Alongside rising interest rates, there have been additional shocks including a significant strengthening of the US dollar, political instability in the UK, China's zero Covid-19 policy and military conflict in Ukraine, each buffeting markets and providing little relief for investors, resulting in a traditional portfolio, comprising 60% in equities and 40% in bonds, on track for its worst performance since 1936.

As inflation continued above target, central banks had to respond fast and hard, led by the US Federal Reserve which has raised its base rate 3% in 6 months. Global government bonds have lost considerable capital value as a result, but the drive to combat inflation via higher rates has also had a significant impact on other risk assets as well.

Investors in floating rate credit (both public and private) were partly protected from the direct impact in higher rates, given their link to interest rates.  But credit spreads in general have risen, and there is an indirect impact of higher yields on default risk, both of which mean capital values have still reduced.

Equity markets also provided little respite for investors, as central bank action increased the likelihood of an economic slowdown or recession. Towards year end in many sectors companies started reducing their profit forecasts for the coming years, to reflect the more pessimistic outlook. Countering this trend, of course, were energy stocks globally as countries, particularly in Europe, secured and stored supplies ahead of winter, given shutdowns in pipelines from Russia.

In Private Markets, the global economic outlook had varying impacts. While private equity deal activity declined in the second half of 2022, across Europe quarter-over-quarter deal value was down 31.6% and deal count was down by 9.6% (Source: Pitchbook, October 2022) as the external headwinds impacted private equity. However, despite this, opportunities across sectors such as IT still exist as long-term trends of digitalisation and tech innovation are still areas of growth. Within infrastructure, power generating assets and investments with inflation linked revenues provided positive returns as inflation forecasts were sequentially lifted, and power prices, particularly in Europe, spiked. The returns generated by power producing assets has brought them under the microscope of law makers, with windfall taxes and price caps mooted. In terms of transactions, we saw a slowdown in activity globally across H2 2022. Deal volume fell to $185.4bn across 701 deals from $255.1bn across 800 transactions in Q3 2021 (Source: Inframation, October 2022) . However, activity did vary across sectors as transport and telecommunication sectors proved resilient with deal count increasing across both. Overall opportunity still exists with infrastructure assets potentially offering better protection against inflation than other assets.

In real estate, the increasing cost of debt financing is impacting all sectors of the asset class, with many Real Estate Investment Trusts trading at wide discounts to NAV in anticipation of lower valuations. The speed of the cost of debt shifts have also disrupted transactional activity for commercial property, particularly in the UK. Indices of residential valuations are falling in the US, Sweden, and Australia amongst other countries, as previously red-hot housing markets cooled rapidly in response to sharp increases in mortgage costs.  Given the recession starting in Q4 this year and stretching into 2023, capital values are likely to decline. It is vital to focus on quality as long-term sector fundamentals are unchanged.

A diversified, simplified strategy and a stable portfolio

Against this difficult backdrop, the Company has managed to preserve capital and pay out income, with a NAV total return (including income, with debt measured at fair value) of 1.2%. While this is below the stated return target of 6% annualised on a five year rolling basis, it demonstrates the portfolio's robustness and diversification in a highly testing environment.

Through building a well-diversified portfolio of investments, including a substantial exposure to infrastructure and real assets, the Company has responded well to the inflationary pressures that have dominated the markets during the last year. The Company has been able to take a long-term view regarding how economies will evolve, supported by the breadth of research and investment capabilities across the abrdn franchise.  The goal of delivering a suite of diversified returns is achievable due to the latitude of the mandate, and it has been pleasing to see the defensive core of the portfolio play its role.  

The task from here is to maintain the resilience of the portfolio to the challenges posed by the current environment.  The investment strategy seeks to achieve diversification across asset classes within a simplified framework under three main headings: Private Markets, Fixed Income & Credit, and Listed Equities.  Exposure to the broad expertise of abrdn across these asset classes, including approximately 350 Private Markets-focused investment professionals, allows the Company to allocate to best in class opportunities, both internally and externally.

Private markets

During the year, the Company's Private Markets exposure increased from 44% to 55%, as commitments to previously made investments were drawn by managers. The largest draw down was into Bonaccord Capital Partners I (BCP I), which buys stakes in private markets asset managers and pays out income from said managers' fee-related earnings. BCP I called 75% of the capital the Company had committed, and has a current weight of 4.1% in the portfolio vs 0.1% at the start of the year. A significant amount of capital was also called by the abrdn Andean Social Infrastructure Fund I (ASIF I) to fund the building of a new port in Colombia and two hospitals in Mexico, the latter leased to the Mexican government. This moved the ASIF I exposure up 1.9% to 3.4% of total investments over the year.

The Private Markets basket was the largest driver of positive returns, contributing +4.8% over the year. Most sub-asset classes were positive, but returns were driven mostly by Infrastructure. The core infrastructure positions in the Company's portfolio have in place long term revenue contracts with inflation linkage built in, so the current inflationary environment has been positive for their cashflows and valuations, allowing the Company to deliver steady performance through a time of inflationary and volatile markets.

The largest single driver of performance was in the Aberdeen Global Infrastructure Partners Fund II, where the value of the I-77 toll road asset in the US was up 40%. The asset uses dynamic pricing, and was able to charge a significantly higher price for use of the road than anticipated in the base case. Overall, AGIP II contributed 1.4% to the Company's NAV performance. There was also positive performance from the SL Capital Infrastructure II fund, which contributed 0.8% as Central European Renewable Investments, which is the largest portfolio of solar energy assets in Poland, increased in value in response to power prices, while the other assets including a fleet of trains in the UK, also grew in value due to their revenues' contracted linkage to inflation. Finally, within infrastructure, the BlackRock Renewable Income UK fund also grew in value, as the market price for energy in the UK increased.

While the current level of inflation was not our base case coming into the year, the Company is diversified with multiple drivers of returns, of which inflation linkage has been the largest driver this year. The Private Markets portfolio has a unique set of long-term drivers which may not be easily accessed elsewhere, and forms part of the reason why we believe the Company is well placed to generate long term attractive returns for shareholders.

In the future, we expect to maintain the proportion of the Company's portfolio in Private Market investments at around current levels as these specialist managers identify attractive opportunities which can be funded from the maturation of existing Private Market investments. We anticipate that there will be £5 million of additional net investments into the current Private Market investments over the next 12 months with future investments slightly outweighing capital returned.

Fixed income & credit

Fixed Income & Credit weight was reduced over the year to fund the Private Market investments, with the allocation towards Junior ABS reduced and switched partly into Mezzanine ABS to reduce the impact of a potential recession, and a trim to Emerging Market bonds as our internal research group moved the outlook from overweight to neutral.

Fixed Income & Credit contributed -1.4% to performance. All sub-asset classes had negative contributions, with the exception of the Global Loans portfolio which was flat. The largest detractor was TwentyFour Asset Backed Opportunities. TwentyFour, which invests in UK and European residential mortgage backed securities and collateralised loan obligations, saw growth in its dividend pay-out due to the floating rate nature of its investments, however, concerns around future defaults caused by high interest costs meant that its share price declined. Other negatives in the portfolio were the Russian bonds within the Emerging Market bonds portfolio. While we had been reducing weight to this exposure at the start of 2022 due to increased military activity on the border with Ukraine, we did not have invasion as a base case, and so were left with a small position which was written down to zero value due to the sanctions applied to Russia. We were able to exit this position at the end of the year at a value above zero, clawing back some performance.

Listed equities

The proportion of the portfolio in Listed Equities (including the Listed Alternatives portfolio reported on separately in the previous Annual Report) was reduced from 45% to 38% over the year as we sold holdings to fund certain Private Markets investments. The principal funding source was the UK Mid-Cap Equity Fund, which was reduced over the year, but then fully exited in early September due to the headwinds facing the UK economy. This proved prescient, as the poorly received "mini-budget" announced by the then new Chancellor Kwasi Kwarteng at the end of September caused market turmoil which outweighed its intended growth agenda. We also reduced exposure to the global sustainable core equity sub-fund due to the pessimistic near-term economic outlook.

Listed Equities contributed -2.0% to performance. At a sub-asset class level, most sectors delivered negative performance over the last 12 months, with the exception of the listed infrastructure basket, which contributed 0.7%. The top performing names in this basket were the wind and solar energy production names as wholesale market prices increased, boosting revenue streams. There were some headwinds at the end of the year as gilts rose, reducing their valuations, but the basket ended the year in positive territory which was pleasing.

ESG factors as part of risk management

ESG considerations form a key part of our investment analysis and decision making when making new investments.  In Private Markets we consider the following ESG factors: environment, social capital, human capital, business models and leadership & governance. These factors are considered throughout the investment process from the point of idea generation, through to portfolio construction, implementation, monitoring and risk management. Key issues are identified and scored over time through the use of our systematic ESG analysis framework (based on the Sustainable Accounting Standards Board Framework) which identifies key materiality issues by sector. Investments are then scored across operational and governance dimensions which encompass elements including climate change, labour management, corporate behaviour and corporate governance, and these scores then inform investment decision-making.

Expected revenue return per share versus dividends per share

As we have moved through the portfolio transition, we have made use of the Company's revenue reserves to cover the planned slight shortfall in income received versus dividends paid out this year. Revenue reserves are a feature of investment companies which allow them to withhold a proportion of annual income which can be drawn upon in the future, as required.

Outlook

The global economy continues to face many headwinds, which is likely to lead to a deeper and earlier global recession than previously forecast. The UK and EU economies are facing a commodity price induced real income squeeze, amplified by central bank actions. We expect interest rate hikes from the US Federal Reserve, the European Central Bank and the Bank of England, as they seek to control inflation. To a degree, markets have already responded to this uncertainty: equity valuations are cheaper and credit spreads wider than they were at the start of the year - as such, many asset classes look more attractive now on a 5-year view. However, the compounding effects of these various shocks will mean that the investment environment will remain volatile and we may see further weakness across asset classes in the shorter-term. In this respect, the Company should benefit from the diversified public private nature of its investment policy.

Firstly, this provides a wide universe in which to invest, meaning we are able to access niche areas where there is idiosyncratic growth.  Secondly, this allows the Company to access Private Markets investments that have the potential to deliver returns in excess of those available from public markets. Finally, there is the income generation capability that we expect to be available from holdings in Fixed Income & Credit, where good quality assets are available at prices which imply a high dividend pay-out. 

While fundraising has reduced in the second half of the year, there already exists a high level of cash available to be invested in Private Markets (also known as 'dry powder'). While we expect a lower level of private equity transactions, there will still be competition for quality assets. However, the specialist managers working on behalf of the Company have a history of targeting selected direct and indirect opportunities to capture the growth potential, and have demonstrated positive performance over the volatile period of the last 12 months. Further market dislocation could also provide good entry points for the managers in the Company's portfolio who have money to invest still, boosting returns over the longer term.

Investor appetite for infrastructure remains stable, especially for social and economic infrastructure where there is potential for long-term, inflation-linked contracts providing yield and inflation protection. In addition, as the world goes through the energy transition, demand for climate and renewable infrastructure is ever increasing, remaining supportive of investment opportunities in this space.

In Private Credit, we believe that there will be opportunities for private financing as companies face a slightly tighter lending environment. However, the quality of deals remains crucial, as company earnings are reduced, the ability to cover interest payments is tested, and default levels increase. 

Within real estate, residential markets are expected to come under strain with mortgage burdens weighing on consumers. However, a reduction in mortgage affordability will mean that many people will remain in rented accommodation, to the benefit of the Build To Rent sector to which the Aberdeen European Residential Opportunities Fund is looking to sell its assets into.  The focus on any further investments in this sector remains on assets with the highest conviction and long-term securely contracted income. 

The Company has a good degree of protection for the current inflationary environment as evidenced by the pockets of positive performance over the last 12 months. The Company has a reasonably high weighting to infrastructure and real estate assets, both within its Private Markets and Public exposures.  Were we to see inflation continue to be persistent, we would expect these assets to keep contributing positively.  In addition, the portfolio is exposed to floating rate credit instruments across Private Markets, Fixed Income & Credit with a focus on quality, which should benefit in a rising interest rate environment. That being said, we continue to monitor market conditions closely, and are prepared to rotate the portfolio as appropriate to the changing situation.

Finally, the specialist investments in vehicles such as Healthcare Royalty Partners IV and Burford Opportunity Fund (litigation finance) have demonstrated their low correlation with the business cycle and economic climate, and we expect these holdings to continue to provide steady returns with upside potential in the future.  Ultimately, we feel that the Company is well protected in the current environment, and ready to take advantage of growth opportunities when the outlook improves.

Nalaka De Silva, Heather McKay, Simon Fox and Nic Baddeley

abrdn Investments Limited, Investment Manager

20 December 2022

Discrete performance (%)

Total return; NAV to NAV, net income reinvested, GBP. Share price total return is on a mid-to-mid basis. Dividend calculations are to reinvest as at the ex-dividend date. NAV returns based on NAVs with debt valued at fair value. Source: Morningstar. Past performance is not a guide to future results.

Important information

Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid offer spread. If trading volumes fall, the bid-offer spread can widen.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• The Company may invest in alternative investments (including direct lending, commercial property, renewable energy and mortgage strategies). Such investments may be relatively illiquid and it may be difficult for the Company to realise these investments over a short time period, which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• Investing globally can bring additional returns and diversify risk. However, currency exchange rate fluctuations may have a positive or negative impact on the value of investments.

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

Find out more at www.abrdndiversified.co.uk/ or by registering for updates. You can also follow us on social media: Twitter and LinkedIn.