Roger Aitken
Alternative credit is an option for institutional investors looking for a new home for their cash, but should pension funds gain exposure to the sector to replace the disappointing returns offered by higher grade debt? Roger Aitken explores the landscape.
“The liquid leveraged loan market is currently very hot, arguably overheated, with leverage multiples rising, price compression and poor terms.”
Anthony Fobel, BlueBay Asset Management
Should pension funds and other institutional investors handle alternative credit with care? As a relatively new but growing sector many institutional investors hungry for yield are turning their gaze towards this area.
Increasingly European pension funds have become active in the wider alternative credit space, particularly in private debt. The latter has seen significant growth from just a handful of investment options years ago to dozens of subset strategies today. At least considering this market has become necessary.
Reflecting on growth in the private debt space, alternative asset data provider Preqin estimates that the value of global private debt assets has quadrupled since 2006, reaching $595bn by June last year. Between December 2015 and June 2016, assets under management (AUM) in the private debt sector had grown by 7.1%.
Yet with a diverse spectrum of products on offer in the alternative credit space, navigating and evaluating the potential risk-adjusted returns and the complexity of the underlying assets as well as individual products is not without challenges.
As an emerging asset class that was formerly dominated by the banking sector, alternative credit provides investors with a variety of opportunities for earning income and offers the benefits of portfolio diversification. With all the various opportunities on offer sharing similar qualities, yields are higher than traditional fixed-income and the cashflow-matching potential is similar. Some
alternative credit strategies contain a floating rate coupon floor to protect lenders from negative rates.
A guidebook published this May by NN Investment Partners’ (NNIP) titled ‘Alternative credit and its asset classes: A guide to understanding the complex universe of private debt assets’, noted: “In the past decade, the European lending landscape has become highly complex, with many players, numerous alliances and partnerships, and a wide range of overlapping terminology.”
ALTERNATIVE OPTIONS
The term ‘alternative credit’ spans a range of strategies and products, from tradeable syndicated loans to direct lending to corporates. It is any credit that is not sovereign debt, semi-government or traditional investment-grade corporate debt. This subcategory includes high-yield, emerging market debt, structured credit and bank loans on the liquid side and private credit, direct lending, specialty finance and distressed debt on the illiquid side.
Even for the experienced professional it is difficult to capture the meaning of the different terms used in this field. As well as direct and syndicate lending, it also includes private debt (senior and subordinated loans), leveraged loans, senior secured bank loans, club deals, private placement, alternative fixed income, mezzanine, senior and unitranche. The latter structures essentially single loans that combine senior and subordinated elements.
Not only can each term mean different things to different players, it can be “just as difficult to decipher the corresponding business models, co-operation structures, alignment of interests of counterparties and the regulatory framework”, according to Hague-headquartered asset manager NNIP, which at 30 June 2017 managed around $280bn.
Its 140-page guidebook noted that “exchanging government bonds or investment-grade credits for alternative credit with a similar risk profile provides a yield pick-up of 50bps to 125bps”.
Alternative credit offers characteristics with long duration and predictable cash-flows that is also highly suitable for liability matching. Default rates are relatively low and recovery rates comparatively high, which leads to lower write-downs.
Added to that, there is low market value volatility due to mark-to-model valuation, which makes the portfolio less vulnerable to market sentiment and offers a steady cash yield. The alternative credit market size offers a scalable alternative to government bonds and investment-grade credits, but investors should beware of pitfalls.
NNIP head of the alternative credit boutique Gabriella Kindert, a co-author of the guidebook, said: “Despite their differing dynamics and risk parameters, alternative credit investments share a number of common features. These include a deep understanding required to assess the asset class and credit risk, the investment decision is bottom-up and the investment is illiquid.
“Transparency remains an issue in many asset classes,” she added. “And, it is not easy to find an appropriate, objective benchmark to assess the quality of investment selection and monitoring.”
True sources of alpha generation in alternative credit remain: 1, the assessment of assets on secondary and primary markets; 2, the quality of risk assessment and ability to avoid losses without compromising on the expected portfolio return; and 3, the costs and efficiency in managing assets.
Wallace Wormley, founder and managing director of UK-based private investment consultancy OSPARA, which advises Pan European institutional investors including pension funds, said: “For several years now, there has been a growing trend for institutional investors, sovereign wealth funds, pension funds and family offices to consider and use alternative credit in their portfolio constructions.”
One reason for this growth, according to Wormley is that “too much investor capital has been tied up in core debt exposure, with not enough alternative sources of return”. Another reason cited is that the marketplace has recognised this fact and “rapidly developed more products” within this sub-asset category.
“For example, there is an increasing influence of private credit within mainstream finance and it is playing a role in supporting the real economy,” he added. “This change is taking place as the shift from traditional bank lending towards private credit looks to be a permanent one.”
There are also regional variations in the growth and uptake in the sub-sectors of alternative credit. Take the US, where about 10 times more capital is allocated to distressed debt compared to continental Europe, Wormley noted.
LIQUID V ILLIQUID
In terms of what investors should choose to invest in from the myriad of options confronting them, perhaps the starting point is to decide on whether to focus on the tradeable part of the market (including high-yield bonds) or the more illiquid section, which is known as direct lending or private debt.
The direct lending market in Europe comprises more than 70 firms each with about €500m of AUM, with only nine firms managing more than €2bn. Despite the pressure banks face, direct lending firms account for less than 0.5% of the European lending market today.
Anthony Fobel, managing partner of BlueBay Asset Management’s private debt business, which manages more than €7bn in direct lending funds, said: “Investors seeking to work out who will achieve the best returns will have to delve into the quality of the team, details of the underwriting process, rigor of the due diligence as well as the ultimate calibre of investments.”
Focused on ‘event-driven’ lending to, for example, fund an acquisition or provide growth finance for European medium-sized companies with €100m to €300m of revenue, BlueBay’s Fobel added: “These investors will also have to assess whether the team in question has the expertise to manage difficult situations, which will inevitably occur when the markets turn down.”
Despite BlueBay’s position as one of the largest and most established players in the fast growing European direct lending market, having recently closed its first senior loan fund at more than €3bn, Fobel noted that this leading position brings advantages as well as challenges.
“We are seeing a certain amount of competition and poor structures from the liquid loan market filtering down into the private debt market for larger deals, although covenant discipline remains a feature for most private debt managers,” Fobel remarked.
“The liquid leveraged loan market is currently very hot, arguably overheated, with leverage multiples rising, price compression and poor terms,” he added. “More than 60% of these loans are now ‘cov-lite’, which is extraordinary given the lessons that you would hope had been learned following the financial crisis – but people have very short memories.”
BlueBay sees covenant protection as “vital in preserving capital” in a situation where businesses underperform due to company specific or economic downturns, he said. But going forward it will be important to pinpoint sectors of private credit that can maintain high barriers to entry for traditional banks.
Nick Warmingham, a senior investment director at investment consultant Cambridge Associates, echoes Blue Bay’s Fobel on the quality of the team and details around the underwriting process, pointing out that when underwriting a manager ideally “one would look for a team that has worked together on restructuring situations”.
However, noting a paucity of data on how funds have performed during a credit crunch, this makes it difficult for pension funds to examine track record and performance. Hence recognising managers that standout can prove problematic.
RETURN TARGET
Given that yields in the direct lending market have declined of late, the demand and supply dynamics are pushing managers to raise leverage in funds in order to meet
expected return targets. That poses challenges for pension funds. As such they need to choose investments that match their return targets as well as managers who are likely to succeed by navigating through tricky times.
But as asset managers are competing to offer lending, they may sometimes alter the covenant lever or leverage lever. In so doing this changes the risk profile of funds. The upshot is that it can prove quite difficult to decipher and understand where managers are taking on added risk.
For investors considering alternative credit it helps to keep an open mind, especially since there are several other asset classes within the sector apart from private debt. Some like Trey Parker, head of credit at Highland Capital, believes there is a “liquidity advantage” to being invested in a tradable asset class versus a non-tradeable one. And, this was despite the higher markto-market volatility.
Others like Ranbir Lakhpuri, a portfolio manager at Insight Investment for secured finance, see advantages in syndicated loans compared to direct lending due to lower leverage in the market. That said, the former can exhibit covenant-light transaction and weaker documentation.
For others, the structured credit market is seen as offering opportunities, provided managers take on sensible levels of risk. With a rise in the number of unitranche structures – complex structures that enable higher leverage and a promise of heightened returns from the loans – their risk and complexity aspects could make them a potentially unsuitable investing avenue for pension funds.
CASE FOR THE DEFENCE
Alternative credit and private asset products are certainly appealing given that they could provide a stable investment return, increase the diversification of the portfolio and can be regarded as a defensive asset class.
As pension funds acknowledging that a static 60/40 portfolio allocation to equities and bonds will not be sufficient to meet their long-term target returns, the risk and return profile of alternatives will keep them in the spotlight.
However, as Kindert at NNIP noted: “Due to their illiquid and complex nature, investors should develop the ability to assess the different products, create alignment of interests among stakeholders, and put stronger emphasis on the governance framework to ensure that companies have sufficient guidance to navigate a vastly changing financial world.”
Whatever the sub-sector, funds should monitor managers and investments carefully. With alternative credit having grown substantially during a prolonged period of low interest rates, it raises the possibility that risky loans have been extended to less than robust borrowers. As such investors should focus on due diligence and evaluate opportunities across the entire sector.
