As investors await the bottom of the interest rate cycle, we consider three key themes to look out for in private asset markets.
3 minute read
1. Healthy deal flow to continue
As the prolonged era of extraordinary monetary policy winds down, we expect healthy deal flow to continue across the spectrum of private assets. With the market calling the bottom in the latest interest rate cycle, sponsors of private assets may look to refinance transactions before the next upward shift from major central banks. Borrowing costs will not remain at such attractive levels indefinitely.
As such, we believe the market for private asset financing is likely to remain active in 2018, characterised by a small number of greenfield projects, a peak in refinancing opportunities and healthy merger and acquisition-related deal flow.
While growth in Europe is accelerating, so are opportunities in private corporate debt. After a post- crisis record year in 2017 with around €80 billion of institutional loan issuance, January 2018 saw a healthy €14.3 billion of transactions1, which is further increased by opportunities in the small cap sector.
Although new construction activity in Europe is expected to be relatively subdued, there are green shoots in some parts of the market. In UK real estate these include the growth of the private-rented sector. Here, demand for new housing units far exceeds supply, with around 130,000 units coming to market each year against demand of around 200,000 to 240,000 homes2. Institutional investors currently hold less than two per cent of the market, but there has been a wave of interest from income seekers, including those wanting to take advantage of the relative weakness of sterling.
In energy, a lack of greenfield wind and solar projects will mean a focus on a small number of new waste/biomass schemes and the continued growth of offshore wind. The sector is developing rapidly, helped by subsidies to promote less established technologies as part of the government’s Industrial Strategy. Plans coming on-stream include the first institutional investor-led offshore wind farm - once operational, the Hornsea project in East Yorkshire will be the largest in the world. Refinancing opportunities may also appear as other large wind farms become operational.
Investment in rolling stock is expected to continue in the UK and France, part of the ongoing modernisation of rail infrastructure. There is also expected to be a concentration of activity around Spain’s new €5 billion public-private investment programme, which is targeting the construction of around 2,000km of roads.
Meanwhile, a significant amount of institutional capital is ready to be put to work. “With the volume of private infrastructure equity seeking a home, shareholders are seeking value by trading stakes at the end of life for some closed-end funds,” says Darryl Murphy, Aviva Investors’ head of infrastructure debt. “The market will continue to see asset sales that will bring new debt opportunities for investors, many of whom are longer-term investors actively seeking longer-term, stable capital structures.”
2. Demand driving down returns
Institutional investors are expected to continue to increase their investment in private assets… This is likely to put pressure on returns from trophy transactions.
Demand among institutional investors for private assets continues to be strong. Solvency II has led insurers to search for assets eligible for favourable capital treatment, and several countries including Italy and Spain are facilitating non-banks’ investing in loans. Pension schemes are looking more closely at risk budgeting and enhancing risk-adjusted returns as well.
“Institutional investors are expected to continue to increase their investment in private assets in 2018,” says Laurence Monnier, head of alternative income strategy and research at Aviva Investors. “This is likely to put pressure on returns from trophy transactions, while better value will be found in less visible or more complex deals.”
In commercial real estate finance, for example, pricing for loans backed by trophy properties has fallen to under 100 basis points over mid-swaps for A or BBB-type risk in Germany3; pricing differentials between different European markets have fallen too. At the higher end of the risk spectrum, leveraged loans have also been in high demand, pushing down borrowing costs for indebted companies, while there has been a gradual erosion of protections in covenant-light loans.
We see opportunities in less crowded areas of the market, such as lending to European small/mid caps (companies with EBITDA >€10m), with B or B+ type ratings. “The small and mid-cap segments are growing and resilient, with better risk-adjusted returns compared to the covenant-light structures applied to the large cap sector,” says Antoine Maspétiol, head of private corporate debt at Aviva Investors. Yields of around four per cent can be achieved for B-rated credits.4
Many companies in these sectors are seeking to diversify funding sources outside banks, hoping for a long-term strategic partner. This is a role pension schemes and insurance companies may be well suited to; non-bank lending already accounts for around 40 per cent of the market5. Borrowers tend to be more conservative in their requirements than large caps, yet the universe is still diverse enough for managers to be selective. The annual flow of debt is estimated at around €54 billion in France alone, spread across a variety of sectors.
Institutional investors are expected to continue to increase their investment in private assets… This is likely to put pressure on returns from trophy transactions.
3. Illiquidity premia persists with a premium on innovation
In spite of competitive market conditions for high profile transactions, illiquidity premia persist (see illustration below).
Trends in illiquidity premia (2006-2017)
Similar to the re-emergence of covenant-light debt, we are increasingly seeing infrastructure equity investors making optimistic assumptions and disregarding risk in their search for higher yields.
Innovation, both in terms of sectors and structures, is likely to command a premium, but it is important to keep a close eye on risk. “Similar to the re-emergence of covenant-light debt, we are increasingly seeing infrastructure equity investors making optimistic assumptions and disregarding risk in their search for higher yields,” says Ian Berry, head of infrastructure equity at Aviva Investors. “More innovative approaches, such as unlevered investment, can provide better downside protection and contribute to more stable income.”
Identifying and understanding the idiosyncratic risks associated with private markets investments will be particularly important as interest rates begin to climb.
References
1 Bloomberg, Leveraged Finance Chartbook, January 2018. Excludes repricings.
2 Knight Frank. Specialist Property Sector Report 2017: Private Rented Sector
3 Aviva Investors. As at 29 December 2017
4 Aviva Investors. As at 29 December 2017
5 Deloitte UK Alternative Lender Deal Tracker, Q3 2017
