Pension Funds: The impact of higher rates on private assets

For a variety of reasons, pension funds have increased their exposure to private assets in recent years. From virtually nothing three decades ago, funds in Europe now commonly have between 10% and 15% of their portfolios allocated to illiquid investments like private equity, real estate (including farmland and timberlands), infrastructure and private debt. In North America, the weighting is often closer to 30% and there are even some funds where it’s more than half. 

Interest in private assets increased in part because fund managers needed to generate yield, which they couldn’t do from bonds in a more than decade-long low interest rate environment. 

Private assets can also increase diversification and decrease risk, with some assets commanding an illiquidity premium, resulting in higher returns. There are other benefits, too: valuations can often keep up with the pace of inflation, and these assets, removed from the emotion of public markets, tend to be less volatile than public securities. Holding private assets looked like a masterstroke in 2022, when stock and bond markets both suffered double-digit declines. 

A more challenging return environment  

These days private investments don’t look as favourable as they once did. Different categories of assets are also impacted in different ways. For instance, private equity has benefited from historically low interest rates, which has made it much easier for companies to take out cheap loans to buy businesses. Higher rates could reduce the number of attractive buyout candidates, or limit the ability to leverage the equity. As well, the weakened IPO and M&A environment could make partners less inclined or less able to sell portfolio companies. As a result, private equity businesses could end up holding companies longer than they want to, potentially generating lower distributions and thereby delayed cash income for asset owners. 

As with public equities, the cost of doing business for private companies has climbed with higher rates and inflation. Businesses may or may not have the leeway to pass those costs on to their customers. Regardless, the rise in bond rates means their ability to generate excess returns will be reduced from years past. 

Likewise with real estate, higher financing costs are reducing demand for properties and, as recently seen in residential markets worldwide, bringing valuations down. Refinancing at the end of a mortgage term could continue to get more expensive, and certain property classes, such as offices and retail, are still experiencing demand uncertainty left over from the pandemic since working and shopping from home persist. 

Consider the risks  

As we’ve already seen in public stock and bond markets, there may be greater dispersion in valuation and performance between different assets, asset managers and strategies as a result of the more restrictive lending environment. There is no rising tide of loose monetary policy to lift all boats. Overleveraged companies and funds could potentially find themselves in trouble. 

To date, the time lag between re-rating valuations in private versus public asset classes has served to create moderate overall portfolio volatility. But pension funds now face three kinds of risks related to their private asset portfolios. First, they have to maintain an appropriate allocation to private assets, in line with their long-term objectives and risk profile, which may be challenging. Second, they need their private assets to continue generating income for overall liquidity planning, which could be more difficult if underlying values decline. Third, there is some solvency risk, as declining valuations could cause plans to become underfunded or get more expensive for employers. 

What should plan managers and trustees do? Now’s the time to re-assess their portfolio allocations to determine their vulnerability to all three of these risk areas. Also, think about how to determine whether your portfolio structure will continue to meet your needs in both the short and the long term. Reach out to an Ortec Finance consultant for help.