Portfolio outcome: Enhanced income

The era of low rates has suppressed yields from traditional public market income-generating assets, such as high yield bonds, and sent investors searching for income from private funds.

Private income-generating assets can offer investors several advantages over their public market counterparts. First, private debt transactions, both on the corporate and real assets side, are highly negotiated and thus can include a variety of items that provide downside protection in the event of default. There is also a potential return premium offered above public markets.

Allocating to illiquid enhanced income asset classes can increase risk-adjusted returns in the portfolio. Within enhanced income, more equity-like asset classes are able to enhance a portfolio primarily through increasing absolute return levels, while simultaneously adding novel risk factors (e.g. brownfield infrastructure and value-added real estate). Others offer significant yields with more downside mitigation potential than is available in public markets at the same levels of return (e.g. core real estate, subordinated real estate debt, and mezzanine).

Direct lending may also be used to deliver enhanced income depending on the risk-return of the underlying credits (e.g. second-lien loans) and structure (e.g. how the loan portfolio is financed). The specifics of the individual portfolio (yield targets, public allocation, etc.) will dictate the exact mix of these assets, but each can be powerful in building a better portfolio for enhanced income investors.

Mapping the private enhanced income asset classes

Below, we show a market-weighted breakdown of the private enhanced income asset classes and the risk characteristics of a proportionate allocation to them. We use the closed-end fund universe to set the market weights and the Aladdin economic risk model for the risk decomposition.” (I assume “Aladdin economic risk model” is not a proper noun.)

Portfolio impact of a market-weighted enhanced income allocation

Having mapped out the available investment choices, we now explore the potential risk-return advantages of a diversified allocation across these asset classes. As an illustrative base portfolio, we consider a 60%/40% public equity/bonds portfolio with a 5% annual spend. According to the analysis presented in The Core Role of Private Markets in Modern Portfolios paper, this portfolio conservatively has an illiquidity budget of 31%. We use that illiquidity budget to size a market-weighted allocation to the private asset classes, funding the re-allocation pro-rata from the public equity and public bond budgets as both asset classes may contribute to income generation, e.g. dividend equity or high yield bonds.

Core real estate equity

• Core real estate equity refers to investments in low- to moderate-risk real estate, where returns are mainly generated through rental income and income growth. Core real estate strategies target stabilized, fully leased, secure investments in major core markets. These assets generally include properties with in-place, long-term leases to high-credit tenants and Class A buildings in desirable locations. These buildings are often well-kept and require little to no improvements on behalf of the new owner. These investments typically utilize minimal leverage (0% to 30% LTVs).
• Competition for global core real estate assets has driven pricing higher. As a result, cap rate compression, a key driver of performance in recent years, has slowed, as evidenced by near all-time lows across the U.S., Canada, Developed Europe, and Developed Asia.
• Fundamentals, however, remain relatively strong, as evidenced by cap rate spreads over sovereigns and near all-time high occupancy levels. For investors seeking modest returns through durable income, core real estate remains a viable option as market fundamentals continue to support cash flow generation at the property level.

Brownfield infrastructure equity

• Brownfield infrastructure equity refers to an investment in operating infrastructure assets (i.e., post-construction and generating revenue). These assets provide essential services to the public in sectors ranging from power and energy to transportation, communication, water and social needs such as student housing. Brownfield investments can either involve 1) an existing, income-generating asset where value can be created through improvements, repairs, or expansion or 2) operational assets with no need for improvements, where investors earn returns through the income generated by the project and potentially spread compression upon exit.
• Brownfield infrastructure equity is dominated by the energy and power sector. In energy, burgeoning production of oil and natural gas from shale has been a key driver of deal flow. In power, natural gas and renewables (both wind and solar) lead the way. Furthermore, infrastructure to support the export of low-cost U.S. natural gas (including pipelines and liquefaction facilities) continues to draw investment.
• Investors in this asset class must be aware of the embedded commodity and duration risks to which they are exposed. While investors can mitigate many of these risks through long-term contracts with highly rated counterparties, we recommend particular focus on possible mismatches between the useful life of the assets and the investment holding period (and the corresponding exposure to discount rates on exit).

Mezzanine corporate debt

• Mezzanine corporate debt is typically junior capital, often including some equity upside (via warrants, etc.) for investors. The investment may be structured as secured debt, unsecured debt, holdco debt or preferred equity, usually sitting just above the common equity tranche in the capital stack. Venture lending can be a subset of this category as well, though some participants consider it as a separate strategy. Mezzanine investments may include a payment-in-kind (PIK) component due to the weaker cash flow profile of many issuers.
• Amid growing investor concern about a macro downturn, we favor situations that are less dependent on the economic cycle. The ability to prudently price risk and exercise patience is crucial.  Moreover, it will be key to identify credits that present more idiosyncratic resilience whether from their business models or through their associated transaction structures. Specifically, a more conservative approach to sectoral exposure (away from commodities and cyclicals) may offer improved risk/reward.
• As in direct lending, weakening credit underwriting has likely flowed into junior capital investments to some extent. Looking at total leverage as a proxy for credit quality, we see that total leverage has crept up to ~5.5x for 2018 vintage deals, compared to under 4x for deals after the financial crisis. Moreover, the covenant packages have trended weaker, while the earnings quality also likely has become weaker due to the inclusion of substantial add-backs to EBITDA (some of which may not be truly “recurring”).

Value-added real estate equity

• Value-added real estate equity refers to investments in moderate risk properties, where returns are generated through a combination of building improvements and rental income. Often amplifying returns by utilizing leverage (generally between 50% to 70% LTVs), strategies typically target properties that have in-place cash flow but seek to increase that cash flow over time by making improvements to or repositioning the property. Such changes could include making physical improvements to the asset that will allow it to command higher rents, increasing efforts to bring in quality tenants, or improving the management of the property (and thereby lowering operating expenses).  If successful, value-added projects will typically generate higher financial returns to investors than core investments, but with a higher level of risk.
• Value-added real estate provides investors the ability to capture complexity premiums, which is a valuable proposition in a market that is characterized by uncertainty and near-record pricing.
• Despite frothy levels, current market valuations are supported by healthy cap rate spreads and sound leverage levels. We believe this support provides protection in a downside scenario. Overall, value-added pricing remains attractive as investors, through active management, seek to generate idiosyncratic returns, which can help mitigate potential volatility in interest rates.

Subordinated real estate debt

• Subordinated real estate debt includes B-Note and mezzanine investments with LTVs generally falling between 60% and 80%. Subordinated real estate debt is the layer of financing junior to a first mortgage but senior to common equity for a single real estate property or group of commercial properties. A B-Note is a junior/subordinate interest in a first mortgage collateralized by a lien on the property and typically has an LTV between 60% and 70%. On the other hand, a mezzanine loan is secured by a pledge of equity interests in a borrower who owns the real estate and typically has an LTV between 70% and 80%.
• Subordinated real estate debt investors can take advantage of reasonably strong real estate fundamentals while limiting their exposure to lofty equity valuations.
• In addition to strong fundamentals, equity cushions have increased in recent years, which is even more meaningful if you consider that rent payments by corporate tenants are senior to interest payments on their own corporate debt.
• Since the asset class is collateralized by a real asset, in the event of a severe correction where the equity tranche is wiped out, debt investors could seize control of the building and manage the asset through an ensuing recovery.