Alternative Investment Solutions: Impact of Brexit
Our Alternative Income Solutions (AIS) platform invests across real estate finance, infrastructure, private credit and structured finance. Assets within these areas are typically characterised by:
- strong covenants and protections, and are secured meaning higher recovery rates in the case of default.
- each investment is scrutinised by an investment committee, where issues such as the potential implications from Brexit are considered. This debate includes the effects on suppliers, customers, and overall business, as well as the effect on the valuations of securities.
- investments are typically in private illiquid assets whose values tend to be less volatile.
A multi-asset approach, involving a diverse range of alternative assets, remains sensible. The breadth of capabilities and experience we have allows us to scrutinise opportunities with a wide view of the market.
We believe the AIS platform is well placed to take advantage of opportunities arising from Brexit developments because:
- the pipeline of new deals is likely to shrink. That favours a multi-asset approach in terms of the speed of deployment and finding the best value deals.
- it helps reduce exposure to financials and public credit markets.
- it is positioned defensively and takes a long-term view.
- there are more opportunities as some participants exit markets.
Market outlook: Potential consequences of Brexit are:
- Government investment policy:
a) Increased political demand for spending on social infrastructure such as schools, hospitals and care homes.
b) Increased spending on economic infrastructure, such as roads, railways and airports, as a means of supporting economic growth. At the same time there is a risk that existing/planned projects, such as the building of a third runway at Heathrow airport, are delayed.
- Uncertainty over the outlook for projects funded by the European Union. How much impact remains to be seen, as it is dependent on whether the UK leaves the European Infrastructure Bank.
- International investors: While foreign investors will be deterred by nervousness and uncertainty, as well as the inevitable increase in the cost of currency hedging, this will be offset by a weaker pound.
- Energy prices: A stronger US dollar makes domestic energy production, and not just renewable projects, more attractive.
- UK and European interest rates will be lower for longer, reducing the cost of funding. Fixed-rate financing is likely to be particularly appealing.
- Credit spreads: Unlikely to widen as supported by looser monetary policy implemented by the European Central Bank and potentially the Bank of England. Pension funds will also continue to source these assets given their ongoing need to match their liabilities.
Short-term outlook (less than six months)
- Some investors are likely to sit on the fence for a while until uncertainty dies down
- Investment committees will review their strategy, delaying the approval process.
- New government projects are likely to be delayed or put on hold.
- Secondary market likely to be quiet as investors hold back or demand better pricing.
- Although there is also more uncertainty in the euro zone, governments will be looking to press on with projects to support their economies.
- Non-European investors may delay investment in the euro zone as they assess the impact of Brexit.
Outlook for the medium term (more than 18 months)
- Currency depreciation will attract international investors into the UK market, particularly from those currently invested in the US dollar and possibly the Japanese yen.
- Low long-term interest rates and stable credit ratings will also support the sector.
- We expect new UK projects to be created to sustain the economy.
Conclusion: Infrastructure remains a highly attractive asset class. We expect to see the following as a result:
- Credit sensitivity should be low as a high proportion of borrowing is at a fixed rate with limited refinancing risk.
- Political support for new infrastructure projects to sustain the economy.
- The illiquidity premium will be especially attractive given that interest rates will remain lower for longer.
- Loss expectations remain low and are independent of the economic environment.
- Reduced number of international investors may push up yields for a while.
The risks to the above view:
- Political risks could limit the flow of new deals as projects are cancelled or delayed. Cross-border deals are most at risk.
- Prolonged recession which will make investors nervous.
- Defaults could rise if weaker economic growth hampers borrowers’ ability to repay investors.
- Governments scale back infrastructure investment.
Real estate finance
The lending environment is much better than in the run-up to the global financial crisis. Banks are significantly better capitalised and funded, lending standards more prudent and leverage across the sector is much lower. It will take some time to understand exactly what the impact will be. But some early trends are emerging:
- There are already some signs that increased funding costs for banks are likely to have an impact on banks’ capacity and willingness to lend, and on the cost of loans.
- Uncertainty as to valuations will limit confidence to lend - valuers have already unleashed a ‘Brexit caveat’. This raises questions over current valuations.
- Maximum loan sizes are being significantly reduced – unlikely to be over £100 million.
- However, the fall in gilt yields / swap rates is helpful for financing transactions from an income coverage perspective.
Brexit can offer both positive and negative implications for structured finance.
- Banks’ cost of funding will rise. The change in the credit default swap curve should incentivise banks to deleverage. Since Aviva has a more stable source of funding (insurance liabilities) we are less sensitive to market movements and therefore this creates opportunities for us to take these positions off banks at an attractive price.
- Current pricing is not as attractive at the moment. Our desk invests in illiquid assets and we are only interested in deals that offer an illiquidity premium. Generally when market events cause a shock in liquid markets, as is currently the case (credit spreads have widened by 20% to 30% since last week), there is a lag effect in the illiquid market. This has led to a reduction in the illiquidity premia available.
Nevertheless, this is only likely to be a temporary phenomenon and we believe illiquidity premia will eventually increase – reflecting stresses in the market – which will provide more opportunities to find relative value.
- Prices should have risen, as the drop in yields was not fully compensated by a rise in spreads. Only once we know the economic outcome of the Brexit vote and the negotiation process, will we be able to assess the fundamental impact.
- The amount of sterling-denominated debt issued in private placements issued in sterling is likely to fall slightly overall, although much depends on the time horizon involved.
- Over the short term, new sterling issuance should be unchanged relative to the first half of 2016, with mainly UK names or opportunistic public issuers approaching private placement markets.
- Over the longer term, lower liquidity and price discovery in public markets could reduce lenders’ willingness to lend while currency hedging costs may rise.
Long income real estate funds
Market outlook: UK capital values look likely to decline moderately over the remainder of the year, driven by direct and indirect consequences:
- Prolonged illiquidity in market
- Heightened risk aversion leading to some yield widening which may hit secondary assets more
- UK occupier market impacted less than investment market
- Central London offices likely to see reduction in both occupational and investment demand
- Caution in Scotland resulting from pressure for another referendum
- Sterling depreciation to support demand from overseas investors, but offset by reduced ‘safe haven’ status
- Prolonged weakness of sterling would have negative implications for UK retailers (especially with lower margins), but could be a positive for tourist spending (e.g. prime central London)
- Looser monetary policy likely to support prices
The suite of strategies that fall under long income real estate are defensive and diversified. The average length of leases tends to be 20 years or more, and they are usually indexed to inflation or have fixed uplifts. Tenants generally have strong credit ratings. Additionally, there is a lack of leverage in this sector. These strategies are not expected to be affected by the Brexit vote.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 29 June 2016. Unless stated otherwise any opinions [and future returns] expressed are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature.
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. Past performance is not a guide to the future.
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