May 13, 2024
In his latest article for IPE Real Assets, Charles Allen, Head of European Real Estate, sheds light on the alternative asset classes that are capturing pension funds attention. With a supply-demand dislocation as the driving force behind UK investment opportunities, Charles writes that “Buying British” is the logical next move for real estate investors.
While the government has its sights set on pension funds to meet political ends, policymakers should be careful not to overstep the mark. Yes, allocations to domestic quoted companies are continuing to slide. The Pension Protection Fund’s most recent Purple Book indicates that the proportion invested in UK equities has fallen to 7.6% (2023) from 38% pre-GFC as a weighted average. But there is more to investing in Britain than plc.
Consider the ascent of alternatives. Now a mainstay of institutional portfolios, average UK pension fund allocations to asset classes such as real estate, private equity, alternative credit, farmland, timberland and infrastructure sit at 14-15% (2023) versus 7-8% a decade before. This sea-change is principally driven by superior returns. Investors also say that capital invested is creating social as well as financial value for members and their pension providers – at home and abroad.
Across these asset classes, pension funds are already ‘Buying British’. Without persuasion from government, domestic and international pension funds appreciate that in needs-based subsectors like infrastructure, logistics and residential rental, there are secular trends – namely the ‘four D’s’, demography, decarbonisation, digitalisation and deglobalisation – and a supply-demand dislocation underpinning a case to invest in the UK.
Infrastructure is the fastest growing asset class in private markets, which comes as no surprise given that the digital transformation and the energy transition demands a new built environment; data centres, solar, fibre connectivity and battery storage being a few examples of nascent asset classes with huge catch-up growth potential. This is especially the case in the UK, where path dependency means we have one of the oldest infrastructure systems in the world.
A similar investment rationale applies in logistics, where the broadening of e-commerce markets is driving ground-up warehouse development. Here, UK stock is still relatively thin compared to the size of the addressable market. Nearshoring, onshoring and urbanisation only compound the structural undersupply in the sector, whose investors – seizing opportunities to generate predictable, long-term cashflows – will treat adjacencies like EV charging and battery storage as complementary forces, and where skill-sets can be transferred.
From a balance sheet perspective, pension funds are also prepared to adopt a more expansive risk profile in light of the compelling qualities of what we could call the ‘hybrid’ nature of income-generating real assets. By that, I mean to say that real assets possess both liability-matching and growth attributes. Lease payments are the natural match for long-term inflation-linked pension payments where reviews can stave off inflation that would otherwise erode the value of institutional portfolios.
Residential rental housing is another asset class that embodies these characteristics. In the UK (and, arguably, in most of the Western world) the opportunity set is universally characterised by two key factors: undersupply and non-institutionalisation. Pension funds can address the chronic undersupply of housing while ‘operationalising’ their platforms to deliver capital appreciation and income through the introduction of high-quality housing in an economy that suffers from disproportionately old and outdated stock. And ‘Buy British’, by creating social good.
As far as alternative real estate goes, I expect to see the continued rebalancing of portfolios in its favour. Continued global uncertainty, with no clear end in sight, means pension funds will be doubling down on their diversification efforts to capture counter-cyclical, risk-adjusted returns in asset classes where they can build portfolios of scale.
And as for mandating UK DC pension funds to disclose their investments in listed equities by geography, I’d suggest the government refrain from meddling with the operation of free market forces. There’s plenty to be proud of – and asset classes that are highly investible in the UK. Quoted companies will have their resurgence and arguably investors already recognise the undervalued nature of the FTSE. So let’s not be too hasty to say pension funds are under allocating to homegrown opportunities.