A genuine alternative
Written by Alison Swonnell
December 2015/January 2016
Alison Swonnell explains why alternative credit, particularly private debt, should be increasingly appearing in pension funds’ portfolios as an alternative to fixed income
The Encyclopedia Britannica defines storm as “a generic term, which is popularly used to describe a large variety of atmospheric disturbances”. This certainly seems a fitting description for the European pensions landscape, which has experienced a series of cyclones since the tech bubble explosion of the early noughties. Fifteen years on and, whilst we may have passed through the eye of the storm, balmy sun filled days feel like a distant memory to many pension schemes.
The systemic changes that have reverberated around the industry have at each stage driven strategic review and resulted in portfolio restructure, incrementally benefitting risk management practices. The tech storm exposed the risks inherent in equities with the Nasdaq Composite from 2000 to 2002 losing 78 per cent of value from peak to trough. At that time, with many pension funds invested in so called ‘balanced portfolios’, holding 60 per cent or more in equities, the industry quickly revised its view on what ‘balanced’ actually meant. This led to the genesis of liability driven investment solutions (LDI), which sought to more closely match assets with liabilities. As LDI took hold, portfolios were built to mirror liability profiles based on the cash flows required for these long-term obligations. In the main these solutions used a mix of derivatives, bonds and ‘return seeking’ assets.
By 2008 LDI had arguably hit the mainstream and once again financial ‘mother nature’ bit back, with the collapse of Lehman Brothers and the hurricane force winds of the global financial crisis. This time derivative and bond based solutions were squarely centre stage for pension funds. So successful have these strategies been that Mercer’s European Asset Allocation Survey 2015 states that bonds are now the single largest asset class within UK pension plan portfolios, accounting for 48 per cent, with equities a modest 33 per cent. This trend is borne out across Europe with countries such as the Netherlands holding bond allocations of 55 per cent or more. Indeed, Barclays research shows that fixed income inflows into funds have grown by $1.2 trillion since the crash. Such has been the thirst for bonds that, at the point of highest demand, bond trading turnover decreased by 40 per cent. This gap between supply and demand is stark. Overlay this with a steady decline in bond yields over the period (10 year AAA yields fell from 3.1 per cent to below 6 per cent in the five years from November 2010 to 2015) and the latest storm clouds look darker still.
So once again, the industry finds itself caught in a perfect storm; one where more closely matched asset and liability solutions have been implemented, but at a point where bond supply has decreased and yields have become suppressed. With the low cost of corporate debt increasing the magnitude of pension liabilities, asset managers are once again innovating: offering alternative credit products with sustained yields and strong levels of absolute return.
Alternative credit, and in particular private debt, has grown significantly since the financial crash because it is a genuine alternative to fixed income and has stood up to yield depression. Preqin estimates $191.7 billion of dry powder is available today for investment in these funds. This is 4.5x the amount of demand seen a decade ago, making this one of the fastest growing alternative asset classes.
The drivers behind this growth are once again a story of supply and demand: supply driven by banks deleveraging; demand driven by pension funds.
A boom in loan supply for specialist credit funds
Since the financial crisis, European banks have been dealt a continual stream of new rules and regulations. Together these pressure the banks to reduce the size of their balance sheet in an attempt to stay in line with new and increasing capital requirements. With banks offering non-performing loans (NPLs) and performing loans (PLs) for sale as well as scaling back new lending, asset managers have seized the opportunity to step into the gap and offer credit funds.
Divestment of portfolios and non-core business lines enable banks to comply with these capital requirements in an attempt to rectify historical capital deficiencies and meet increased future requirements. The need to improve return on equity through focus on higher contributing assets and the realisation of operational efficiencies, alongside the regulatory pressures over use of capital, mean that the desire to sell these portfolios is increasing: the IMF first estimated in 2012 that European banks would need to cut their balance sheets by around €2 trillion, largely through the disposal of non-core assets (NPLs and PLs). This has since resulted in year-on-year increases in portfolios available for purchase, with more than €150 billion worth expected to be traded in 2015 according to Deloitte.
IMF director of the Monetary and Capital Markets Department Jose Vinals recently pointed to these problem loans being the greatest impediment to growth in Europe, saying that the banks must take "decisive action" to tackle the €900 billion worth of NPLs on their books. Furthermore, the recent publication of the European Banking Authority’s EU Wide Transparency Report revealed the scale of the issue that banks still have to deal with: The European NPL ratio is double that of the US and stock stands at €1 trillion (7.3 per cent of GDP): 6 per cent of European bank loans are impaired versus 3 per cent in the US.
The supply side pressures are unambiguous and will only continue to build over the next five years as banks scramble to adopt the Basel III capital accord and the IFRS 9 loan loss provision accounting standard amongst others.
Preqin estimates that three out of three institutional investors are considering investing in private debt. With spreads forecasted to remain tight, buying wholesale credit portfolios in the form of private debt alternative investment funds offers pension schemes a true alternative to corporate and government bonds:
1) High levels of absolute return: a consistent 12-14 per cent unleveraged yield can be achieved through building a portfolio of NPLs and PLs;
2) Liquidity: investments pay cash from day one and quickly amortise with capital typically returned within three to four years and so even if offered in closed end fund format, they are not illiquid in the same way that a private equity fund can be;
3) Low relative risk: more granular non-corporate credits can spread risk across many thousands of underlying borrowers and results in low correlations to other asset classes offering diversification benefits;
4) Control over portfolio performance with limited tail risk: Buying impaired or non-core loans in the primary market and then improving the cash flow profile through loan servicing means that the manager can actively control returns, for example being able to react to correct underperformance. The strategy by its nature generates lower risk assets with established track records of payment which means that the value left in the tail can be readily sold into the market at a premium;
5) Transparency: buying loan portfolios in a wholesale format offers investors greater transparency and look through to the underlying assets. This provides good visibility over the composition and performance of the assets, coupled with the control aspect, in stark contrast to buying a securitized product, which may well be investing in exactly the same underlying assets. Such transparency also creates a favourable Solvency II treatment.
Realising the credit opportunity
With the evidence for supply and demand clear, how can pension schemes invest in this privately traded asset class for whole loans?
Despite the fixed income style characteristics of buying whole loans, traditional fixed income asset managers do not typically have the skillsets able to realise this opportunity. Private debt expertise has emerged out of long-term commercial market participants, like LCM Partners who started investing in consumer and SME receivables 16 years ago, or via new entrants that have moved into the marketplace out of the banking sector: Typically former prop desk traders from investment banks, loan managers from commercial banks or via PE houses that have moved into private debt as an expansion of their product offering. Universal to all however is the transaction expertise required to source, underwrite and close deals.
Expertise and experience are of course the fundamentals to the evaluation of any potential investment manager, but in private debt and, more specifically, the purchase of whole loans, LCM would encourage investors to consider three things in selecting the right partner:
1)Sourcing ability: to identify sufficient, attractively priced transactions;
2) Underwriting expertise: a track record of delivering returns across the cycle;
3) Implementation experience: successful onboarding and servicing of a range of portfolios across markets and underlying product types.
With these three components evaluated, institutional investors can be confident that their manager is well positioned to deliver the double digit returns and yields still available in this part of the credit market, which should outshine bonds for the foreseeable future; wherever the next storm clouds blow in from.
Written by Alison Swonnell, director of fund operations, LCM Partners