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Assets not listed on public markets are receiving much greater attention as long-term investors are challenged to meet their return requirements through traditional investment strategies.
Although the narrative in financial markets is overwhelmingly dominated by events taking place on public markets, a large part of the global economy is funded and controlled privately. With yields low or negative in the years following the financial crisis, the private sphere has become increasingly important for investors searching for diversification benefits, higher investment returns and the potential security that comes with recourse to the underlying assets.
Although ‘private markets’ is used quite loosely, the phrase usually covers illiquid assets which are not listed on a stock exchange or traded publicly. In these fields, investors might find that a private route makes it possible to access a broader opportunity set and higher yields. In infrastructure debt, for instance, the number of private issuers has been around three times larger than public ones in Europe in the last decade, with greater breadth of sector exposure.
The illiquidity premia available - higher expected returns from investing in a private rather than a public asset of broadly similar credit quality - vary widely from transaction to transaction, and change over time as well. Understanding and mapping the scale of the premia is a key challenge. Most alternative assets trade infrequently and do not have a close parallel in public markets, but a pragmatic approach to valuations can give a deeper understanding of how an asset is expected to perform, both in absolute and relative terms.
One way to do this is to compare private deals to a public benchmark, adjusting each deal spread to give a reasonable comparison with the benchmark’s characteristics. Adjustments can be derived from data sets of spreads on corporate non-financial bonds with different ratings profiles. Typically, the publicly-traded asset used as a comparator is not as liquid as risk-free assets, and may provide some reward for illiquidity as well.
Drilling down in this way reveals the range of premia available across different asset classes. Recently there has been some spread compression, particularly for assets that meet the specific regulatory requirements for insurers writing annuity business. Here, competition has been intense for higher yielding assets that meet the restrictions imposed by Solvency II’s matching adjustment framework. Nevertheless, the rewards for taking illiquidity risk persist. In 2017, that might mean infrastructure debt yielding Euribor +200 or 300 basis points for financing transport in Spain or Italy, or Euribor +120 to 200 basis points in core markets such as Germany or France (higher than the line of best fit, shown in Exhibit 1.) This might be an attractive proposition for insurers in the euro area, and other institutional investors as well.
Illiquidity premia vary over time
Given that each asset type has diverse drivers of return, and that corresponding listed markets also move largely independently, opportunities can be volatile. Analysing transactions in detail is the only way to understand opportunities and help investors meet their objectives.
Broadly speaking, primarily investment-grade bond and loan assets will be most suitable for investors seeking predictable cash flows, perhaps as part of a cash flow-driven investment approach. The inflation-linked income streams offered by long-lease real estate might be helpful for investors with liabilities to match in real terms, as can income from infrastructure assets that is not dependent on the volume of usage or market pricing. In these cases, the nature of risk is clearly very different from opportunistic, structured finance transactions or equity exposure taken in cyclical markets.
Whatever the case, the ability to compare risk and reward - in conventional and non-conventional structures - is essential to make the most effective relative value calls. This realisation is driving current interest in multi-asset rather than single strategy approaches.
Seeing tolerance for illiquidity as a source of competitive advantage
Tolerance for illiquidity is an important differentiator and can be a source of competitive advantage. Although it might be difficult to find willing buyers for private assets in volatile down markets, investors who intend to hold assets to maturity can benefit from a long investment time horizon. Nevertheless, the cash flow impacts of private market allocations need to be assessed through extensive stress testing to ensure that exposure to illiquid assets is set and remains within appropriate limits, illustrated below.
Assessing and managing appetite for less liquid assets
The unique, idiosyncratic nature of the assets means investors who are able to search widely across a broad opportunity set will have much greater opportunities to find the kind of risk and revenue profiles that match their needs most closely. They may well be able to deploy capital more rapidly as well.
Opportunities for pension funds and insurers
In late 2017, there are a number of opportunities that might be attractive for institutional investors, particularly as Basel IV already seems to have precipitated some balance sheet restructuring in the banking sector. Certain banks are looking to reduce their holdings of large debt transactions, freeing up capacity in floating rate deals, some of which are becoming available at a discount to par.
Another area of change - also resulting from increasing constraints on banks - is in fund financing. Here, a growing number of funds are lending to SMEs (companies with EBITDA of around £20m to £50m), and seeking to raise finance to bridge the gap between identifiable opportunities and the receipt of funds from investors. Fund financing can offer an attractive risk/return profile while the lender potentially retains a degree of control over which companies the funds lend to.
For clients with derivative hedging requirements, there are opportunities to trade uncollateralised swaps; some corporates need swaps but do not have sufficient liquid collateral to support them. Banks have limited appetite for uncollateralised swaps, given their existing capital requirements. This scenario is creating opportunities for investors to trade swaps with corporates directly, rather than through a bank counterparty. As they are uncollateralised, these transactions require rigorous credit review but can offer yield pick-up over an equivalent collateralised swap (on a cash credit support annex) for highly-rated names such as the European Investment Bank or IBM.
For insurers, there may be potential in real estate financing, including providing longer-dated loans with terms stretching over 10 years, as well as opportunities in long-lease commercial real estate (including student accommodation and social housing), ground rents and equity-release mortgage loans. These assets could be used in long-term savings business, such as with-profits, to back long-dated general insurance liabilities or within shareholder funds, backing the on-going capital requirements of the business.
Investors need to be aware that understanding tolerance for illiquidity and the wider risk environment is immensely important in private market assets, as changes of strategy can be difficult to execute rapidly. Nevertheless, private markets offer diverse opportunities for return seekers, where the trade-off for greater complexity and illiquidity can be reflected in the bottom line. With Basel IV seen as a potential game-changer, a range of opportunities is available as banks continue to reshape their balance sheets and rein in the scope of their activities.
This article originally appeared in Investing in Private Markets, Europe 2017, issued by Clear Path Analysis
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 20 November 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.