real economy, either as providers of debt capital, or as buyers of loan portfolio assets.
The array of available investment opportunities across the asset class has grown exponentially but we believe this growth is set to continue. Offering investors the ability to access high quality performing loan pools originated by core banks and non-bank lenders alike, structured credit has the potential to target different parts of the capital structure and source investments from both public and private markets depending on risk-reward. The asset class has consistently offered excess returns and reduced return volatility relative to traditional fixed income investments, together with the strong structural protections inherent within the asset class, which we believe should prove particularly attractive to investors in the face of an ever-changing investment landscape.
The ability to access such compelling opportunities requires a very specific skillset and suite of capabilities. In particular a manager needs to demonstrate deep structured credit experience in order to access unique and differentiated deal flow. Within this investment arena, a vast network of relationships matter, with well-established managers best placed to secure a robust pipeline of deals across a unique and evolving opportunity set.
Active in private and alternative debt markets for over 40 years, M&G Investments is an originator and investor spanning the entire asset universe and referencing a range of diverse collateral types. We have a large structured credit team comprising over 40 professionals managing €7.5bn1 of dedicated structured credit assets. We believe this provides M&G Investments with both the resources and expertise to successfully leverage this exciting area of the wider fixed income complex now and going forward.
[1] Source: M&G, as at 31 December 2023
A well-timed entry for real estate debt?
Dan Riches
Head of Real Estate Finance
With equity-like returns for credit investing, real estate debt is attracting increasing attention from investors globally, as well as new market entrants.
In our view, the benefits of the asset class stand out in the current economic environment, given that debt benefits from a significant equity cushion, in addition to typically predictable cash flows. The ability to lend at lower debt bases, based on a reduction in property values, can further improve risk dynamics. Loan margins also appear attractive on an absolute and relative value basis. Investing in real estate debt today therefore looks well-timed, in our view.
Traditional bank lenders continue to retrench from the asset class as a result of increasingly onerous regulatory capital requirements, while falling values and higher interest rates mean banks’ focus is likely to turn towards performance and existing loan books. However, we are cautiously optimistic that systemic risk remains an unlikely scenario given generally lower leverage and higher underwriting standards throughout the last lending cycle, and a more diverse lender base.
For non-bank lenders, the opportunity to continue to grow market share remains significant. The UK will likely remain a key focus as one of Europe’s largest property markets, with a favourable loan enforcement regime. Further reduction of bank lending in markets such as Germany and France, where bank lenders represent a large share of the market, could also offer a pronounced deployment opportunity for non-bank capital. A granular understanding of country-specific issues is necessary, however, given the complexities involved in navigating nuanced property market dynamics and legal regimes.
Banks’ retreat coupled with downward property valuations is likely to create a sizable debt funding gap over the coming years – estimated at €93 billion by 20262 – though it is an evolving picture, with changing rates and capital values starting to stabilise.
In our view, refurbishments and new developments represent a compelling opportunity for non-bank lenders to provide moderate leverage at potentially attractive returns. Regulation has made this type of lending unviable for some banks, while others are pulling back over concerns about the impacts of cost inflation and increased insolvency risk in the construction supply chain. Another consideration is the fact that projects can often take longer and be more costly than anticipated to complete. However, these risks can be factored into loan metrics through rigorous due diligence.
In particular, we are seeing an increasing requirement for ‘brown to green’ property transitions, with the potential to create assets that meet modern occupier requirements and help to regenerate city centres. A solid understanding of sustainability costings is necessary as part of these financings, since the capex required to complete heavy refurbishment of this kind can be challenging to quantify.
[2] AEW Capital Management, August 2023.
An ongoing recovery for global real estate?
Richard Gwilliam
Head of Global Real Estate Research
Following a challenging couple of years, we expect global real estate markets to continue to recover throughout the rest of 2024, with stabilising capital values and largely positive rental growth prospects. Nevertheless, we believe a focus on income and asset quality will be important in the new cycle, as investors and lenders become more selective, and investment performance differentials become apparent between assets of higher and lower quality. New investments made in the next 6-12 months are likely to be recognised as a robust vintage in the long term, benefiting from high entry yields and strong occupational profiles.
Nominal rental increases are expected to be driven by a stronger economy – particularly in Asia – or at least an uptick in economic growth, which will spur occupier demand. Challenged development viabilities have limited the supply pipeline in most geographies – though there are some examples of the converse – which should help to stimulate rental growth over the next few years, in light of acute supply-demand imbalances.
Though refinancing challenges remain, the risks within banks are largely well understood and appear modest. The risk of wider systemic stress is unlikely, in our view, but lender behaviour and financing availability will be a key determinant of asset bifurcation and performance moving forward.
Despite some challenges and risks on the downside, with investment market stabilisation in sight and the global economy appearing set to recover, the outlook for property is looking increasingly optimistic, in our view. As such, 2024 may present the most attractive buying opportunity for real estate that has been seen for some time.
Digital infrastructure – an energising opportunity
Toby Rutterford
Associate Director, M&G Real Assets, Impact and Private Equity
The world is becoming increasingly digitalised and data has been called the lifeblood of the knowledge-based economy. This shift is made possible by digital infrastructure, the physical infrastructure required to support the delivery of digital technologies in the everyday lives of global communities.
The M&G Real Assets team believes that digital adoption represents a multi-billion-dollar investable opportunity. Significant capital expenditure (capex) will be required to keep pace with technological change, and evolving business and consumer practices globally.
However, the digital infrastructure market is at an intersection. Demand for digital services is increasing at a pace beyond the market’s ability to build the critical infrastructure required to promote their delivery. For private market investors, this creates a nuanced and, in our view, compelling investment opportunity with long-term, persistent and systemic tailwinds.
Rising demand for data centres
The digital infrastructure market has evolved over the past decade. From mobile network towers to the evolution of 5G technology and fibre internet networks, we have seen a new wave of investment opportunities that offer stable cashflows, often with escalating rates during the contract life, and defensive characteristics, making them attractive to infrastructure buyers.
As the demand for data has increased, data centres, a collection of servers in a dedicated structure, has become an increasingly investable asset class, key to the delivery of digital services. This demand, driven by growing use of outsourced IT capabilities (the Cloud) and widespread adoption of artificial intelligence (AI), is expected to grow rapidly in the coming years.
Like towers, data centres offer hard-to-replace, contractual cashflows which, given their critical nature, are highly attractive to infrastructure investors.
A key challenge of digital adoption and greater demand for data centres, is the accompanying increase in power consumption. Generative AI, in particular, is seen as a “game-changer” when it comes to demand for electricity. According to the International Energy Agency, on average, a single ChatGPT request is nearly 10 times more power intensive than a simple Google search3.
In our view, the data centre market is at an inflection point where demand has accelerated beyond the market’s ability to absorb new capacity. We observe near record low vacancy rates across the US and Europe. We believe this makes it an attractive time to deploy capital.
However, we would argue that practical challenges and market nuance mean that not everyone deploying capital into this theme today will be successful.
Practical considerations
The International Energy Agency estimates that 460 terawatt-hours (TWh) of electricity was consumed by data centres in 2022. Growth in consumption is projected to reach more than 1,000 TWh in 2026 due to the aforementioned growth drivers. That increase is greater than the annual electricity demands of Germany!4
This level of demand, at a time when supply is constrained in key markets, creates several practical execution considerations which we believe will shape the investment opportunity.
There are several key diligence items we believe investors should be focused on, namely: grid capacity constraints which are a limiting factor in many markets; competition for skilled labour and availability of key components which continues to be a challenge; sustainability considerations associated with the delivery of power (water and energy use as well as carbon intensity); location and counterparty creditworthiness.
As we stand today, there is a risk that the rising tide lifts all boats; however, locational specific factors and strength of contract underpinning the assets are key to delivering long-term value and minimising stranded asset risk, in our view.
Accessing themes through private markets
We believe there are two significant investment themes emanating from the current paradigm: providing digital capacity through selective investment in data centres and adjacent infrastructure; and providing energy solutions which unlock capacity constraints and, in the process, decarbonise the energy mix.
In our view, private markets are the optimal way to access this significant growth opportunity today. Public markets tend not to reward capex heavy strategies in infrastructure where the focus can be on delivery of quarterly earnings and yield.
In contrast, we believe the long-term patient nature of private markets offers investors an attractive route to participate in this once in a generation opportunity. We do not believe the heightened take-private activity in the data centre market over the past few years to be co-incidental, and likely where a significant proportion of the growth will be observed.
[3,4] Source: International Energy Agency (IEA),
“Electricity 2024: Analysis and Forecast to 2026”, January 2024.
A spectrum of possibilities within private credit
Catherine Ross
Head of Private Credit
While the global economy may be experiencing a downturn, we believe investment opportunities exist that could allow investors to both mitigate risk and secure attractive long-term returns. Private credit is a strategy which potentially has these characteristics. Indeed, one of the largest areas of private credit, direct lending, can be capable of delivering reliable income stream potential together with high risk-adjusted returns.
With balance sheet restraints restricting lending by public banks, direct lending has stepped in to fill the void. Together with a trend by both small and larger corporates to remain private for longer, the direct lending market has expanded significantly. However, we believe its attractions have enduring appeal. As direct loans typically are floating rate, they naturally provide a hedge when interest rates rise. Coupled to this, the asset class may provide portfolio diversification benefits due to the contractual nature of returns offered and mitigate equity market volatility given limited mark-to-market price risk.
With global economies unsettled, direct lending is not risk free. It is not immune to weaker overall business conditions and any serious recession would lead to higher default rates. However, tighter documentation of direct lending deals via maintenance covenants, together with the advantage of a greater depth of access to both company management and financial information, give the asset class a clear advantage. In our experience, this deeper due diligence can limit the risk of borrower default.
A final compelling characteristic of the wider private credit universe, in our view, is its ability to typically generate real income returns over long term inflation (c.2%). More traditional credit classes, such as investment grade corporate debt and government bonds, struggle to achieve this.
Success within private credit, and direct lending specifically, depends on the expertise and experience of the private corporate lender. M&G Investments has been investing in direct lending since the emergence of the asset class in 2009 with a large and highly experienced investment team with over 50 professionals.
For investors prepared to broaden their investment horizons, we believe private credit offers deep attractions given its ability to deliver both real income and high risk-adjusted long-term returns.
