Aaron Costello, Head of Asia, and Vivian Gan, Investment Director, Capital Markets Research

Asian and global market volatility surged in early 2025 as US tariffs triggered global growth fears. Given the export-oriented nature of most Asian economies and their sensitivity to global growth and demand, the region may bear the brunt of US tariffs. As such, Asia market volatility is likely to persist in the near term, particularly since US trade policy can shift abruptly.

With the United States and China locked in a tariff standoff, at least for now, a key question is to what extent China and other Asian economies will increase fiscal and monetary stimulus to offset the economic impact from US tariffs. Aggressive stimulus, particularly from China, may help to support growth and sentiments in Asia more broadly.

Considering the current environment of higher uncertainty and volatility, as well as global equity market concentration in US large-cap technology stocks, we view portfolio diversification is key in managing downside risks. We favour strategies that are more attractively priced, are less correlated to the broader market, or are able to capitalise on any dislocations that may result from economic stress.

In this edition of Asia Insights, we highlight:

• Within Public Equities: We view Asia ex Japan value-oriented strategies could add a layer of downside protection, given less demanding starting valuations and a differentiated sector exposure that is less concentrated in technology.
• Across Hedge Funds: Asia event-driven strategies warrant a second look today, given an improved manager competitive landscape and a current macro environment that is supportive of alpha generation. Event-driven strategies also tend to be less correlated to broader equity markets, and therefore could serve as a diversifying strategy amid current market volatility.
• Within Private Investments: We remain constructive on Japanese buyouts, given strong underlying supply and demand fundamentals. Deal flow is likely to remain robust as Japan’s aging demographics and ongoing corporate governance reforms continue to drive corporate actions. It may be further accelerated by dislocations created by US tariffs. Meanwhile, attractive entry valuations today and the availability of cheaper leverage lend support to continued capital inflows.
• For Real Assets: We see increased opportunities in Asia-Pacific value-add and opportunistic infrastructure today, given the region’s maturing regulatory environment and longer-term demand for infrastructure spending. We are positive today on data centers and renewable energy infrastructure, which are backed by strong fundamental demands while also less sensitive to potential growth and trade shocks.

Public Equities: Seek Diversification Through Asia Value-Oriented Strategies

Wilson Chen, Managing Director, Public Equities, and Vivian Gan, Investment Director, Capital Markets Research

Global equities saw heightened volatility in early 2025 as US tariffs added uncertainty to the global growth and inflation outlook. Markets also saw a tentative rotation in leadership from US large-cap technology stocks towards non-US markets. In the current environment, we view that Asia ex Japan value-oriented strategies could add diversification to investor portfolios, given favourable valuations and underlying exposures.

Value-oriented strategies range from deep value to quality value, with managers seeking to identify undervalued segments of the market. Today, we would focus on value managers that invest with a quality lens, as companies that have stronger balance sheets can better withstand economic shocks. Value strategies that emphasise dividend returns may also be poised to benefit as global rates decline amid continued central bank easing.

While markets are in flux following the tariff announcements, active Asia value-oriented strategies tend to overweight China and Southeast Asia and underweight Taiwan and India as of end March. They also tend to underweight IT and communication services in favour of cyclical sectors (e.g., industrials) or more defensive segments of the market (e.g., consumer staples and utilities). While Asian equities as a whole face macro headwinds, the lower valuations for these markets and sectors may ultimately help to limit the downside. They may also see greater upside should Asian economies strike trade deals with the United States, and benefit from increased monetary and fiscal stimulus, particularly from China.

Overall, the market environment remains uncertain, but we still think Asia value-oriented strategies allow for a differentiated and less tech-concentrated exposure to Asia while offering a valuation cushion that could be more defensive in the current environment.

Hedge Funds: A Second Wind for Asia Event-Driven Strategies

Benjamin Low, Senior Investment Director, Hedge Funds, and Vivian Gan, Investment Director, Capital Markets Research

Asia event-driven strategies are starting to look more interesting today as a diversifying strategy amid current market volatility. Heading into 2025, the region had seen a tentative recovery in capital markets activities, with mergers & acquisitions (M&A) and initial public offerings (IPOs) on the rise. At the same time, the closure of a prominent Asia event-driven hedge fund in early 2024 has created a more level playing field for the remaining players and improved the manager competitive landscape.

Event-driven strategies seek to generate alpha from market inefficiencies around corporate events, such as mergers, spin-offs, stock buybacks, and IPOs. While these strategies are typically equity-oriented, managers may invest across the capital structure to add value. Event-driven strategies tend to be less correlated to broader equity markets, and therefore could play a role in investor portfolios as a diversifying strategy.

The opportunity set for Asia event-driven strategies had been improving amid a rebound in the region’s capital markets activities. Managers invest across both developed Asia (e.g., Japan and Australia) and emerging Asia (e.g., China, India, and Southeast Asia). While US tariffs are adding uncertainty to the near-term outlook, we continue to see the environment as favourable for event-driven strategies. Japan remains a key market of interest as ongoing efforts to improve corporate governance and shareholder returns have led to more robust levels of corporate actions, including M&As, take-privates, and spinouts. Managers also note similar opportunities may increase in South Korea following the introduction of its ‘Corporate Value-Up Program’. China and Hong Kong are also of focus. Weaker economic growth in recent years has led to increased deal opportunities from market consolidation and divestments by multinationals, and these trends may actually accelerate should US tariffs create economic and corporate dislocations in Asia.

Overall, we view Asia event-driven strategies warrant a second look today given the likely increase in corporate actions in the region and the added diversification such strategies can bring to portfolios.

Private Investments: Japan Buyouts Remain Attractive Despite Near-Term Macro Volatility

Sharad Todi, Senior Investment Director, Private Equity

Heading into 2025, buyout activity in Japan was on the rise, with the number of transactions reaching 162 in 2024, the highest level in a decade. Although the penetration level of private equity (PE) in Japan remains lower than in other developed markets, the country is emerging as a natural harbour for leveraged buyouts. We see reasons to remain positive on Japan buyouts now despite near-term macro volatility.

On the supply side, deal flow is likely to remain strong. First, several family-owned small- to medium-sized enterprises struggling to find natural successors are turning to PE firms to ensure business continuity. Second, large conglomerates in Japan are streamlining their operations by divesting non-core assets, creating opportunities for PE investors. Third, the Tokyo Stock Exchange’s demand for listed companies to justify their status by improving book value and capital efficiency ratios is also increasing take-private transactions. All these trends may be magnified by dislocations created by US tariffs.

On the demand side, investors are drawn to Japan for several reasons. Unlike most other Asian markets, control is the norm in Japan, allowing investors to shape the company’s journey more effectively. Valuations also remain attractive. According to Dealogic data, median EV/EBITDA multiples in Japan were 12.0x in 2024, compared to 14.4x for broader Asia, and Japan buyout managers can target even lower entry multiples of 10.0x or below. Plenty of low-cost debt is available, with most managers able to secure financing at 40% to 60% of enterprise value at an all-in cost below 4.0%. The terms of leverage are typically investor friendly, with banks being more relationship-focused and cooperative with borrowers dealing with struggling assets. Japan’s low economic growth rate drives corporates to pursue inorganic growth, making strategic buyers the preferred exit route for PE firms. Furthermore, Japan’s attractiveness as a private investment destination in Asia has increased as China’s appeal has waned, providing large pan-Asian funds a stable market to deploy capital. In addition, investors seeking currency diversification from the US dollar may benefit from a strengthening Japanese yen over the coming years.

All in all, we expect these broad macro trends should persist in the near term and lend support to buyout activity in Japan.

Asia Infrastructure: A Maturing Market with Growing Opportunities

Minesh Mashru, Global Head of Infrastructure Investments, and Derek Yam, Associate Investment Director, Real Assets

Asia-Pacific (APAC) is quietly gaining traction as an investment destination for infrastructure funds, supported by the region’s economic growth and demand for infrastructure spending. Historically, much of the region’s infrastructure capital had originated from global or emerging markets funds, while dedicated APAC infrastructure fundraising has been lumpy year to year. However, we view this should change going forward, given an improving regulatory environment and opportunity set, particularly in emerging Asia with increased deregulation and a relaxation of foreign control ownership rules.

APAC value-add and opportunistic infrastructure have the potential to deliver returns in the mid-teens and above, albeit requiring careful management and local knowledge. These strategies involve greenfield risks tied to development activities and operational complexities, as opposed to core infrastructure, which focuses on brownfield assets. The opportunities are broad based across developed Asia (i.e., Australia and Japan) and emerging Asia (i.e., India and Southeast Asia). However, given that Asian economies are more reliant on trade and, therefore, vulnerable to US tariffs, investors need to be discerning when investing in APAC infrastructure. Economically sensitive and trade-related segments, such as ports and logistics, may be especially impacted.

In the current environment, we favour sectors that are less exposed to trade while backed by strong fundamental demands. Data centers are one, given the region’s increased digitalisation and growing adoption of cloud computing. Current supply of data centers still lags the rapidly expanding demand by local enterprises, as well as hyperscalers seeking to expand their cloud service offerings across both traditional and secondary markets ¹ . Renewable energy infrastructure is also attractive, given low current penetration rates and a strong regulatory push towards decarbonisation. Opportunities range from regional solar assets across broader APAC to offshore wind farms in Taiwan, although an understanding of local regulations and onshoring requirements is key. The expansion of cross-border power trading in markets such as Southeast Asia has also bolstered the region’s renewable energy development.

In sum, despite the economic headwinds from US tariffs, we view there remains growing opportunities for APAC infrastructure, given the region’s maturing regulatory environment and structural tailwinds for infrastructure demand.

David Kautter also contributed to this publication.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.

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Gold’s performance this year has been exceptional, gaining 25% through April 23 close and surpassing the returns of other major asset categories. This surge has fueled bullish forecasts and renewed debate about gold’s role in portfolios. The rally has been underpinned by the Trump administration’s trade policies, which have heightened fears of a global economic slowdown, a rise in US inflation, and the potential for greater declines in the dollar. These risks have motivated investors to turn to gold as a potential hedge.

Historically, the dollar’s performance has had a negative correlation with gold. Since 2000, when the trade-weighted dollar has declined by more than 3% in a quarter, as it did in first quarter 2025, gold has averaged a 7% quarterly return. If the economic landscape deteriorates further due to protectionist policies, a decision by President Donald Trump to undermine the independence of the Federal Reserve, or some other issue, it could add pressure to the dollar and support greater flows to gold.

However, there are several key reasons why gold’s future performance could disappoint. First, gold recently touched its highest inflation-adjusted price ever, reaching $3,500 per troy ounce. This tops the real price that it reached in 1980. From these levels, gold’s momentum could be due for a reversal. History offers cautionary lessons after gold’s cyclical peaks: after surging during the stagflationary 1970s, gold lost 62% of its value in just 2.5 years when the Fed tightened policy. More recently, gold declined by 30% in 2012–13 after a rapid run-up during the Global Financial Crisis.

Second, much depends on the persistence of US political uncertainty and investor sentiment. If the Trump administration pivots toward more pro-growth policies, de-escalates tariffs, or restores confidence in the dollar, gold’s safe-haven appeal could diminish. In recent days, we have seen indications of US progress toward trade agreements with India and Japan, and signs that tariffs on China may be lowered. Moreover, recent bond market volatility appears to have prompted the Trump administration to adopt a more conciliatory approach on trade policy, likely in an effort to reassure investors and restore market stability.

Third, central bank demand may no longer provide the same structural support to bullion prices that supported gold’s rally in recent years. Central banks ramped up gold purchases around the time of Russia’s 2022 invasion of Ukraine, but buying has since stabilized at high levels. If this trend continues, ongoing central bank demand should still help underpin prices, though the market’s adjustment to higher purchase levels means the marginal impact of further buying is likely to be less significant than during the initial surge.

With gold now trading near record inflation-adjusted highs and bullish sentiment widespread, the risk of a significant pullback is elevated. History reminds us that rapid price gains can quickly reverse, especially if investor sentiment shifts or US policy uncertainty abates. For most investors, this may be an opportune moment to realize gains rather than initiate new allocations. For some investors—for instance those with significant unhedged US dollar exposures and liabilities denominated in another currency—it may be prudent to delay rebalancing gold allocations. Maintaining these positions could provide a hedge if uncertainty increases, though this approach may forgo some of the gains embedded in gold allocations within the portfolio. Ultimately, the decision to hold or trim gold should be grounded in a number of factors, including the asset owner’s currency exposures, risk tolerance, and other portfolio holdings.

Sean Duffin, Senior Investment Director, Capital Markets Research

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.

The post Is Gold’s Rally Sustainable? appeared first on Cambridge Associates.

Infrastructure Equities Should Perform Similar to Developed Markets Equities in 2025

Sehr Dsani, Senior Investment Director, Capital Markets Research

Infrastructure ² earnings growth accelerated in recent years to above usual levels, partly due to the end of COVID-19 lockdowns, supportive regulation, and AI development. As a result, some sub-sectors enjoyed strong performance, but overall, returns have lagged those of DM equities since 2020. Going forward, as we balance infrastructure’s lower earnings growth relative to DM equities against its defensive attributes and reasonable valuation, we think it will likely perform in line with DM equities.

Infrastructure equities offer defensive qualities, such as steady dividends that are backstopped by stable inflation-protected income. Recently, their dividends have become more attractive as interest rates have declined—with dividend yields nearly twice those of DM equities. We think these attributes will help retain interest in the sector.

However, infrastructure earnings are expected to grow at a healthy cadence of mid-single digits in 2025 versus strong double-digit growth in 2022 and 2023. Meanwhile, valuations sit at the 66th percentile of data from the past 20 years. Conversely, DM equities are meaningfully more expensive, but growth of 7.2% is accelerating and handily outpacing that of infrastructure.

Supportive regulations for energy transition and strong demand for digital and power infrastructure to fuel AI development have propelled growth. Sub-sectors directly related to these tailwinds are overweight in infrastructure and trade at rich valuations, such as electric utilities (77th percentile). Globally, new legislations have been introduced to inject investment into infrastructure and shorten permitting timelines to incentivize new projects. Although, the recent change in US administration could result in some of these legislations being repealed. Additionally, AI data storage needs are significant and have driven power and digital infrastructure demand higher, creating growth opportunities for utility companies. While we think these tailwinds largely remain, since growth rates are forecast to normalize in 2025, expensive valuations in these key sub-sectors pose a risk to performance.

We think AI-related stocks within both infrastructure and DM equities will likely take a breather in 2025 after rallying at a torrid pace. This—alongside the dynamics of income generation, growth, and valuation levels—should result in similar performances between infrastructure and DM equities.

US REIT Performance Should Lag Broader Equity Markets in 2025

Wade O’Brien, Managing Director, Capital Markets Research

Despite a strong third quarter rebound as the long-awaited Fed easing cycle began, US equity REITs are on track to again trail broader US equity benchmarks in 2024. We expect this underperformance to continue next year. Earnings growth trails that of broader indexes, valuations are uncompelling, and the delayed impacts of the previous hiking cycle are still being felt.

Fundamentals look reasonable for US equity REITs, with average occupancy rates of around 94% across categories, slightly above long-term averages. While sectors like office continue to show elevated vacancy, demand for others like data centers and warehouses is more robust. Despite high occupancy, REIT earnings may barely rise in 2024. And even with expected improvement in 2025, the sector’s 4% earnings growth may trail earnings growth in major US equity indexes.

Valuations seem unlikely to provide a tailwind in 2025. Metrics like price to funds from operations (P/FFO) look in line with historical averages but low transaction volumes raise questions about asset values. Many investors buy REITs for their income potential, and REIT yields are well below those of credit assets like BBB-rated corporate bonds as opposed to offering their traditional premium.

REITs have historically done well during rate-cutting cycles, which both flatter their dividend yield and lower the cost of their leverage. Recent outperformance can be viewed through this lens. However, many REITs have outstanding debt that was issued at low yields well before the 2022–23 hiking cycle, which insulated earnings in recent years. Notwithstanding additional expected easing, issuers may still face higher borrowing costs to refinance this debt.

Investors looking to allocate to real estate next year may find better opportunities in private funds, which offer the opportunity to get access to operators that can add value via development and management expertise and offer tailored exposure to secular themes like digital infrastructure and the growth of senior housing. As with public markets, of course, valuations need to be taken into consideration.

US Private Real Estate Funds Raised in 2025 Should Deliver Above-Average Returns

Marc Cardillo, Head of Global Real Assets

The past few years have been challenging for commercial real estate (CRE), driven by higher interest rates and a constrained lending environment. Sentiment toward CRE has been weighed down by a steady barrage of negative headlines highlighting distressed property owners. However, we believe CRE values are near a bottom and the large pool of distressed owners will create an attractive investment environment for new CRE commitments in 2025.

Distressed CRE in the United States stood at $94 billion as of the end of second quarter 2024, and is expected to continue rising, with much of that made up of properties purchased and financed when interest rates were at record lows. Despite this dynamic, CRE values appear near a bottom, having declined 19.6% since their third quarter 2022 peak. Listed real estate, which is typically a leading indicator to private CRE in both downturns and recoveries, troughed in October 2023 and is up 38.9% from that point through November 2024.

Two additional data points suggest CRE values are near a bottom. Lending markets have continued to improve throughout 2024, marked by higher advance rates and narrowing spreads. Improvement in debt markets was reflected in stable year-over year levels of transaction activity following significant declines in 2022 and 2023. Higher transaction volumes reflect buyers and sellers having a similar view of value, which is also consistent with a bottoming process. Finally, the recent cut in interest rates has further improved sentiment and the view that the market is near a bottom.

Notably, CRE fundamentals have remained largely resilient even during the period of Fed tightening, with office a notable exception. The residential, industrial, and self-storage sectors have seen significant new supply delivered in 2024. However, new constructions starts have declined meaningfully in response to higher financing costs. The retail sector has remained strong with minimal new supply added since the pandemic.

The combination of distressed deal flow, improving debt markets, and solid CRE fundamentals should create a favorable investment environment for CRE funds raised in 2025.

Figure Notes

Infrastructure Earnings Growth Expected to Lag Developed Markets
Data for 2024 reflect year-over-year growth through November 30 and 2025 estimates reflect differences in 12-month forward EPS growth forecasts.

Recent Cash Flow Growth Has Been Weak
Funds from operations per share pertain to all equity REITs. Data are quarterly.

Private Real Estate Tends to Follow Listed Real Estate
Return data are quarterly. “Private Real Estate” is represented by the NCREIF Fund Index – Open-End Diversified Core Equity (Net) and “Listed Real Estate” is represented by the FTSE® NAREIT All Equity REITs Index.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. As expressed by the MSCI World Core Infrastructure Index.

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This note provides an update on the current opportunity set in infrastructure investments and highlights some of our preferred areas in the private space, including energy transition and digital infrastructure.

Growth in Infrastructure Opportunity Set Broadens Its Investor Base

Infrastructure investments are often characterized by stable and inflation-linked contractual cash flows, high barriers to entry, diversified return drivers, and the potential for attractive income. This sector traditionally featured projects with modest yet predictable earnings growth such as toll roads and bridges. While its salient characteristics still hold true, the asset class has expanded beyond project finance opportunities.

Twenty-first century infrastructure investing includes telecommunications assets such as cell towers and data storage, emerging technologies in clean energy, and “platform companies” intended to scale their operations rather than investing in single assets. This means growth opportunities are significantly more substantial today. Operational expertise is therefore more important than ever to develop assets and drive returns versus simple financial structuring.

The expanding opportunity set for investors, as well as increasing liquidity of the underlying investments, is reflected in rising transaction volumes (Figure 1). In turn, the universe of potential investors has expanded beyond traditional participants, such as pension funds and insurance companies, to include sovereign wealth funds, endowments and foundations, and private individuals. These investors seek income and inflation protection as well as total returns, which compete with those of other private real assets strategies.

Comparing Public and Private Infrastructure Strategies

The definition of infrastructure investment is evolving as are the indexes used to track this asset class. Many infrastructure indexes are heavily weighted toward traditional sectors such as utilities, telecommunications, and transportation (Figure 2), though in other cases, “infrastructure” indexes can include constituents in tangential categories like industrial companies. In comparison, private infrastructure offers more tailored exposure and can provide risk profiles ranging from core to opportunistic investments. Risk and reward can vary significantly across strategies, which can span greenfield project development to lower-returning regulated operating assets. These differing sector and project exposures mean return drivers can be very different between public and private infrastructure indexes.

Public infrastructure equities have posted mid-single-digit annualized returns in recent years (Figure 3). The asset class has performed similar to most real assets peers but with more consistency, given the higher return contribution from dividends. Year-to-date performance has been stronger as interest rate cuts have again piqued investor interest in the sector’s steady dividend stream. Not all funds have done well. Some previous projects have suffered from higher-than-expected financing costs and some have had sector-specific issues, such as the struggles of European utilities. Public infrastructure indexes have also not enjoyed the same performance uplift as private equivalents, given their lack of exposure to recent winners like digital infrastructure. Still, despite strong recent returns, valuations look attractive relative to both other real assets categories and broad equity markets (Figure 4).

Private Infrastructure Returns Have Been Compelling

In contrast, returns for private infrastructure assets have been strong in recent years and compare favorably with those of other real assets (Figure 5). Across categories, core assets have generated significantly lower average returns (Figure 6), reflecting their lower risk profile while also increasing competition. Returns for more value-add and specialized categories have been significantly higher. This is especially true for energy transition funds in recent years, reflecting the maturation of technologies (e.g., renewables) from earlier funds that tended to underperform, as well as the green premium for such assets being offered recently. Digital-focused strategies have also significantly outperformed, benefiting from market growth.

The growing size of infrastructure funds and competition among funds (and with strategic buyers) has boosted valuations, which could create a headwind to returns, especially for existing core assets. This has also been a tailwind to some value-add investors that have benefitted by selling to core investors and providing multiple expansion opportunities. Nonetheless, the infrastructure sector may face fewer secular challenges than some of its peers. For example, private office real estate may continue to struggle with high office vacancy rates, rising insurance costs, and diminished bank appetite to lend. Similarly, private natural resources have lagged as investors shift focus to renewable energy sources, which has weighed on valuations.

Diversification Benefits

Infrastructure investments can also help reduce overall portfolio volatility. Given their ability to post steady returns across various economic environments, infrastructure assets can aid in stabilizing overall portfolio performance. Demand for services like toll roads and power tends to be recession resistant and providers (often protected by long-term contracts) can pass inflationary pressures to end-users, supporting returns on capital. Figure 7 illustrates how infrastructure investments provide a ballast to portfolios by generating attractive real returns in both rising and falling inflation environments. In fact, the consistency of their returns across these environments suggests they are better suited to cushion portfolios against both inflationary and deflationary shocks.

Where Investors Should Focus

Private investments are our preferred method of gaining exposure to infrastructure because of their ability to curate exposure to attractive sub-sectors. We like assets within infrastructure that support energy transition and digital infrastructure, which are boosted by secular tailwinds and offer especially attractive opportunities. Taking on greenfield (earlier stage development) projects is not without risk and leverage must be used prudently. However, private infrastructure funds that can successfully construct essential and scalable assets are likely to continue rewarding investors.

Energy Transition

Energy transition refers to the ongoing shift in sourcing the world’s power needs from fossil fuels to options with lower greenhouse gas emissions. Despite political crosscurrents in some regions, this transition is occurring rapidly. In 2023, capacity growth in renewables rose a staggering 50%. Significant capital flows are fueling this growth. According to Bloomberg, global energy transition investment totaled around $1.8 trillion in 2023, and 30% of private infrastructure investment focused on renewables.

Within renewables, the opportunity set is shifting, as prices for existing and contracted assets have risen. Private infrastructure funds seeking higher returns are developing assets and often start by acquiring renewable energy “platforms” (i.e., companies with in-house management teams) or through utility-scale greenfield developments. Developing assets is far less costly than acquiring assets from utilities or other players (e.g., c. $5K/megawatt [MW] for pre-permitted development solar projects versus c. $350K/MW for built projects). ³ While many private energy transition funds from recent vintages seem on track to post high returns, others have been hit by rising costs, asset markdowns, and other challenges, such as delays to grid connections.

Opportunities vary across geographies. The United States presents significant growth opportunities for renewables development. The policy backdrop has been favorable, given the benefits from the Inflation Reduction Act. However, there is risk in this policy being unwound following the recent US presidential election. In our view, the growing demand for power in the United States, especially from data centers, continues to create a relatively attractive investment environment. The flipside is that valuations of developed projects can be elevated, while new projects may face multiyear delays to be connected to the grid. In Europe, experienced management teams are also increasingly scarce. Furthermore, the complexity of the European regulatory environment, along with challenges in grid connectivity, has impacted investment. Finally, Asia-Pacific offers significant growth opportunities and supportive regulatory regimes, though proven management teams can be harder to source. Australia, Japan, Korea, and Taiwan are examples of geographies seeing increased investment, including in solar and offshore wind projects.

Transition fuels such as natural gas are an opportunity within energy transition. Demand in Asia and Europe is rising, creating a need for new liquefied natural gas infrastructure, including storage and transportation. The Middle East and United States will play a significant role. Traditional energy producers are also likely to support the growth of blue hydrogen, which currently has greater economic viability than early-stage green hydrogen (but subsidies and technology risks remain). ⁴

Electric vehicle (EV) charging is a burgeoning market that will likely continue to offer attractive opportunities in Europe. This market stands to benefit from subsidies and the potential for lower marginal costs. In contrast, the geographic size of the United States, shifting policy backdrop after the recent elections, and cultural attitudes are likely to make EV adoption slower and slow investment in underlying charging infrastructure.

Circular economy development offers another opportunity through building infrastructure for waste collection, recycling, and distribution. This has generally been successful, although areas such as energy from waste have seen challenges, including securing feedstock. Additionally, battery storage solutions continue to scale, offering complementary support to renewables in mitigating intermittency. Co-location and hybrid projects (a mix of wind, solar, and batteries) are also growing and can have contractual backing to mitigate market and technology risks.

Digital Infrastructure

The global demand for digital infrastructure assets, such as cell towers, fiber optic cables, and data centers, has surged dramatically. This heightened interest is driven by interconnected trends, including the proliferation of data-intensive devices, the expansion of the Internet of Things (IoT), and the rise in mobile content creation and streaming. Consequently, the need for enhanced global interconnectivity is escalating, with bandwidth projected to grow at a compound annual growth rate (CAGR) of over 30% from 2022 to 2026.

Data centers address the growing need for more data storage and handling, accelerated in recent years by the growth of generative AI. “Hyperscalers” like Amazon, Google, Meta, and Microsoft have growing global footprints, creating opportunities for developers and operators of these assets.

Power demand has also significantly jumped since data centers have substantial electricity needs, creating a related opportunity. According to Goldman Sachs, electricity demand in the United States had been relatively flat for years but is now expected to rise around 2.4% per annum through 2030, largely due to demand from these sites. The main customers of these facilities want them powered by low-carbon energy, creating an opportunity for new providers that make use of renewables and perhaps nuclear sources. Infrastructure funds seeking to fill this void need to navigate challenges, which can include grid capacity, intermittency issues, and local regulatory requirements.

Telecommunications-focused infrastructure funds have also generated strong overall returns in recent years and have bright prospects. Increasing cell tower capacity will mostly come from densification of existing assets, and the penetration of 5G/6G technologies is expected to have a long runway of opportunity. Permitting requirements for additional buildouts can be a challenge, as can the need for some managers to rely on large telecommunication groups to try and monetize their existing infrastructure.

Fiber optics presents another growth opportunity, but this segment can be more cyclical in nature. Some Fiber to the Home (FTTH) developments have failed, as adoption levels fell short of expectations, costs rose, and “overbuild” became a concern. It is likely this slower adoption will continue in some regions (e.g., Germany, the United Kingdom, and the United States), particularly as newer technologies (e.g., satellites) become an option for less urbanized regions.

Other Private Infrastructure Opportunities We Find Attractive

Infrastructure debt and secondaries have seen significant growth, benefiting from broader growth in global private credit and secondary markets. These strategies let investors gain exposure to the trends we prefer, while allowing them to tailor their risk profile through debt securities or by purchasing assets at a discount (relative to direct equity) via secondaries.

Infrastructure debt opportunities are attractive because they can provide stable income. They currently offer compelling spreads of 200 basis points (bps) to 300 bps over investment-grade opportunities, and an attractive return profile of 10%–15% returns for development opportunities, particularly for those focused on renewables and natural gas ecosystems.

Secondaries are increasingly attractive as the impact from the denominator effect (investors being overweight private investments and needing to sell) and pension de-risking creates attractive buying opportunities. The market has enjoyed tremendous growth, from $1 billion to $2 billion a decade ago, to transaction volumes of $15 billion in 2023.

Conclusion

We believe allocations to infrastructure will likely continue, given its diversification benefit and potential to outperform comparable public and private real assets. We prefer to lean on private strategies that offer tailored exposure to sectors boosted by supportive tailwinds such as digital infrastructure and energy transition. We believe these will continue to attract a wider cohort of investors and present an outsized opportunity for growth but require nuanced expertise for successful development and thus, value creation. As a result, we advise aligning with proven and operationally able managers that can increase the odds of successful execution, while being mindful of delivering on attractive return profiles for investors.

Wade O’Brien, Managing Director, Capital Markets Research

Minesh Mashru, Global Head of Infrastructure Investments

Sehr Dsani, Senior Investment Director, Capital Markets Research

Francesco Dell’Alba, Associate Investment Director, Real Assets

Drew Boyer, Elisa Lavric Chiazutto, and Graham Landrith also contributed to this publication.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. As expressed by the MSCI World Core Infrastructure Index.
3. Example of an Irish solar project seen by Cambridge Associates LLC.
4. Green hydrogen is produced from water using electrolysis powered by renewable energy, while blue hydrogen is generated from natural gas with carbon capture and storage (CCS) technology.

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Spreads are elevated on CRE debt for several reasons. Roughly 50% of maturing 2024 loans were made by banks, many of which are shrinking loan books. Small- and medium-sized banks, which have the largest CRE exposure as a percentage of overall loans, face concerns over credit quality and pay more for deposits. At the same time, the largest banks, which tend to have smaller exposures, face pressure from new regulatory capital requirements. Meanwhile, falling property prices reduce the amount of equity held by owners and higher interest rates weaken debt servicing metrics, which creates an opportunity for mezzanine and preferred equity investors to help tweak capital structures.

Investors have several options when allocating to this market. Open- and closed-end funds offer a variety of exposures, including originating new loans as well as buying existing securities backed by CRE loans—such as commercial mortgage-backed securities (CMBS) and CRE collateralized loan obligations—in the secondary market. Many of these funds focus on new senior loans, but others will also extend mezzanine loans or buy preferred equity to help offset how property price declines have reduced equity cushions. Some funds employ leverage to boost returns by borrowing at the fund level; others may consolidate pools of new loans into a CMBS transaction and retain the “first loss” or “B-pieces.” Strategies vary across markets (primary versus secondary), seniority (senior versus mezzanine, etc.), sectors, and other dimensions.

Return potential varies according to approach. Managers extending new loans on stabilized buildings in sectors with strong fundamentals may target mid-/high-single-digit unlevered yields; with leverage, potential returns may be in the low double digits. In contrast, funds looking to buy secondary market securities (e.g., CMBS) at distressed prices may target low double-digit returns. Closed-end funds that are originating mezzanine or preferred equity may have even higher return targets, though the share from their cash coupon will be lower.

Real estate lending carries potential risks. Higher interest rates have put upward pressure on cap rates, and the potential for interest rates to remain higher for longer could put pressure on owners that have used floating-rate debt. Reduced transaction volumes in recent quarters reflect uncertainty around rates and raise questions around where property prices will stabilize. Fundamentals like vacancies and rent growth are also in flux for some property types. Many private funds are sitting on significant amounts of dry powder, which, if deployed, could increase competition for new loans and reduce spreads. Preqin estimates private real estate debt funds have around $77 billion of dry powder, and so-called opportunistic funds have another $200 billion+ they may be willing to invest at the right yield.

Still, some risks may be exaggerated, creating an investment opportunity. Excluding categories like office (roughly a quarter of the US CRE lending market), fundamentals look healthier in categories such as industrial and multi-family. Given recent price declines, new lenders are both obtaining more security (lower loan-to-value) and lower valuations. Further, existing dry powder seems small relative to the roughly $5 trillion of outstanding CRE debt. In other words, some opportunistic funds may never deploy if spreads retreat, potentially putting a floor under spreads.

Investors should ask how the real estate debt opportunity compares to other opportunities. CRE debt internal rates of return are likely to be attractive for current vintages, given higher rates and spreads. Whether they outperform CRE equity funds in future years will depend on several factors, including the direction of rates, property prices, and riskiness of the underlying assets. Regardless, debt capital can be put to work more quickly relative to equity. Within private debt or diversifier portfolios, CRE debt provides an opportunity to diversify away from corporate credit exposures, though leverage and area of focus will impact relative performance. For investors considering an allocation, we prefer managers that have experience investing through market cycles and can invest across different parts of the capital stack. We also prefer those that have in-house asset management capabilities, given managers may need to take possession of assets.

Wade O’Brien, Managing Director, Capital Markets Research

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. As expressed by the MSCI World Core Infrastructure Index.
3. Example of an Irish solar project seen by Cambridge Associates LLC.
4. Green hydrogen is produced from water using electrolysis powered by renewable energy, while blue hydrogen is generated from natural gas with carbon capture and storage (CCS) technology.

The post Should Investors Consider Allocating to US Commercial Real Estate Debt? appeared first on Cambridge Associates.

The rallies in both bitcoin and gold since last fall have certainly been noteworthy. Bitcoin fervor has returned, owing to two factors. First, the SEC approved spot bitcoin ETFs in January, making it easier for investors to access and triggering significant investment inflows. Second, the anticipation of bitcoin’s fourth “halving” event, which will decrease the rate of new bitcoins entering circulation, sparked speculation that the fair value of bitcoin exceeds its recent price. The digital currency reached $73,000 by mid-March, surpassing its November 2021 high. It climbed 190% trough-to-peak since its September low, representing the ninth time that bitcoin has seen a price increase of more than 100% without a significant price reversal during the run-up. ⁵

Gold’s surge has been driven by geopolitical tensions, an uptick in central bank purchases of gold, and the decline in the US ten-year Treasury yield. On the latter, the US ten-year Treasury yield has declined by roughly 70 basis points to 4.3% since mid-October, which has decreased the opportunity cost of holding gold. As a result, gold gained 10% over that same period and is currently near an all-time high of just under $2,200/troy ounce. This has been a sharp rally by gold’s standards.

But focusing on prior rallies is only half of the story. After each of the prior eight episodes when bitcoin gained more than 100%, it experienced a median drawdown of 30%, which often happened in less than a month. It is also worth noting that bitcoin plummeted 77% in just over one year after reaching its last peak of around $68,000 in 2021. Gold’s drawdowns have been fewer and smaller in magnitude. Still, since 1990, it has seen nine drawdowns with a median of -22%, and these drawdowns occurred after gold had rallied by around 40%.

Still, we view bitcoin and gold as different investments. We see bitcoin as highly speculative, and we believe it will behave like other risk assets in a market downturn. In contrast, gold has a more proven track record as a reliable haven instrument, meaning it may perform well in a risk-off scenario.

All this is to say that these rallies in bitcoin and gold may be overextended when viewed with a historical lens. At the very least, investors choosing to add either asset should size positions modestly, understanding that rapid price swings are likely to persist. Recent price action in bitcoin furthers this point; in the week since it reached its all-time high, it saw a 15% pullback in its price. For those investors thinking of adding gold as a potential source of portfolio protection, we favor long US Treasury securities, which also offer that benefit and include the added bonus of a healthy yield.

Sean Duffin, Senior Investment Director, Capital Markets Research

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. As expressed by the MSCI World Core Infrastructure Index.
3. Example of an Irish solar project seen by Cambridge Associates LLC.
4. Green hydrogen is produced from water using electrolysis powered by renewable energy, while blue hydrogen is generated from natural gas with carbon capture and storage (CCS) technology.
5. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

The post Should Investors Chase the Bitcoin and Gold Rallies? appeared first on Cambridge Associates.

US REIT Performance Should Rebound in 2024

Sehr Dsani, Investment Director, Capital Markets Research, and Marc Cardillo, Head of Global Real Assets

US REITs have performed poorly since the end of 2021, underperforming US equities by 20 ppts. Increases in bond yields were a significant headwind, diminishing the relative attractiveness of REIT dividend yields and raising concerns over the value of underlying assets. Following the weak performance, valuations have fallen to an attractive level. This reality—combined with the fact that REITs are well positioned to take advantage of acquisition opportunities from overlevered private property owners—positions the sector for a rebound in 2024.

Recent poor performance has improved the attractiveness of valuation metrics. First, the sector’s price-to–funds from operations (P/FFO) multiple relative to a similar measure for the broader US market is at the 35th percentile of observations since 1990. Second, REITs are trading at a 17% discount to net asset value, which is lower than the 20-year average of a 0.9% discount. Taken together, these metrics suggest the market has already adjusted price levels to reflect difficult conditions in 2024. Historically, REITs have outperformed as a new business cycle emerges. We expect investors will increasingly get clarity on the next business cycle as 2024 evolves.

Despite concerns that the real estate sector must refinance a material volume of debt, REIT balance sheets are generally sound. This is in part because REITs delevered since the GFC. The sector’s debt/equity leverage ratio is 35% versus the sector’s 50% level during the GFC and 60%+ for many private counterparts today. Around 90% of REIT debt is fixed rate, maturities are reasonably staggered, and the low leverage rate relative to the private sector is due in part to REITs’ low office exposure (4.6%). In addition, many REITs have the advantage of being able to access the unsecured debt market. These dynamics position REITs favorably relative to their private peers and should allow them to address upcoming refinancings and have the necessary capital to make strategic acquisitions in this environment.

Infrastructure Performance Should Rebound in 2024

Wade O’Brien, Managing Director, Capital Markets Research 

Public infrastructure equities underperformed broader benchmarks in 2023, weighed down by rising interest rates, policy uncertainty, and recent profit warnings in some sectors. Improved valuations, a supportive policy backdrop, and an ability to grow earnings during inflationary environments mean the sector should boost investor portfolios in 2024.

Infrastructure assets include those in areas such as transportation, communications, and power generation. An increase in benchmark bond yields, as well as profit warnings from some large renewable energy players, caused listed infrastructure assets to underperform, with US and global ex US infrastructure stocks returning -4.5% and 2.4%, respectively, year-to-date through November 30.

Improved valuations should mean better relative and absolute performance in 2024. P/E ratios for global ex US and US infrastructure indexes have fallen by around 40% and 25%, respectively, since their mid-2021 peaks. Despite weaker earnings guidance from some companies, profitability in both regions remains in line with long-term averages and is protected by long-term contracts that include the ability to pass on higher costs to users. These dynamics help explain why utility sector earnings forecasts have predicted higher growth than most others in 2023, as well as why listed infrastructure assets historically have outperformed during periods of elevated inflation.

Infrastructure assets also have tailwinds from recent policy developments. Legislation like the US Inflation Reduction Act and the European Commission’s REPowerEU plan will boost demand for clean energy infrastructure and underlying profit margins. Ambiguity around yet-to-be finalized language in the US legislation has been one factor recently weighing on stock performance, but this should be cleared up in the months ahead.

While public infrastructure equity performance is likely to improve in 2024, investors willing to lock up liquidity for several years may also benefit by allocating to private funds. While approaches and operational risks can vary (i.e., greenfield versus brownfield assets), the best of these funds can offer exposure to skilled operators capitalizing on secular themes such as the energy transition and burgeoning data center demand. Despite near-term economic uncertainty, these trends continue to accelerate, which we expect will generate rewards for investors.

Nuclear Should Emerge as a Budding Investment Opportunity in 2024

Michael Brand, Managing Director, Real Assets 

Technological advancement, moderating public perception, improved safety, and new challenges in the drive for net zero have created a foundation for nuclear energy’s next chapter. Renewable energy’s adoption as a key replacement for dirty coal and other fossil fuel–oriented power has created large challenges in maintaining reliable baseload power capacity, which underpins the keystone of energy transition—electrification. Even as the memory of past disasters lingers and the issue of waste storage endures, new technologies and the urgency to bridge the new challenge of intermittency has helped nuclear re-emerge as an option for clean, reliable, and scalable baseload electricity. Policymakers have also provided a boost, with countries such as France pledging in 2022 to further build out its nuclear fleet, and even the United States implementing substantial subsidies to keep its existing fleet operational as part of the recent Inflation Reduction Act—a sharp about-face from a policy standpoint. We believe nuclear will emerge as an energy transition investment opportunity in 2024, given the need for clean, reliable baseload electricity, recent government policy changes, and technological advancements.

The opportunity is not exclusive to just reactors, where it is unclear whether the future is modular or traditional, large-scale. Complementing the reactor fleet is a fragmented ecosystem of services and technology companies, which both construct new reactors and keep existing ones running. The landscape features an abundance of small, entrepreneur-run businesses that fly under the market radar and transact at significant discounts to the broader opportunity set. These companies seek to add value by helping businesses professionalize, consolidate, and harness new technologies. There are also opportunities associated with AI, software platforms, and plant-management technology, all of which should continue to make the sector safer and more efficient.

Hurdles certainly exist in the form of public perception, political jockeying, and even securing a steady stream of fuel, as the mining sector remains constrained. However, energy transition’s demands have created an ideal environment for the sector’s next chapter. With power-hungry 21st century initiatives, such as digitization and electrification, the sector should continue to enjoy increased investor attention as the opportunity emerges.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. As expressed by the MSCI World Core Infrastructure Index.
3. Example of an Irish solar project seen by Cambridge Associates LLC.
4. Green hydrogen is produced from water using electrolysis powered by renewable energy, while blue hydrogen is generated from natural gas with carbon capture and storage (CCS) technology.
5. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

The post 2024 Outlook: Real Assets appeared first on Cambridge Associates.

In this edition of VantagePoint, we look at the progress in the energy transition to date and consider means for investors to both profit from and accelerate the transition across the risk/reward spectrum through investments in private equity (PE), venture capital (VC), infrastructure, public equities, and green metals. Investors looking to maximize impact should invest in strategies that lean into recent policy initiatives and specialized climate tech funds seeking to solve difficult challenges such as decarbonizing industry. Those looking for more stable returns will find an abundance of opportunity in infrastructure funds given soaring demand for renewable energy. ⁶

Pockets of Momentum With More Innovation, Derisking, and Scaling Required

Spending on the energy transition totaled $1.1 trillion in 2022; a 31% increase over the prior year, but still well short of the scale required to meet net zero greenhouse gas (GHG) emissions targets by 2050. Investment amounts have been far smaller, as spending figures include sales of items, like electric vehicles (EVs) and heat pumps, as well as government investments. For example, China—where the government is a key player—accounts for roughly half of total spending ($546 billion), compared to just $141 billion and $180 billion in the United States and EU, respectively.

Nearly 90% of spending in 2022 was directed to renewable energy ($495 billion) and electrification of transportation ($466 billion, 83% of which is spending on passenger EVs). These segments have seen prices fall to levels competitive with some fossil fuel–heavy options, which has pushed up demand. Policy initiatives, such as the United States’ Inflation Reduction Act (IRA) and Europe’s Fit for 55 and Green Deal Industrial Plan, further improve economics for many energy transition technologies.

As economics have improved, corporate and consumer demand for lower-carbon products and services has increased, accelerating the transition in a virtuous cycle. Lazard estimates that before subsidies, the levelized costs of energy for utility-scale solar and onshore wind have decreased 83% and 63%, respectively, since 2009. As a result, renewables are taking market share over fossil fuels, as demand is broadening to include corporations—such as Amazon—that are increasingly purchasing clean power. With nearly 50% of new annual global electricity capacity coming from renewables, installed capacity is now roughly 40% renewable, driven by growth in utility-scale solar and onshore wind over the last decade.

Similarly, electric cars are becoming increasingly cost competitive with internal combustion vehicles. Although the sticker price for a comparable auto is higher for EVs, lower fuel and maintenance costs and potential subsidies make prices more comparable over time, while improved battery performance and growth in charging stations also boosts demand. It will take time to turn over the stock of vehicles, given EVs account for less than 2% of cars on the road globally. Still, EV sales are growing rapidly, with global EV market share increasing from less than 5% of new passenger vehicle sales in 2020 to 14% in 2022.

While meaningful progress has been made in critical areas, the pace of the transition has lagged ambitious objectives. For example, venture capitalist John Doerr keeps track of progress against a six-point plan for reducing emissions that he outlined in his book, Speed & Scale. ⁷ Outside of autos and renewables, progress has fallen short of ambitious targets. Investments in hardware technology to solve the biggest problems—such as power storage, difficult-to-abate industries (e.g., steel and cement production), and commercial transportation (e.g., trucking and shipping)—remain in the development phase. Investment in hydrogen fuel cells, the source of much hope for greening transportation and industry, totaled less than 0.2% of energy transition spending last year, while areas like energy storage and carbon capture also attracted relatively few dollars.

Further advances must address numerous challenges and constraints. Key among them is access to metals needed for the green transition and bottlenecks in expanding the electrical grid globally. Decarbonizing the grid and electrifying as much heating, transportation, and industry as possible are central to a low-carbon future. While renewables are more competitive, further progress must overcome some hurdles. The electrical grid is already congested, interconnections face multiyear delays (averaging three to four years for US solar and ten years for UK onshore wind), and significant grid expansion is needed to meet swelling demand. Grid expansion requires planning for future electricity needs, allocating costs, and permitting, all of which present challenges. Interconnections to the grid are the most pressing issue in the near term. For example, in the United States, there is more energy capacity (2,020 gigawatts, mostly renewable) in the queue to be connected to the grid than is installed (1,250 gigawatts of power capacity, mostly non-renewable). These challenges also create opportunities for companies that can operate around or mitigate such constraints.

Opportunities for Investors

Investors can play the energy transition across private and public markets and have a variety of options in terms of fund return targets and liquidity. On the private side, climate tech VC funds target mid/high double-digit returns by focusing on early-stage companies in areas such as software, battery/storage technology (including recycling, management, etc.), commercial transportation, renewable fuels, and solutions for complex industrial challenges (e.g., cement and steel production). PE strategies with similar return targets will overlap in some of these areas but tend to focus on scalable, cash-generative businesses in areas such as renewable developers, grid enhancement (storage, efficiency/metering, etc.), and transportation plays (e.g., EV charging). Private infrastructure funds will sometimes overlap. For example, some smaller infra funds will invest in areas like scaling solar developers and EV infrastructure, given double-digit return targets, while larger funds with lower return targets may focus on acquiring contracted power assets (and related storage plays). Public opportunities are varied and include managers that focus on a range of companies across the industrial, tech, utility, and mining sectors. There are also opportunities across both private and public markets to invest in the supply chain resilience of green metals—a critical component to the energy transition—with investments in recycling and new mining processes being examples.

We focus our discussion on the largest investment opportunity sets: private equity and venture capital (PE/VC), private infrastructure, and public equities, and highlight key investment considerations and opportunities.

PE/VC Investment Opportunities Will Continue to Scale, but Higher Global Rates Are a Near-Term Headwind

Close to $200 billion of climate-related private investments were made in 2022, roughly 2.5x the level three years prior and representing 12% of all private-market equity investments made in the year. Investment opportunities include both software and hardware, which tend to have different risk/return profiles. Software companies (e.g., building energy management, smart grid analytics, carbon accounting) have similar risk profiles to their non-climate tech peers and a quicker path to market. These strategies are more investable for generalist VC, growth equity, and buyout strategies, and therefore more competitive, often offering lower returns. In contrast, hardware climate technologies require dedicated expertise in the fields of technology, engineering, manufacturing, and project finance, but offer higher scalability and potential payoffs. De-risked sectors focused on the scaling of energy transition technologies (e.g., power generation, transmission, and transportation) continue to attract the bulk of the capital, while earlier-stage hardware targeting sectors that are harder to abate via electrification have seen a lower volume of investments.

Despite their riskier profile, investments into climate tech hardware solutions have increased as the industry has evolved with strengthened technical and operating expertise and a network of climate tech peers that can take nascent technology from seed and early stage to more mature growth phases and deployment. Capital flow has accelerated to areas like battery/storage technologies and solar energy following targeted financial incentives in the United States and Europe and higher conventional energy prices. Investments also flowed to alternative battery chemistry technologies and battery recycling processes to reduce dependency on certain critical metals, such as lithium.

Further, policy incentives have improved the commercial viability and attractiveness of nascent and more expensive technologies—such as green hydrogen—leading to a rise in such investments. Green hydrogen start-ups are looking to produce lower-cost hydrogen at scale for multiple potential applications, including decarbonizing hard to abate industrial sectors (e.g., steel and cement production) and to provide long-duration energy storage to resolve renewable energy intermittency. The capital-intensive nature of many climate tech hardware solutions imply room for private capital ranging from VC to infrastructure, albeit requiring higher risk tolerance and patience for potentially longer holding periods.

Climate tech PE/VC is facing similar headwinds as the broad market in terms of slowing deal activity and exits, given the higher rates environment. Globally, first half 2023 VC climate tech–invested capital and deal count fell 31% and 38%, respectively, from first half 2022 levels, albeit less than the declines seen in broad VC over the same period (50% and 40%, respectively). Public market exits for climate tech companies in 2022 also fell alongside their peers, with the decline more marked for exits via special purpose acquisition companies (SPACs), which had been a preferred option for high revenue growth but negative earning tech companies. Another metric to monitor is valuations, which have diverged from their peers over the past two years. Valuation-to-revenue multiples for climate tech PE/VC deals stood at 9x and 22x, respectively, in 2022, versus 3x and 15x, respectively, for their broad market equivalents.

Higher financing costs and elevated valuations may weigh on future round financings and exits in the near term, particularly for earlier-stage hardware climate tech companies that have a longer runway to profitability. However, overall investment activity should gradually recover as climate tech PE/VC funds look to deploy a significant amount of dry powder, estimated to total $37 billion as of the end of 2022. The opportunity set for climate tech PE/VC is also likely to broaden further, given tailwinds from positive policy shifts and demand/cost trends. More importantly, the manager landscape and performance of climate tech PE/VC funds today has improved meaningfully from the CleanTech 1.0 wave. Recent vintages have delivered comparable returns to their traditional PE/VC peers as managers’ technical knowledge and investment discipline strengthened, allowing for the generation of more sustainable and competitive returns to add value to investor portfolios.

Infrastructure Is the Largest Sandbox but Beware Crowding in Some Corners

Energy transition–focused infrastructure funds offer investors a large opportunity set with varying expected returns that depend on factors such as capital intensity, development stage, and valuations.

Large funds often focus on existing renewable power assets with long-term revenue contracts in place, though some seek higher returns via greenfield projects. Returns for existing assets can be enhanced via scale and financial optimization. In comparison, smaller funds might take more operational or technology risk by investing in local developers or emerging areas like green hydrogen and battery storage, although others are focusing on existing technologies in carbon capture and sequestration that will benefit from increased IRA tax credits. Some managers focus on specific geographies and assets (e.g., solar), while others take a generalist infrastructure approach and blend exposure to energy transition assets with assets in digital infrastructure and transport. Finally, the definition of energy transition–related assets also varies, with some managers mixing in what are viewed as “transitional” assets in areas such as natural gas transportation and generation plays with renewable assets like wind and solar.

Infrastructure funds benefit from the investment scale needed to meet net zero goals, but face headwinds including rising competition for assets, higher financing costs, and difficulties with everything from supply chains (e.g., IRA requirements) to delays in grid connections. One result is that even some large infrastructure funds have broadened their focus from renewable power project development and operation to related plays like utility-scale storage and residential installation and financing. Investors looking at managers allocating in these markets should consider skill sets (including technical, regulatory, and financial), sourcing abilities, and public market trends, as some energy transition plays have struggled to perform (in part due to initial public offerings executed at high valuations).

Investors selecting among energy transition managers should also consider the potential risk/return of their targeted investments. The opportunity set for large funds investing in renewable power is considerable, given this market represents nearly $500 billion in annual spending versus biofuel investments, which are 1%–2% this amount. The flipside is that acquiring contracted renewable assets likely will generate more predictable returns but less potential upside than investments made by smaller infrastructure funds taking technology risk in areas like biofuels or carbon capture. Investors can improve their odds by identifying manager edges—such as technical and regulatory expertise—and flatten J-curves by looking for pipelines of approved projects with guaranteed grid access. Managers with experienced teams and diversified portfolios that invest across several areas may see smoother returns than those targeting areas with more technological risk like battery science or decarbonizing industry. Investors can also tap infrastructure investments via certain publicly traded plays but should take into consideration valuations and higher potential for volatility.

Public Equities Offer a Broad and Diverse Opportunity Set for Active Managers, but Watch the Valuations

Public equity managers focused on the energy transition typically cover a broad array of securities in businesses ranging from renewable utilities and renewable equipment to energy efficiency, advanced materials, software, agriculture, and the circular economy. The companies themselves may participate in a mix of activities but tend to meet some threshold of green revenues. Managers may also incorporate other environmental, social, and governance (ESG) considerations into their strategy.

Significant up-front capex costs for many clean technologies require scale to spread fixed costs over a wide swath of customers. Indeed, we are seeing consolidation in categories such as renewable manufacturers and infrastructure companies. At the same time, smaller companies have potential to be more innovative and may also be worth holding for high risk/high reward opportunities like battery storage. However, managers must consider the global competitive landscape as customers may view larger companies as steadier hands, often benefiting from diversified revenue streams, particularly when related to riskier technologies. Overall, we see room for winners and losers from this disruptive transition—a facet that can be exploited by talented active managers, including long/short strategies.

Another consideration when investing in public securities is that much of the industrial sector will need to adapt their business models over time to a low-carbon future. Managers that engage with portfolio companies to understand, support, and hold them accountable for realistic climate reduction strategies should unlock value in portfolio holdings over time. Further, equity strategies focused on industrial transformation (i.e., suppliers, enablers, or decarbonizing firms) have more of a value/cyclical orientation beneficial to style diversification in portfolios with high ESG requirements that tend to lean toward quality/growth exposure.

Like PE, performance in public equities addressing the energy transition has been volatile, with some indexes dramatically underperforming the broad market for a decade through 2020 before experiencing a year or two (depending on the index used) of explosive relative and absolute performance. Valuations for renewables remain elevated relative to utilities and the broad market, while more tech-oriented indexes (e.g., the Wilderhill Clean Energy Index) have negative aggregate earnings reflecting the risk of owning such securities, especially if the cost of capital remains elevated.

Green Metals: Tailwinds for Companies Invested in Supply Chain Resilience

The energy transition will be accompanied by a structural increase in demand for certain critical metals, considering the intensity of their usage in renewable energy infrastructure and in the electrification of transport. Copper will see the highest growth in absolute volume, given its application across the value chain, from wind turbines and electricity grids to EVs, but lithium will see one of the sharpest rises in demand relative to current levels due to the dominance of lithium-ion batteries. Without new discoveries, BloombergNEF forecasts that the supply of many of these metals would fall short of the projected increase in demand, thereby increasing input costs to clean infrastructure and constraining newbuild projects.

While the heavy reliance on these green metals poses a risk to the energy transition, it also creates opportunities for investors. There are arguments already in place that the energy transition could drive a new commodities supercycle. However, there are several risks to consider to directly investing in these metals (either via commodity futures or natural resources equities) near term. Many of the transition metals are still predominantly used for industrial purposes and are sensitive to global economic cycles. For instance, prices of copper and nickel surged during the post-pandemic recovery phase and have moderated since, but not yet to cheap enough levels relative to history (in real terms) to mitigate further downside risks from slowing global growth. Demand for industrial metals may soften if China sees a secular shift from an industrial-led to a services-driven economy, while secondary supplies may increase with further investments into metals and battery recycling. The substitution effect would also spur innovations—such as alternative battery technologies—to reduce critical mineral dependency, as seen with Tesla and other major automakers’ switch to lithium iron phosphate batteries to mitigate high nickel and cobalt prices.

Another way to address the green metals theme is through investing in battery recycling and battery technologies, although these are earlier stage in nature and will require careful manager selection to identify potential industry winners. The response to price mechanics should also incentivize both start-ups and existing industry players to rethink traditional mining processes to reduce lead times and/or costs. We are seeing evidence of this today in the lithium market, where higher prices have encouraged investments into technologies such as direct lithium extraction from brine to boost production. An active strategy approach, either within private or public markets, could better help investors to identify sustainable green metals opportunities and add alpha over the broad market.

Conclusion

The energy transition involves a complex and dynamic set of changes in the way we do just about everything from activities as mundane as manufacturing steel and cement to heating buildings and transportation. While significant progress has been made in some quarters, considerable capital will be needed to fund the massive investment required over coming decades. The investment opportunities and the disruptive forces this evolution brings will create plenty of winners and losers that require investor focus. We expect investors with a deliberate and thoughtful plan to invest in the transition across the risk/reward spectrum will be rewarded.

Celia Dallas, Chief Investment Strategist
Wade O’Brien, Managing Director, Capital Markets Research
Vivian Gan, Associate Investment Director, Capital Markets Research

David Kautter and Kristin Roesch also contributed to this publication.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. As expressed by the MSCI World Core Infrastructure Index.
3. Example of an Irish solar project seen by Cambridge Associates LLC.
4. Green hydrogen is produced from water using electrolysis powered by renewable energy, while blue hydrogen is generated from natural gas with carbon capture and storage (CCS) technology.
5. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
6. We use renewables and renewable energy interchangeably to reference technology to decarbonize the electrical grid.
7. See https://speedandscale.com/tracker/ for annual updates on progress.

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