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Opportunities in Illiquid Credit


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Opportunities in Illiquid Credit

  1. 1. Opportunities in Illiquid Credit 25 April 2013Opportunities in IlliquidCreditPete DrewienkiewiczDavid Bennett1
  2. 2. Opportunities in Illiquid Credit 25 April 2013The Seven Steps to Full Funding TM2Design an efficientinvestment strategyDestination for agilehedging strategyTransparency to maketimely decisionsArticulate clear objectivesand constraintsMission StatementTo help our clients achieve full-funding with the minimum level of riskCLEAR GOALS &OBJECTIVESACCESS TODERIVATIVE HUBLIQUID ALPHA & BETASTRATEGIESLIQUID & SEMI-LIQUIDCREDIT STRATEGIESILLIQUID CREDITSTRATEGIESILLIQUID ALPHA & BETASTRATEGIESONGOINGMONITORING
  3. 3. Opportunities in Illiquid Credit 25 April 2013Seven Steps to Traditional Asset Classes3Step(2)Derivative Hub(3)Liquid α & β(4)Semi-Liquid Credit(5)Illiquid Credit(6)Illiquid α & βCollateralManagementEquities Corporate Bonds Infrastructure Debt Insurance-LinkedHedging Multi AssetAsset BackedSecuritiesSocial Housing Debt Private EquityActive LDI Sovereign Bonds High YieldDirect Mid-MarketLendingInfrastructureEquityEquity Derivatives Commodities / CTA Leveraged Loans Mezzanine Finance Unlisted PropertySwaptions CurrenciesEmerging MarketDebtDistressed DebtHedge Funds withLonger Lock-UpsGilt Repo Liquid Hedge FundsCommercial RealEstate DebtLong Leases /Ground Rents
  4. 4. Opportunities in Illiquid Credit 25 April 2013Terminal Portfolio ApproachThe Role of Credit Within a Scheme’s Asset Allocation4CorporateBondsDirectLendingCorporateLinkersInfrastructureDebt / LongLeasesGround RentsGiltsCash
  5. 5. Opportunities in Illiquid Credit 25 April 2013Introduction: IlliquidCredit5
  6. 6. Opportunities in Illiquid Credit 25 April 2013European Bank Distress6“Much has been written on the entanglementbetween banks and sovereigns in Europe since thefinancial crisis started in 2007-08.At its heart, we believe, the issue is quite simple:European banks are too big.By “too big” we mean that the size of their assetsand liabilities is such that – in theory – they havethe capacity to threaten the solvency of theirown sovereign.”Source: Barclays Research, ‘Bank Deleveraging in Europe: Not Done Yet’ (October 2012)
  7. 7. Opportunities in Illiquid Credit 25 April 2013• Recourse to national sovereign in times of crisisimplies that overall size of banking system ismanageable.• Where this is not the case (e.g. Ireland), depositguarantee schemes can lack credibility.• National regulators in Europe thus have animportant interest in ensuring ‘their’ banks havesufficient capital to withstand stress scenarios.Pressure on Banks to Delever70%20%40%60%80%100%120%140%160%180%200%Barclays RBS Santander BNPParibasING Group DeutscheBank*Unicredit0%20%40%60%80%100%120%140%160%180%200%JP Morgan GoldmanSachsBAML Wells Fargo MorganStanleyCitigroupBank Liabilities vs. ‘home’ country GDP in Europe and the US*All data as at year end 2012 except Deutsche Bank at year end 2011 (date of last available annual report). Source: Company Filings, Eurostat, Barclays Research“Global banks are global inlife, but national in death”- Mervyn King
  8. 8. Opportunities in Illiquid Credit 25 April 2013Impact of New Regulations8ICapital andLiquidityBasel 3II IIIRisk Mgt.andSupervisionMarketDisciplineNarrowerrange ofeligiblecapitalIncreasedcapitalreqs.Capital Ratio2019 deadline to complete implementation of Basel III.Institutions are seeking to demonstrate capital andliquidity resilience much earlier.Capital standards require banks to hold more capital ofhigher quality under Basel III than under Basel II rules.Quantity of capital:• Total common equity Tier 1 capital ratio rises from 2%to 7% (includes capital buffer of 2.5%)• Minimum total capital (Tier 1 & Tier 2) increased from8% to 10.5% (including buffer).• Banks may target total capital ratios of 13-15%• Introduction of 3% non risk-based leverage ratio• Liquidity requirements: Liquidity Coverage Ratioand Net Stable Funding RatioQuality of capital:• Common equity and retained earnings should be themain component of Tier 1 capital, not debt-likeinstruments
  9. 9. Opportunities in Illiquid Credit 25 April 2013Scarcity of Capital in the Face of Robust Demand:The ‘Maturity Wall’9• Recent strong US loan and bond sales have pushedout the maturity on the corporate debt of theneediest borrowers to c. 2017.• $645bn of sub-investment grade maturing innext five years• Peak due in 2017• Macro concerns (e.g. US debt ceiling) coulddisrupt financing markets• Total amount of debt maturing in the next fiveyears is down modestly from 2012...• ...but amount of maturing debt held by lower-rated companies is now higher.Source: S&P Leveraged Credit Review, Ares Capital, Barclays Research, Moody’s0501001502002503003502013 2014 2015 2016 2017 2018 2019 2020$bnmaturingSecured Loans High-Yield Bonds0102030405060702013 2014 2015 2016 2017 2018 2019 2020€bnmaturingSecured Loans High-Yield Bonds2. European Maturity Wall1. US Maturity Wall
  10. 10. Opportunities in Illiquid Credit 25 April 2013Current Opportunities10
  11. 11. Opportunities in Illiquid Credit 25 April 2013Higher-RatedLower-Rated“Shorter-Dated” “Liability Matching”InfrastructureCRE DebtGround RentsLong LeasesAircraft FinanceDirect LendingDistressed Debt11
  12. 12. Opportunities in Illiquid Credit 25 April 2013Real Estate Long Leases12Maturity Profile 20 years +Liquid Alternative 20-Year Tesco BondExpected Spread / Rate 285bpsApprox. Premium overLiquid Alternative108bpsAttractions• Security over underlying asset provides downsideprotection• Long-dated, inflation-linked cashflows• Potential to target sub-asset classes (e.g. socialhousing) as part of long lease portfolioPoints to Note• Potential for concentration risk given prevalence oflong-lease deals in certain sectors (e.g.supermarkets) – also may have exposuresreplicated in corporate bond portfolio• More popular pooled funds have built up capitalqueuesInvestor(Lessor)RentTenant(Lessee)Right tooccupypropertyfordurationof leaseLegal ownership ofproperty remains withinvestor and property istransferred back at endof lease
  13. 13. Opportunities in Illiquid Credit 25 April 2013Ground Rents13Maturity Profile 99 – 999 yearsLiquid AlternativeBBB Long-Dated SterlingCorporate CreditExpected Spread / Rate 300bpsApprox. Premium overLiquid Alternative73bpsAttractions• Long-dated, index-linked cashflows• Security of underlying asset• Freeholder has recourse to mortgage lenderin case of tenant default• Over-collateralisation of ground rent viaproperty built on landPoints to Note• Individual rents must be acquired in volume to havemeaningful impact on portfolio and to providediversification• Large-scale supply is limitedGroundRentMortgageLeasehold EquityGround rents rank higher than any claim on theleasehold including mortgage repayments
  14. 14. Opportunities in Illiquid Credit 25 April 2013Infrastructure Debt14Maturity Profile 15 years +Liquid AlternativeBBB Long-Dated SterlingCorporate CreditExpected Spread / Rate 275bpsApprox. Premium overLiquid Alternative48bpsAttractions• Long-dated, index-linked cashflows• Secured lending• Government support for sector via PFI• Many projects are likelier to experience lower returnvolatility due to the natural bias towards essentialservice sectorsPoints to Note• Time to become invested• Prepayment risk exists (although prepaymentpenalties are common within loan structures)• Limited availability of debt investment opportunities• Potential for exposure to development risk• Different sectors have different risk factors (e.g.Ongoing demand for services offered)Indicative risk breakdown:• Education• Rail• Water• Pipelines• Airports• Satellites
  15. 15. Opportunities in Illiquid Credit 25 April 2013Commercial Real Estate Debt15Attractions• Bank deleveraging has arguably createdfundamental dislocation in asset class• Falls in LTVs have resulted in cushion on fallingproperty values to senior loan providers• Security on underlying asset mitigates default riskPoints to Note• Diversification of tenants / loans required tocounteract void risk• Significant allocation required to achievediversification• Prepayment risk exists (although prepaymentpenalties are becoming increasingly common)Maturity Profile 5-10 years (varies)Liquid AlternativeSterling IG CorporateCreditExpected Spread / Rate 350bps for Senior LoansApprox. Premium overLiquid Alternative104bpsSponsor(PropertyOwner)LenderCommercialPropertyTenantsThe lender has a lienon the underlyingpropertyPrincipal + InterestLoan Advance
  16. 16. Opportunities in Illiquid Credit 25 April 2013Aircraft Leases16Maturity Profile c. 5 – 10 yearsLiquid AlternativeBBB Short-Dated USCorporate CreditExpected Spread / Rate 350bps for senior debtApprox. Premium overLiquid Alternative155bpsAttractions• Nature of underlying asset as global commodity(supports resale value in case of default)• Opportunity to structure either via sale andleaseback of aircraft or as asset-backed debtsecured on underlying planesPoints to Note• Difficult to price residual value of asset accurately(given depreciation, potential for technologicalchange, upkeep costs etc.)• Limited manager universe• Exposure to business cycle0100200300400500600700800900Sep2004Sep2005Sep2006Sep2007Sep2008Sep2009Sep2010Sep2011Sep2012Global Commercial Aircraft Order Backlog (Bn $USD)Source: Bloomberg
  17. 17. Opportunities in Illiquid Credit 25 April 2013Direct Mid-Market Lending17Maturity Profile 24 – 72 MonthsLiquid AlternativeBB/B Non-Distressed USHigh YieldExpected Spread / Rate600bps prior to defaults,450bps after defaultsApprox. Premium overLiquid Alternative230bpsAttractions• Attractive spreads available relative to other illiquidopportunities• Loans typically secured on borrower’s assets• Direct origination allows greater capture of loaneconomicsPoints to Note• Private-equity style structure of manager offeringsimplies high fees (including performance fees)• Prepayment risk exists (although prepaymentpenalties are common within loan structures)• Dependence on manager sourcing abilities inallocating capitalCorporateCorporateBankAssetManagerBankAsset ManagerBankAsset ManagerBank
  18. 18. Opportunities in Illiquid Credit 25 April 2013Distressed Debt18Maturity Profile VariesLiquid AlternativeBB/B US Distressed HighYield CreditExpected Spread / RateN/A (owing to difficulty inquantitatively assessingdefaults, and differingIRRs according toinvestment approach)Approx. Premium overLiquid AlternativeAttractions• Large proportion of available deals sourced outsideof public markets – same considerations apply as indirect SME lending• Diverse opportunity set, including non-performingloans, special situations lending, liquidation claims• Potential for attractive returnsPoints to Note• Wide range of potential opportunities – some aredifficult to analyse / idiosyncratic (e.g. liquidationclaims)• Importance of manager skill in identifying gooddeals and avoiding blow-ups• Managers differ in extent of control over borrowerdesiredDiscounted Debt Activist Investing Control InvestingSecure CompaniesNo RestructuringShort-TermInvestment HorizonLower Target IRRCompanies UnderPressureRestructuringMid-TermInvestment HorizonMiddling TargetIRRsCompanies InDeep DistressSignificantRestructuringLong-TermInvestment HorizonHigh Target IRRsSpectrum of Control
  19. 19. Opportunities in Illiquid Credit 25 April 2013Implementation19
  20. 20. Opportunities in Illiquid Credit 25 April 2013Use of Illiquid Credit as Equity Alternative2040%20%20%20%Sample Equity Replacement PortfolioRisk ParityLong / ShortCreditDirect Lending(SMEs)Distressed DebtSources of FundingDevelopedEquityEM EquityPrivate Equity50%35%15%Previous Allocation25%50%25%Replacement PortfolioPortfolio Weightings: Return-Seeking Assets• Overall risk in the return-seekingassets bucket reduced by 20%• Overall expected return on schemeassets increased by more than 10%Equities Credit “Alternatives”
  21. 21. Opportunities in Illiquid Credit 25 April 201313-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 BennettHead of Investment ConsultingDirect Line: 020 3326 DrewienkiewiczHead of Manager ResearchDirect Line: 020 3326 professional investors only. Not suitable forprivate customers.The information herein was obtained from varioussources. We do not guarantee every aspect of itsaccuracy. The information is for your privateinformation and is for discussion purposes only. Avariety of market factors and assumptions may affectthis analysis, and this analysis does not reflect allpossible loss scenarios. There is no certainty that theparameters and assumptions used in this analysis canbe duplicated with actual trades. Any historicalexchange rates, interest rates or other referencerates or prices which appear above are notnecessarily indicative of future exchange rates,interest rates, or other reference rates or prices.Neither the information, recommendations oropinions expressed herein constitutes an offer to buyor sell any securities, futures, options, or investmentproducts on your behalf. Unless otherwise stated,any pricing information in this document is indicativeonly, is subject to change and is not an offer totransact. Where relevant, the price quoted isexclusive of tax and delivery costs. Any reference tothe terms of executed transactions should be treatedas preliminary and subject to further due diligence.This presentation may not be copied, modified orprovided by you , the Recipient, to any other partywithout Redington Limited’s prior writtenpermission. It may also not be disclosed by theRecipient to any other party without RedingtonLimited’s prior written permission except as may berequired by law. “7 Steps to Full Funding” is a trademark of Redington Limited.Redington Limited is an investment consultantcompany regulated by the Financial ConductAuthority. The company does not advise on allimplications of the transactions described herein.This information is for discussion purposes and priorto undertaking any trade, you should also discusswith your professional, tax, accounting and / or otherrelevant advisers how such particular trade(s) affectyou. All analysis (whether in respect of tax,accounting, law or of any other nature), should betreated as illustrative only and not relied upon asaccurate.Registered Office: 13-15 Mallow Street, London EC1Y8RD. Redington Limited (reg no 6660006) isregistered in England and Wales.©Redington Limited 2013. All rights reserved.Risk Management Firmof the Year (2011, 2012)Pension Consultant of theYear 2012
  22. 22. Opportunities in Illiquid Credit 25 April 2013Manager Research Team:Division of Responsibilities Across Steps 2-7               22
  23. 23. Opportunities in Illiquid Credit 25 April 201313-15 Mallow Street London EC1Y 8RDTelephone : +44 (0) 20 7250 TeamPete DrewienkiewiczDirector | Head of Manager ResearchDirect Line: 020 3326 NicollDirector | Manager ResearchDirect Line: 020 3326 LiuVice President | Manager ResearchDirect Line: 020 3326 McCartanAssociate | Manager ResearchDirect Line: 020 3326 DasAssociate | Manager ResearchDirect Line: 020 3326 MijakowskaAnalyst | Manager ResearchDirect Line: 020 3326 FedorenkoAnalyst | Manager ResearchDirect Line: 020 3326