The global financial crisis had a massive impact on the funds industry leading to a boom in alternative credit, finds Fiona Rintoul.
Behind the global expansion of alternative credit lies one key event: the global financial crisis. By squeezing bank lending and creating a hunger for yield, the crisis manufactured both the market conditions and the investor demand for alternative credit to thrive.
The new situation creates a range of opportunities for asset managers to operate as alternative lenders.
“We can lend in parts of the markets where banks may be constrained by regulatory capital requirements: long-dated real estate finance or sub-investment-grade private corporate lending, for example,” says Barry Fowler, managing director, alternative income at Aviva Investors. “This doesn’t mean simply lending at the fringes but having the flexibility to provide finance that banks may find difficult.”
In an article on alternative lending, Gabrielle Kindert, head of alternative credit at NN Investment Partners, highlights four alternative sources of credit that can provide diversification and higher yields to investors:
• The Dutch residential mortgage market, where new players have pushed out traditional lenders and gained significant market share;
• Leveraged loans (or senior secured bank loans), where institutional investors already contribute more than 50% of market share;
• Infrastructure financing and commercial real estate financing, where institutional investors gained approximately 30% market share since the crisis; and
• Direct lending initiatives, where significant funding has been raised to finance SME initiatives directly.
These new opportunities are perhaps nowhere more in evidence than in Europe, where, before the crisis, some forms of alternative credit barely existed.
“Prior to the crisis, senior lending to middle-market companies was provided almost entirely by banks,” says Tom Newberry, head of private credit funds at CVC Credit Partners.
Today, alternative lending is booming in Europe. The Deloitte Alternative Lender Deal Tracker, which covers 66 lenders in Europe, reports a 34% increase in alternative lending deals in the 12 months to the end of the second quarter 2018. Deals were down in the third quarter, partly because of the political uncertainty created by Brexit, but lending in the second quarter alone reached 102 deals, representing a 31% increase on the same period in 2017.
In all, 1,510 deals were recorded in Europe in the last 22 quarters by the Deloitte Alternative Lender Deal Tracker. Of these, 929 were in mainland Europe and 581 in the UK.
“The move towards a less bank-centric model is becoming more prevalent in Europe, and this is where the more profound growth is being seen,” says Emer Stephenson, product manager at HSBC Securities Services.
Not only do the conditions that fostered the alternative lending market in Europe persist; the direction of travel in banking regulation also favours greater use of alternative credit.
“Banking regulation continues to drive new investment opportunities,” says William Nicoll, co-head of alternative credit at M&G. “Capital requirements on banks continue to grow and with Basel IV under discussion, European banks are increasingly seeking more capital-efficient avenues to lend.”
At the same time, it’s perhaps worth remembering that some of the new lending structures on the market may be not be as new as they seem. Until 2008, notes NN Investment Partners’ guidebook on alternative credit and its assets classes, the most common way to obtain exposure to the alternative credit market was via collateralised loan obligations (CLOs). When that market collapsed, many managers moved on to unleveraged or “unstructured” formats that bypassed investment banks. The underlying securities remained the same; it was just the name and fund structure changed.
“After the crisis, in Europe most managers renamed leveraged loans senior secured bank loans, and very often when I talk to people and I refer to leveraged loans, they say, we don’t want that, we only invest in senior secured bank debt,” says Kindert. “They don’t understand that these companies are leveraged six or seven times and are sub-investment-grade. This is why I find it very important that we create more transparency about risk and return.”
This comment sheds light on one of the key problems in the alternative credit asset class: complexity. Basically, this asset class ain’t for chickens.
“To ensure investors aren’t exposed to unforeseen risks requires a depth of expertise and due diligence that, to be frank, you can only do across the range of private debt if you have sufficient scale and resources,” says Fowler.
Often the best opportunities are in emerging, complex and underserved areas, and managers need a high degree of expertise and experience to navigate them. In Europe, specialty finance, which includes residential mortgages, personal loans, auto loans, student loans, credit card advances and small business loans, is one such area.
“The emergence of a specialty finance sector in Europe represents an opportunity for institutional investors to gain exposure to one of the largest and best-performing portions of European bank balance sheets,” says Nicoll.
For certain other credits, competition has intensified, driving down excess returns in the process. It is in underserved areas of the market, where there is less competition and fewer financing options available to borrowers, that returns and value remain attractive.
Intensifying competition can also be attributed to an expanding range of players in the market. For example, many fintech companies have entered the market and established business models that are challenging the traditional status quo.
“They are still small in size in comparison with incumbent players,” says Kindert. “However, their business model is addressing many current challenges in the financial sector.”
These challenges include inefficiency, information asymmetry and maturity transformation. There are no public ratings so alternative credit assets are more difficult to understand and evaluate, particularly in more complex segments of the market. At the same time, investors need to be able to move quickly to capitalise on a deal when conditions turn favourable – even if their counterparties don’t.
“Private and illiquid markets can be lumpy, structures can deteriorate, changes in supply/demand dynamics can be fast while negotiations can be slow and complex,” says Nicoll. “This means that private and illiquid credit opportunities can take years to bear fruit.”
Another challenge – partly a result of the intense competition in the market – is dry powder. Preqin data show that, with the exception of 2014, capital available to private debt fund managers has increased year on year since 2008, and dry powder now stands at a record total of $251 billion (June 2018). Of this, a little under $80 billion (€71 billion) is in Europe-focused funds.
However, alongside competition sits collaboration, according to Nicoll. For non-bank lenders, investment prospects look increasingly collaborative with opportunities to source assets by partnering with banks.
“Competing with banks for borrowers is no longer the only source of lending opportunities, as it was in private debt’s infancy,” he says.
The challenges are many. However, for the large institutional investors, such as pension funds and insurance companies that make up the investor base for alternative credit, this asset class can solve a range of tricky problems, which is driving demand.
“Everything points to increasing demand for real assets and their associated financing,” says Fowler. “Our year-on-year private lending grew by 25% last year, and we expect to see our volumes continue to grow over the next five years.”
That growth comes from pension funds looking for cashflow-driven strategies, insurance companies providing buyout of maturing liabilities, and – increasingly – by DC [defined contribution] pension platforms looking to access the assets in which their DB [defined benefit] counterparties have long invested. Indeed, for pension schemes, insurance companies, endowments and other institutional investors, private debt is becoming a strategic allocation in portfolios.
“It is valued for many purposes, from the best-known goals of higher yields and diversification from public debt markets, to attractive outcomes that can include longer-dated maturities, inflation linkage, security over hard assets, defensive or counter-cyclical properties, and access to borrowers not found in the bond market,” says Nicoll.
In many ways, it’s a new – or newish – solution to an old problem.
“Pension schemes’ need for income sources above government debt rates are underpinned by Europe’s changing demographics and the EU’s increasing old-age dependency ratio,” says Nicoll.
Increasingly, those pension schemes and other institutional investors are not just looking for single-strategy products in the alternative credit sector to meet that need. They are asking managers to provide multi-asset solutions for their cashflow or liability requirements. For this and other reasons, Aviva Investors sees benefits in having an integrated platform across the range of real assets.
“We can talk to borrowers on deals such as student accommodation or data centres, for example, from both a real estate and infrastructure perspective,” says Fowler. “For example, we have provided both infrastructure debt and structured finance facilities to the same borrower, so the opportunity for managers who have skillsets across a range of asset classes are immense.”
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