The rise and rise of unlisted assets
A combination of higher yields, lower volatility, and reduced correlations to traditional assets have seen a boom in unlisted investments in recent years. For example, in the three years to December 2019, data from The Association of Superannuation Funds of Australia (ASFA) shows that investments in unlisted property grew at almost twice the pace of those in listed property. It’s not just super funds either, anecdotally, there’s been an increase in the number and the range of these products available to retail investors, covering everything from unlisted credit to private equity and anything in between.
In this first part of this three part series, I reached out to three experts to get a better understanding of their sectors and what's driving the popularity of unlisted assets. David Leslie from Ellerston Ventures discusses venture capital, Tim Slattery from APN Property Group discusses unlisted property, and Rob Mead from PIMCO discusses private credit.
Investing in the next big thing – before everyone else
David Leslie, Ellerston Capital (JAADE)
Simply, we invest in Australia's new economy, namely Australian private companies with established revenue, proven business models and high levels of compounding growth. These are companies that aren’t listed on the ASX, have a technology bias, and are looking for additional resources (funding, advice, networks etc.) which will help them to continue their growth trajectory and reach their strategic goals.
Looking back, we see many notable companies that have followed this path during their time being unlisted - US giants like Google and Facebook, and locally in Australia the likes of Seek, Carsales and more recently Afterpay. We believe that adding unlisted Australian growth companies to a traditional portfolio provides greater diversification, together with the potential for higher returns and lower volatility.
Some of the factors which we see driving these higher returns relative to listed markets include a greater alignment of interest, more long-term focus, and considered exit strategies. By taking an active role in our investments, most notably Board positions, we have greater control over outcomes, working closely with founders and management. The JAADE team has a broad and relevant set of skills to achieve this, through the operational experience of Toni and I, the early stage experience that the Ellerston Ventures team provide, and the broad, well respected knowledge, advice and resources which Ashok Jacob and the team at Ellerston provide.
Following the example of The Future Fund
There is a greater level of emphasis on asset allocation within a diversified portfolio, particularly with listed markets valued at current levels, and so it makes sense to add diversity to mitigate risk and provide a greater level of return in an environment of anticipated lower expected returns & heightened volatility moving forward. Therefore, there’s a greater focus on investing not just across listed markets but also in unlisted markets. This has been an area of focus for institutional investors globally for quite some time, and is at the heart of the JAADE strategy.
Firstly, it’s difficult for smaller investors to directly access these private assets, and secondly by investing within a portfolio of assets as we do, the risk can be spread across multiple investments. By JAADE being listed on retail platforms such as Panorama and Macquarie we provide access to these assets for retail investors for the first time. As a comparison, Australia's $165bn Future Fund (regarded as one of best sovereign wealth investors in the world) has a current allocation to unlisted investments of around 30%. Within that, allocation to private equity stands at around 16%. Contrast this with current average allocations to PE within Australia of less than 1% and you can see that many Australians have very little exposure to this asset class and are under exposed to the new economy of fast-growing private technology companies.
Given the strong initial levels of interest we have received after just one year, we are very confident that the trend within a diversified portfolio towards greater allocation to unlisted assets and in particular PE will continue, as investors become increasingly aware of the portfolio characteristics and potential for the higher return profile of Australian PE relative to other asset classes, including listed Australian equity.
More good times ahead for unlisted property
The easiest way to explain commercial property investment is through the great Australian love affair with residential property. Everyone’s familiar with residential property; you buy an apartment or a house and rent it out. Depending on what and when you’ve bought over the past few years you’ve probably done well. There’s been solid increases in prices and the added benefit of negative gearing along the way.
The uglier truth is the rental income yields from residential property are generally pretty miserable – it’s not uncommon to get less than 2% per year after all expenses.
While interest rates are low and while commercial property yields have reduced over the past few years and values have risen, commercial property as a general statement offers a much higher rental yield. Annual cash yields of 6-7% are still available today with well established businesses and governments as your tenants, typically much longer leases and with the tenants bearing most if not all the running costs mentioned above. There’s also the prospect of capital and income growth in addition to the regular income yields we are talking about and the commercial property sector has a very good long-term performance record.
What sorts of assets are we talking and what are they used for? The last time you went to a meeting in an office building, stopped to fill your car up, had a trip to hospital or ordered that new pair of shoes online chances are you were using a commercial property. We are talking shopping centres, warehouses, hospitals, childcare centres, office buildings, data centres and the list goes on!
Next is “Hey, I’m not Frank Lowy or Donald Trump - how can I afford an office block?” Just as friends sometimes band together to buy a residential property, unlisted property trusts allow a group of investors to pool funds to buy commercial real estate. Each owns a slice of the property just as a group of friends might own a portion of a house. You can invest in a commercial property fund from as little as $1000 and receive a regular distribution payment. A lot of commercial property trusts will also pay a good percentage of the distribution as a tax deferred distribution –the income you receive reduces your original cost base rather than that year’s taxable income which can provide a tax benefit.
The other key difference is while residential property is often funded with up to 90% debt, commercial is usually much lower – 20-50% is typical and this is very important when it comes to thinking about investment risks.
Property trusts offer professional, independent management and clear financial objectives and reporting. Our job is to find great properties and make it easy (and profitable) for our investors.
Reasons for the rise in unlisted property
Firstly, falling interest rates have made life difficult for income investors. Unlisted commercial property usually delivers a more stable and comparatively higher income than conventional assets like shares. As rates have fallen, commercial property yields (although they have fallen too!) look more attractive.
Secondly, investment income derived from rents rather than fluctuating corporate profits is more reliable. Compared to listed asset markets, commercial property is less volatile. Income investors like that. If you think of owning the office building leased to the bank rather than owning the bank which occupies the office building you can see the monthly set rents they are paying under a long term lease are typically much more reliable than the profits to bank shareholders who take the good with the bad.
The other thing attracting people to our sector is that you are investing in ‘real’ assets – that is, you can go and touch or kick them, they have a real, physical value. People like the idea of investing in ‘bricks and mortar’ and it can provide a good hedge against inflation.
As to why unlisted investments are increasingly attractive versus listed investments, I think a lot of it is to do with people’s views on the correlation of their returns with other asset classes such as shares. Unlisted investments are not readily tradeable like shares on the ASX, so there’s not the same volatility in pricing. An unlisted investment is valued periodically by an independent expert valuer. Unlisted investments are typically held for five or more years without the option of selling on a day to day basis. Some people will like seeing a nearly constant ‘market value’ of their investment while others are content to invest for the five years, collect the income and sell the asset at the end.
For these reasons, over the next five years I think the popularity of unlisted property assets will continue to increase. Given my job, you might expect me to say that, but I also think it’s true.
Searching for alternative sources of income
Robert Mead, PIMCO
In the aftermath of the global financial crisis, banks retreated from many forms of lending, creating what were widely referred to as funding gaps. Asset managers responded by raising investor capital to provide private loans to borrowers that were unable to access debt from either banks or capital markets. These private loans are collectively referred to as private credit.
Within the private credit space, PIMCO focuses on three main areas: residential real estate-backed credit, commercial real estate-backed credit, and speciality finance (niche areas such as litigation financing or receivables financing).
Since private credit investments are directly originated and held by a single or small handful of investors, there is very limited, if any, public information about the credit. As a result, the ability to sell to another investor is very limited, so the vast majority of private credit is considered a hold-to-maturity asset.
Investors should be prudent about where they invest
With current low yields and tight spreads in traditional liquid fixed income markets, many investors are looking for attractive sources of income and higher returns, which may be available by assuming credit risk in this private, generally more illiquid form. Looking forward we believe that global interest rates are likely to remain low over the intermediate term, which will continue to drive demand for these assets as investors continue to search for opportunities to enhance income and returns over the years ahead.
Having said this, some of these funding gaps are closing. Due to the demand for these assets, some segments have seen an influx of capital, while banks have also selectively re-entered many markets, accelerating the closure of some funding gaps. For instance, the corporate middle-market sector has seen an oversupply of capital which has been reflected in less attractive pricing, weaker capital structures and lighter covenant protections.
Importantly though, funding gaps in key markets are closing at different rates. We therefore believe investors should be prudent about the areas of the private credit markets to focus on. By taking a broader approach to private investments, investors can bypass the crowds in middle-market lending and other sectors and continue to rely on private credit in seeking to meet their income and return goals.
While it's tempting to view them as an homogeneous group, in reality, unlisted investments are broad and diverse. They offer reduced volatility and potentially high returns, but often at the cost of locking your capital in for a time.
Keep an eye out for the next part of this series, where we discuss some of the myths and the risks in unlisted assets.
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Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.
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