With low yields and tight spreads prevalent in traditional liquid fixed income markets, many institutional investors are considering whether higher returns are available by assuming credit risk in private or illiquid form. We believe this type of alternative credit strategy may enhance portfolio returns, but investors should be extremely judicious when giving up liquidity, particularly today.
Assets that are illiquid cannot be sold immediately without a potentially significant impact on price. We think investors should therefore require incremental yield or an illiquidity premium for holding such assets. However, it is not easy to calibrate what level of illiquidity premium an investor ought to demand as compensation for tying up their capital.
Seek adequate compensation
Simply comparing yields or credit spreads is appropriate if the underlying debt has similar credit and other risks. However, that is rarely the case; and even where credit metrics are comparable, underlying credit risk may still be quite different. For example, a large company may have similar leverage to that of a smaller one, but the earnings of a smaller business may be much more volatile, resulting in a significantly higher probability of default.
We believe that it is therefore essential for investors to adjust for the underlying credit risk or anticipated losses when comparing prospective returns from both more and less liquid forms of credit risk (see Figure 1).
Even after adjusting for anticipated losses, some form of illiquidity premium is apparent. For both commercial mortgage-backed securities (CMBS) and commercial real estate collateralized debt obligations (CRE CDOs), the underlying economic exposure consists of mortgages secured by commercial property; yet CRE CDOs tend to offer significantly higher yields, even after adjusting for anticipated losses. There are two primary reasons for this:
- CMBS trade in secondary markets, while CRE CDOs are more tightly held and change hands sporadically, and hence should offer an illiquidity premium.
- Legacy CRE CDOs are also subject to onerous regulatory capital charges and involve additional complexity, limiting the pool of potential holders, which again demands they offer incremental yield.
In fact, illiquidity and complexity premiums can often dominate the underlying credit risk premium.
It is also apparent that loss-adjusted yields do not necessarily rise in proportion (or in line) with the liquidity profile of the asset. Exceptionally low yields have driven capital into less liquid credit, but investors’ preferences and constraints have distorted illiquidity premiums. The asset types (framed by the red line in Figure 1) are semi-liquid or shorter-dated, but have relatively attractive loss-adjusted yields. At the opposite end of the spectrum, significant amounts of capital have been raised in non-performing loan and direct-lending funds, compressing loss-adjusted yields on these significantly less liquid assets.
However, the required holding period itself may deter many investors. Two to three years can be too long for hedge funds, which typically offer investors quarterly redemption rights, but not long enough to compound returns to the level many private equity funds target.
Funding gaps in key markets are closing, but at different rates
In the aftermath of the financial crisis, banks retrenched from many forms of lending, creating what were widely referred to as funding gaps. Asset managers responded by raising investor capital to provide private loans to borrowers unable to access debt from either banks or capital markets.
More recently, debt capital markets have seen record issuance, while banks have selectively re-entered many markets, accelerating the closure of funding gaps.
The U.S. corporate credit sector is leading this trend. A record volume of collateralized loan obligations has swelled the supply of loans to sub-investment-grade issuers, with high-leverage multiples and fewer covenants on average than at the onset of the global financial crisis in 2007. Simultaneously, business development companies have been raising capital and extending credit directly to smaller borrowers. Today, funding availability is generally plentiful and on terms that we often believe are in many cases too generous.
Meanwhile, the markets for U.S. commercial and residential real estate loans remain more compelling. The volume of origination of U.S. residential mortgage loans that do not qualify for government agency guarantees has been barely perceptible. The lack of credit in this sector still leaves compelling opportunities to originate such loans at historically high yields or to acquire legacy residential mortgage exposure in a form that others find problematic. The securitization of U.S. commercial real estate loans into CMBS is recovering (see Figure 2), though structures largely comprise loans that fit banks’ inflexible underwriting templates, and opportunities remain to supply credit in less-vanilla cases.
Turning to Europe, banks in certain countries have further deleveraging to undertake and public credit markets are shallower, suggesting more pervasive funding gaps. However, the European Central Bank has viewed the region’s credit supply as an economic imperative and has devised bank liquidity facilities contingent on stabilizing loan books, alongside attempts to restart securitization of loans in Europe through its asset-backed securities purchase program. Banks have resumed certain forms of high credit quality lending.
At the same time, a record amount of non-bank capital, in the form of insurers and direct-lending funds, is focused on originating real estate and corporate loans. These lenders often have to compete with banks to make vanilla loans in core European countries, either offering lower yields or greater structural flexibility via higher leverage, looser covenants and a greater scope for cash flows to be paid as dividends. In contrast, secondary sales of legacy loans are actually picking up in Spain and Italy, where localized issues represent a high barrier to entry.
Creating liquidity is a compelling form of exit strategy
Sourcing a higher yielding form of private credit exposure is only the first step to realizing an illiquidity premium. Ultimately, it is a question of how the borrower will repay or refinance the debt. An illiquidity premium is not earned until principal is repaid or the asset is sold.
While an improving fundamental credit profile might encourage other lenders to refinance the loan, actively creating liquidity can be a valuable strategy. One example is accumulating re-performing mortgage loans that can be securitized and sold into public markets. Short-maturity corporate and CRE loans, designed to bridge events and then be refinanced into more vanilla syndicated term loans, are another example. Each loan requires the ability to source and structure credit risk privately and to price that risk in public credit markets (see Figure 3).
Mitigate risk and maximize loan recovery
Whether buying debt at par or at 50% of par, understanding both the underlying value and the various pathways through which value might ultimately be realized is critical. However, in private credit, the lender must be prepared to be much more hands-on in order to maximize a loan’s recovery.
Effective recovery depends significantly on how close the investor is to both the loan and the underlying collateral. While some directly originate private loans to borrowers, others source exposure indirectly from banks in some form of risk transfer. From a recovery perspective, being one step removed from the loans and dependent on the bank’s servicing or workout capabilities can materially diminish effectiveness, while potentially creating conflicts of interest. This must be factored into the initial assessment of the realizable illiquidity premium, i.e., the price of the asset.
The process for maximizing a loan’s recovery based on underlying collateral value requires specialist loan servicing, restructuring and legal resources. Furthermore, to access this second pathway to realizing returns, the investment mandate itself must be sufficiently flexible to hold assets coming out of a restructuring in whatever form makes most economic sense, including equity in a private company or real estate.
Finding the right fit
We believe a flexible mandate is critical when investing across credit sectors and spanning public and private forms of credit risk. Being truly opportunistic is as much about avoiding mistakes as it is about finding the most attractive investments, and a broad, global opportunity set reduces pressure to put capital to work in crowded sectors.
In our view, the appropriate terms for an illiquid investment mandate should never force the asset manager to demand liquidity from the market. However, that does not necessarily mean investors ought to accept 10-year capital commitments as the only means of capturing an illiquidity premium. Where portfolios have significant cash flows and principal repayments, we believe investment managers could prudently pass some of that liquidity through to investors.
There is no free lunch
While the private credit markets can seem relatively opaque, they are of course closely linked to the public credit markets. The ability to price and transition credit risk between these markets creates a rich opportunity; but there is no free lunch. To responsibly capitalize on this, we believe investors do have to both forgo some level of liquidity and accept some price volatility, while investment managers must themselves invest significantly in specialist resources. Put simply, the illiquidity premium must be earned.