In November 2020, the Bank of England, Her Majesty’s Treasury (HM Treasury), and the Financial Conduct Authority (FCA) created the Productive Finance Working Group to develop practical solutions to address barriers to investment in longer-term and less liquid UK assets like venture capital, private equity, and infrastructure that are needed for the UK’s economic growth and development.
The Chancellor also proposed creating a new fund structure – Long-Term Asset Fund – designed to make it easy for investors, especially Defined Contribution (DC) pension schemes (who don’t invest in these assets as much as their Defined Benefit pension schemes counterparts), to invest in these illiquid and long-term assets.
After much work perfecting the regulatory framework, the first Long-Term Asset Fund was launched in March 2023.
Since the creation of the Productive Finance Working Group (PFWG), the concept of productive finance has found its way into the mainstream. However, though the aim of productive finance is clear – economic growth and development – it is not always clear how to define it.
In what follows, we seek to clarify what productive finance is all about and identify investment opportunities that asset owners and managers can explore in 2025. We’ll cover:
- What is productive finance?
- How productive finance works
- Benefits of productive finance for investors
- Opportunities for productive finance investing in 2025
- The risks of productive finance investing
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1. What is productive finance?
Productive finance is a term that covers investments that are designed to support economic growth and development by providing capital to businesses and projects that are capable of providing long-term value.
The goal of productive finance
“They are investments that help support businesses and the wider economy,” according to Barry Kenneth, the Chief Investment Officer of the Pension Protection Fund, a financial institution in the UK.
There are three key aspects of productive finance, according to Simons and Simmons, a law firm headquartered in London: expansion of productive capacity, sustainable growth, and contribution to the real economy.
Supply of long-term capital, financial stability, and the achievement of net zero are the three key aims of productive finance, according to a roadmap published by the PFWG, titled “A Roadmap for Increasing Productive Finance Investment.”
For investors, productive finance is an opportunity to diversify their investments and achieve long-term returns.
“Individuals are increasingly responsible for their future financial wellbeing, and better outcomes and greater choice may be achieved if a more diversified set of investments is available,” according to Andrew Bailey, the Governor of the Bank of England, quoted in the PFWG roadmap. “Against this backdrop, products offering exposure to alternative assets, such as productive finance, can play an important part in an individual’s investments, particularly their pensions.”
A higher rate of return is another goal highlighted by the PFWG. “Low interest rates and relatively slow economic growth by historic standards have increased the challenge for savers in terms of returns on their investments,” they noted. “One way of potentially achieving higher returns, net of cost, is by investing in longer term, less liquid assets, managed appropriately and as part of a diversified portfolio.”
Productive finance assets
There is no standard definition of what assets qualify to be termed productive finance. However, there are indications of the type of assets that fit the bill.
Kenneth groups productive finance into two types – equity and real assets. Under equity, we have investments in public and private equities while real assets cover investments in real estate, infrastructure, timberland, and farmland.
Kenneth also mentions that in the cleanest definition of productive finance, debt instruments – infrastructure debt, corporate debt, and mortgage debt – would be excluded.
In the roadmap quoted above, the Productive Finance Working Group the focus was on illiquid and long-term assets like venture capital, private equity, and infrastructure. They also mentioned growth equity investments that target profitable companies with potential for further expansion (usually in high-growth industries like artificial intelligence, biotechnology, etc).
More importantly, private equity, venture capital, and growth equity were consistently contrasted with public equity/listed equity/tradable equity, which implies that they are not part of the definition of productive finance as conceived by the group.
Schroders Capital received the FCA approval to launch the first LTAF in the UK. The company currently has three LTAFs – UK Innovation LTAF, renewables+, and climate+. Across all three categories, the focus is also on long-term and illiquid assets – venture capital, private equity, growth equity, and infrastructure financing.
Thus, we can narrow our definition of productive finance assets to long-term and illiquid assets and exclude listed equities.
2. How productive finance works
The original targets of productive finance in the UK were pension schemes (especially the DC pension schemes) and high-net-worth individuals (HNWIs). However, there is nothing inherent in productive finance that excludes other asset owners and institutional investors with a long-term focus.
There are three main investment strategies to explore with productive finance: a Long-Term Asset Fund, allocation to funds investing in individual productive finance assets, and direct or co-investing.
Investing in productive finance through a LTAF
Schroders Capital has already led the way in this new fund structure with its UK innovation LTAF, renewables+ LTAF, and climate+ LTAF.
More importantly, the UK has created a regulatory framework for other investment management firms that may wish to start such funds. Thus, investors in the UK can invest in productive finance through these funds.
However, while they may not use the same name, similar funds exist outside of the UK. For example, while explaining what LTAFs are all about, Schroders Capital mentioned that there is a similar initiative in the European Union (EU) where European Long-Term Investment Funds (ELTIFs) are being developed.
“The proposed European Long-Term Investment Fund, or ELTIF, is a new type of collective investment framework allowing investors to put money into companies and projects that need long-term capital,” according to the European Commission.
Allocation to funds investing in individual productive finance assets
In countries where specific LTAFs or LTIFs don’t exist, asset owners can still invest in productive finance by allocating a part of their portfolio to long-term and illiquid assets like private equity, growth equity, venture capital, infrastructure funds, and real estate.
Interestingly, this is something that has been going on in a place like the US.
“Large institutional investors, including pension funds and endowments, face the prospect of swelling future liabilities and diminished expected returns for most asset classes,” noted Morgan Stanley, the investment management company, as far back as 2020. “As a result, they have reduced their portfolio allocation to public securities and have increased their allocation to private equity, where returns have historically been higher.”
The chart below shows that asset owners across the globe were already allocating up to 23% of their funds to alternative investments like private equity (buyouts, venture capital, growth equity), real assets (real estate, infrastructure), private credit, and hedge funds.
A broad view of investing in alternatives
Source: Fidelity Investments
Furthermore, as shown below, since 2020, asset owners across the globe have increased their allocations to infrastructure funds:
Source: CBRE Investment Management
In summary, asset owners can invest in productive finance by allocating a part of their capital to alternative investments (private equity, venture capital, real estate, infrastructure) or increasing their allocation to them.
Direct or co-investing
Asset owners can also invest directly in productive finance assets instead of investing through a fund. This will require more active management since they have to evaluate these assets (due diligence), manage risks, and handle the purchase themselves.
Another form of direct investing is co-investing. This involves partnering with other asset owners or investment firms to invest in private assets. Such arrangements will involve deciding how costs as well as profits and losses will be shared.
3. Benefits of productive finance for investors
Though talks about productive finance tend to focus on how it benefits society – supporting economic growth and development – the advantages it provides to investors are as real. We review some of them below.
Higher returns
“Investment in long-term, less liquid assets, managed appropriately, can help savers secure higher net returns,” according to the PFWG roadmap.
For example, between 1999 and 2019 (20 years), the US PE market outperformed public markets by an average of 6% per year, according to data provided by FS Investments Solutions and accessed by the PFWG. The chart below shows how this difference in returns turns out in the growth of a hypothetical $100,000:
Growth of a hypothetical $100,000 investment in PE, S&P 500, and Russell 2000
Source: Productive Finance Working Group
They also pointed to a study by the British Private Equity and Venture Capital Association (BVCA) which showed that as of 2019, the 5-year and 10-year annual returns of funds managed by its members were 20.1% and 14.2%, respectively, while the FTSE All-Share Index produced 7.5% and 8.1% annual returns, respectively, over the same period.
The chart below shows that more recent data also support this overperformance thesis:
Performance of Private Equity vs Public Equity over 5, 10, 15, and 20 years as of December 31, 2023
Source: FS Investments
Finally, private assets are expected to outperform traditional ones over the course of a full economic cycle, according to UBS Asset Management:
Expected annualised risk and return for traditional and private market investments
Source: UBS Asset Management
The higher return provided by productive finance is one reason why it has been of interest to pension schemes.
DB pension scheme trustees need access to a wide range of investments to meet their pension liabilities while DC pension schemes need the same access to make it more likely that pension scheme members will reach their retirement goals.
Diversification
This was the benefit highlighted by Bailey, the Governor of the Bank of England.
The chart below shows that adding private assets to a 60/40 portfolio of stocks and bonds increases its returns, reduces its risk, and increases its risk-adjusted returns (measured via the Sharpe ratio):
Impact of adding less liquid and illiquid assets to a 60/40 portfolio between 9/30/2004 and 12/31/2008
Source: Productive Finance Working Group
A more recent survey (October 2023) by the Vanguard Group also supports this thesis. As the chart below shows, adding private equity to a 70/30 portfolio of equities and bonds increases the Sharpe ratio, whether the private equity portion is 10%, 20%, or 30%.
Private equity offers investors the opportunity for enhanced risk-adjusted returns
Source: Vanguard Group
Steady, long-term returns
Asset owners with a long-term horizon will find the stable, steady, long-term returns of productive finance to be beneficial.
Real estate, income-generating infrastructure, and profitable private companies provide regular long-term income that can help asset owners, especially pension scheme service providers, meet members’ liquidity needs.
Opportunity to contribute to economic growth and development
The focus on corporate social responsibility (CSR) and stakeholder capitalism in recent years exemplifies the need for firms to look beyond the interests of their shareholders and contribute to society.
In the investing world, there has also been a focus on sustainable investing, environmental, social, and governance (ESG) investing, and impact investing. All of these reiterate the need to act in the interest of society at large.
Productive finance is another initiative along this line. Such investments provide another avenue for investors to contribute to societal improvements while securing higher and stable long-term returns.
Active ownership
The ownership structure of private assets is also advantageous for asset owners who are concerned about exerting an influence on the direction that firms take.
“Private assets are typically owned by a smaller group of investors, in contrast with listed companies, which are held in minority by a much wider pool,” according to Schroders Capital. “As a result, private asset investors can more actively influence a portfolio asset not only to be more operationally efficient, but positively aligned to environmental and social goals.”
However, this is an advantage available only through the direct or co-investing route.
4. Opportunities for productive finance investing in 2025
Before approaching productive finance investing, asset owners should understand the current state of the industry and where the opportunities lie.
Interest in artificial intelligence, healthcare, and climate in private equity
AI was the leading category for capital raises in the US in H1, 2024, according to Rothschild and Co, a private banking company. They also noted that a total of $34.5 billion was raised by AI companies in 2024.
Top US AI deals in 2024
Source: Rothschild and Co.
In Europe, the largest raise in 2024 was for Wayve, an AI-powered autonomous vehicle software company.
Top VC deals in Europe in 2024
Source: Rothschild and Co.
Also, more than 55 biopharma companies raised $100 million or more in H1, 2024, according to Silicon Valley Bank while 17 biotechnology companies raised $5.7 billion in the US, according to Rothschild and Co.
The top US deals in biotech in 2024
Source: Rothschild and Co.
Finally, while climate technology continues to struggle in the US, it is booming in Europe. “In all deals in Europe of $100m plus Climate Tech leads by value, as it did in 2023,” noted Rothschild and Co. In the list of the top 23 VC deals in Europe, only AI has more representation than climate technology, as seen below:
Top 23 European VC deals in 2024
Interest in renewables, data centers, multifamily, and logistics in real assets financing
The private real estate market is still bottoming out but UBS Asset Management, quoted above, expects it to recalibrate in 2025. They also recommend that investors focus on those with strong fundamentals like multifamily, data centers, and logistics.
This is in line with developments in the real estate market. Multifamily is experiencing strong growth due to the high cost of homeownership and the growth of e-commerce continues to make logistics viable.
Finally, data centers have been benefitting massively from the growth in AI. “Data centers need to scale to accommodate the demands of AI and the sector saw the biggest deal of the year, a $9.2bn equity investment for Vantage Data Centers,” according to Rothschild and Co.
What about infrastructure?
“Meanwhile, we see infrastructure assets as attractive, especially those supported by government stimulus and benefiting from inflation-hedged and GDP-resilient cash flows,” says UBS Asset Management.
The global trends towards decarbonisation, deglobalisation (nearshoring and reshoring), and digitisation also imply that investors should prioritise assets along those lines.
Growing secondaries market
In H1, 2024, about $72 billion worth of transactions were done globally in the secondaries market, according to Evercore, a private capital advisory firm.
Also, they noted that the dry powder in the secondaries market has increased to $189 billion at the end of H1, 2024, a 14% increase from the beginning of the year. This is the highest amount of dry power that has been available since 2013.
Secondaries dry powder between 2013 and H1, 2024
Source: Secondaries Investor
Based on this trend, UBS Asset Management recommends that asset owners allocate a part of their capital to the secondaries market.
5. The risks of productive finance investing
While the benefits are enormous, asset owners must also be aware of the risks involved in productive finance.
First, we will consider the risks that are general to productive finance, irrespective of the investment method (Long-Term Asset Funds, individual private asset funds, or direct investing):
- Illiquidity: Productive finance requires that asset owners tie up cash for a long period. “By their nature, such assets typically involve liquidity risk, whereby investors may have to wait significant lengths of time to realise their investments,” according to PFWG. “A large infrastructure project such as a windfarm, for example, is likely to require investors to tie up cash for many years.”
Though asset owners can sell their stake in the secondaries market, there is no guarantee that they will find willing buyers. Even if they do, it might be at a significant discount to fair value.
If asset owners don’t implement sound liquidity management, they may find it difficult to meet the distribution demands of investors. As the PFWG noted, DC pension schemes will need to manage liquidity at the fund level.
- Getting accurate data: Accurate measurement of risk is another challenge with productive finance.
“The main stumbling block preventing the widespread development of infrastructure investment amongst DB plans in the UK is [that] the type and quality of data available to investors in such assets have been remarkably poor and unreliable,” according to the EDHEC Infrastructure & Private Assets Research Institute, in response to a call for evidence by the Department of Work and Pensions (DWP).
They conclude by saying that much better data is now available and investors (especially DB schemes) should use that data to gain a better understanding of risk.
- Market risk: Changes in interest rates can affect the value of real assets. Economic conditions like recessions and inflation can also affect the performance of productive assets.
- Regulatory and political risk: Infrastructure and real estate are especially subject to regulatory risk. A change in regulations, government policy, or political administration can affect the profitability of investments.
If asset owners go through the Long-Term Asset Funds or individual private asset funds routes, additional risks will include the following, according to UBS Asset Management:
- Blind pool risk: Asset owners who invest in Long-Term Asset Funds or individual private asset funds have to make significant investments before they know what the general partner will invest in.
Though they can ask for information on current holdings, that doesn’t guarantee what future holdings will be.
- Fees: Investment managers focusing on private markets charge higher management fees than traditional asset managers. They also charge incentive fees, payable when they achieve attractive returns.
- Lack of control: Investors in private market funds have to cede control to the fund manager who will be responsible for making entry and exit decisions.
- Limited disclosure: “Disclosure on the performance of underlying investments is periodic and can be more limited given that managers need time and flexibility to work with underlying companies and are focused on long-term value creation,” explained UBS Asset Management.
- Uncertain cash flows: The general partner, rather than the limited partners, will decide the amount and timing of cash flows.
- Use of leverage: Private market strategies like leveraged buyouts involve credit default risk, which adds to the risk of private investing.
Given these risks, asset managers should approach productive finance more cautiously. Those who go through the third-party funds route should be careful to choose the right one and those who embrace direct investing should conduct due diligence on every investment.
Asset managers can also benefit from talking to other asset managers and investment professionals. They can put them on to investment opportunities, help in the due diligence process, and even suggest the right funds to invest in.
At cio investment club, we provide you with a community of asset owners and managers from across the globe. You can get connected to good investment opportunities and also gain a better understanding of current developments in productive finance by having discussions with other investment professionals.
We also organise exclusive roundtables and investment breakfasts where you can physically network with investment professionals from every part of the world.
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Takeaways
- Productive finance refers to investments in long-term, illiquid assets like private equity, venture capital, real estate, and infrastructure.
- These investments provide capital to businesses and projects that contribute to economic development while offering investors the potential for higher returns, active ownership, and a diversified portfolio.
- Areas of high interest for productive finance in 2025 include artificial intelligence, healthcare, and climate-focused private equity investments. Additionally, real asset financing is seeing strong demand in sectors like renewables, data centers, logistics, and multifamily real estate.
- Investors in productive finance must navigate risks such as illiquidity, market fluctuations, regulatory uncertainties, and limited transparency in private market investments. Careful portfolio allocation and risk management strategies are essential for long-term success.
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