The trend is highlighted in the recent Mercer 2015 European Asset Allocation survey which canvassed 1,100 European institutional portfolios across 14 countries, with total assets of more than £700bn. It showed the average asset allocation to alternatives rose to 14% from 12% with private debt and multi-asset credit being the favourites in the illiquid space. Private equity, on the other hand, was further down the list due to its relatively higher level of risk as well as the governance required to manage closed-end investment programmes.
REPLACING THE BANKS
On the ground, fund managers differ in their approach and risk appetite. One common theme though is so-called bank replacement finance. In other words, institutional investors are stepping into plug the gaps left by banks whose balance sheets are being squeezed by the more stringent Basel III banking regulations. Popular options range from long-lease properties, sale and leasebacks, trade finance and corporate loans to small-to-medium-sized companies which can be done via a private placement or directly.
“Regulations have enabled pension funds to access asset classes that were not previously available,” says Jo Waldron, director within the alternative credit team at M&G. “There are new forms of finance emerging although there are not enough sufficient assets to create standalone funds. What we have done is built diversified funds from scratch to take advantage of best ideas.”
Broadly speaking, Waldron believes returns on corporate illiquidity range from Libor plus 3-4% for leveraged loans to 5-6% for a more diversified portfolio of assets from mainstream to niche areas such as trade finance.
“We see interesting opportunities in lending to smaller companies, long-lease property investments such as student accommodation as well as in leasing,” says Waldron. “For example, leasing companies providing fork-lift trucks to supermarkets would be financed by a bank, but now they can come to us. The supermarkets are ultimately responsible for the payments which mitigates the risk.”
RETURN OF THE MAC
M&G along with fund managers such as Babson have also created multi-asset credit (MAC) funds which provide exposures to a wide array of credit strategies, including loans, high yield bonds, emerging market debt as well as distressed debt, alongside more traditional bonds – in a single fund. The main selling point for pension funds de-risking is a decent return – 5% to 8% – but with lower volatility than equities.
Babson has a wider geographical approach than many, offering senior and second-lien loans, uni-tranche, mezzanine debt and private equity co-investments across the US, Europe and Asia Pacific.
“We have a global diversified portfolio which enables us to source the best deals,” says Eric Lloyd, head of private finance for the firm. “You also get paid differently for the senior and mezzanine tranches in different locations, but if we move down the credit curve we want to ensure that the premium is high enough to offset the risk.”
Lloyd sees prospects in lending to medium-sized companies in particular sectors such as consumer products, business services and core industries in developed markets.
“We are not big players in the distressed or turnaround space but prefer companies with solid cash flow and attractive capital.”
April LaRusse, senior product specialist in the fixed income team at Insight Investment, also does not believe now is the right time to be moving into sub-grade credit and prefers the investment grade equivalent end of the spectrum.
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