Real estate, infrastructure defy other asset classes with strong growth in 2022

Institutional investors' infrastructure and real estate portfolios took off in the 12 months ended Sept. 30, boosted by returns, a delay in write-downs and interest in sectors that can provide a hedge against inflation.

The results of Pensions & Investments' annual survey revealed that infrastructure assets of the top 200 asset owners were up 30.1% to $72.1 billion, while real estate increased by 22.1% to $511 billion.

By comparison, private equity was up only slightly, by 1.6% to $692 billion.

There was also a wide dispersion between the various types of private equity tracked by the survey. Mezzanine assets increased the most, albeit from a small base, by 19.2% to $6.2 billion. Buyouts, the largest category by asset size, squeaked up by 1.2% to $385.6 billion. The biggest losers were venture capital, down 18.2% to $62.9 billion in assets, and distressed debt, which fell by 15.8% to $17 billion.

Another alternatives asset class tracked by P&I, private credit, was also up double digits with a 12.5% increase to $98 billion.

Asset owners' private markets portfolios were buffeted by the sector's valuation lag. Unlike stocks and bonds, which trade daily, private market assets are valued by appraisal, which take longer. Some private market managers marked down their portfolios in the second quarter in response to the drop in equities and fixed income, but most of the fourth quarter write-downs are not expected to be reflected in investors' portfolios until March or April of 2023, industry insiders said.

"In June, we saw certain managers be more proactive based on mark-to-market comparables, but it was mixed. It was not across the board," said Scott Voss, Boston-based managing director and head of global primary team at HarbourVest Partners LLC, a fund-of-funds and secondary market manager.

This lag in valuations makes it tricky for asset owners to determine how their portfolios are being impacted by the denominator affect, which is a drop in public market assets pushing up private market actual allocations, investors say.

"(Private markets) firms may be going through their valuation process right now," said Jonathan Grabel, CIO of the Los Angeles County Employees Retirement Association, Pasadena, Calif., at the Jan. 11 board meeting.

In response to a question from a board member, Mr. Grabel added that the impact of the denominator effect on the $67.6 billion pension fund "is to be determined."

Pension fund officials won't know the full extent of the impact for three months or so from now, he said.

The areas with the biggest risk of write-downs are "some of the growthier investments across private assets, not only private equity," Mr. Grabel said.

"Companies that are profitable can weather any economic storm."

Companies that are not profitable depend on raising new capital, which they will get at the expense of better terms for the entity making the investment and at a lower valuation, Mr. Grabel said.

LACERA had $12.5 billion in private equity as of Sept. 30, up 13.5% from a year earlier, P&I's data show. The pension fund's real estate portfolio was also up, increasing 5.1% to $5.5 billion as did its infrastructure portfolio, which was up 43.8% to $3.3 billion.

At LACERA, part of the increase was due to returns. The pension plan's best-returning asset class for the 12 months ended Sept. 30 was real assets and inflation hedges, with a 9.2% net return outperforming the 6.4% benchmark.

Also during 2022, LACERA expanded its co-investment program to include real assets, Mr. Grabel said. The pension fund already co-invests in private equity, which helps reduce the fees for these investments, he said.

The $430.4 billion California Public Employees' Retirement System, Sacramento — the largest U.S. pension fund which also tops this year's lists of defined benefit assets in infrastructure, real estate and private equity — bet big on private markets. In July, CalPERS' board approved a new 5% private debt target, while also boosting private equity by 5 percentage points to 13% and increasing real assets by 2 percentage points to 15%.

In the past, CalPERS had a larger exposure to riskier real estate — value-added and opportunistic — and the pension fund was not compensated for the risk, said Nicole Musicco, CalPERS' CIO, at a Sept. 19 investment committee meeting. CalPERS' return for value-added was 5.9%, compared to 11.7% for its peer universe, and its opportunistic real estate return was 4.8% vs. 11.3% for its peer universe for the 10 years ended March 31, according to a staff presentation to the board.

"In recent years, the good news is ... that our program has transitioned back to core, and it's currently more than 90% of our real estate program," Ms. Musicco said during the same staff presentation. Core earned a 10-year return of 12% vs 9.9% for its peer universe.

The pension plan's core real estate portfolio outperformed the other asset categories due to the strong returns of its multifamily, industrial and data center portfolios, Ms. Musicco said. What's more, she added, CalPERS' real estate portfolio is underweight office.

Office properties remain one area of concern in CalPERS' real estate portfolio due to the long-term negative impact the COVID-19 pandemic is having on the office sector as well as certain transportation assets, said Sarah Corr, managing investment director for real assets, at the same meeting.

Part of the reason CalPERS' non-core real estate did not produce the expected returns is that it included development projects "that didn't work out," Ms. Corr said.

Now that most of its real estate portfolio is in core assets, CalPERS officials will "probably add some more value-add and opportunistic back in and that should perform better than the legacy has," Ms. Corr said.

At the same time, CalPERS is in the process of building up its exposure to infrastructure, since boosting its allocation in 2021, Ms. Corr said. The board on Nov. 15, 2021, increased real assets, which includes infrastructure, by 2 percentage points to 15%. The portfolio grew to $11.6 billion in June from $4.8 billion in June 2019, she noted.

"However, to meet the new strategic asset allocation targets, the infrastructure … portfolio needs to triple over the next three years," Ms. Corr said. "Doing this effectively and efficiently will require CalPERS to commit larger dollars to each investment."

For its infrastructure portfolio, CalPERS officials are targeting deal sizes of $2.5 billion, she said.

CalPERS' private equity portfolio has suffered from inconsistent investment in the asset class in the past, Ms. Musicco added That could be an opportunity, she said.

"In spite of ourselves, we actually have more room to do more in private equity than some of our peers, because we were late to the game" and many other asset owners around the world find themselves over-allocated to private equity and other private asset classes due to the denominator effect, Ms. Musicco said.

CalPERS staff could "backfill" vintages of funds its portfolio is missing in private equity, real estate, private credit and infrastructure by buying limited partnership interests on the secondary market, Ms. Musicco said.

More recently, at a Jan. 18 stakeholders meeting, Ms. Musicco said that staff also will be discussing direct investing in private assets, including private equity, infrastructure and real estate, with the board in 2023.

What's more, CalPERS "will be leaning more into renewable energy, energy transition with our partners," she said.

Overall, CalPERS officials aren't interested in "plain vanilla" investments in private assets but are looking for more creative investments such as emerging disruptive technology, Ms. Musicco said.

For investors with technology exposure in their existing private asset portfolios, these investments could be the poorest performers for 2022, said HarbourVest's Mr. Voss.

"If I had to guess, we could see technology-oriented portfolios in venture capital and buyout written down 5% to 7% at year-end (2022)," Mr. Voss said.

More traditional buyout deals that were not subject to the run-up in valuations of technology companies in 2021 could be flat to possibly down by 5% in the fourth quarter, he said.

Private equity managers became more speculative during the run-up in technology valuations and moved away from fundamentals, he said. "Companies became grow at all cost," Mr Voss added.

Now, technology companies are moving toward profitability, he said. "It's really is getting back to steady state long-term sustainable growth," Mr. Voss said.