European Insurers have been building up their investment in the private credit market these past three years. Although there is room for growth in this asset class, there are currently some serious caveats which need to be borne in mind. Sarfraz Thind reports
Harvesting the illiquidity premium has become one of the more focused areas in insurance asset management. According to a BlackRock survey from 2015, the illiquid asset class to have seen most interest by insurers in recent times is private credit with more than half indicating an increased allocation to the sector for 2016. In Europe, insurers have indeed been ramping up funds into commercial real estate loans (CRE), small-medium enterprise (SME) lending, energy project finance and shipping and transport, a move triggered by plunging yields and an increasingly desperate hunt for return as rates continue to dive in traditional fixed income markets.
Less than 5% of largest European insurer portfolios
Yet, as of now, private credit makes up less than 5% of even the largest European insurer portfolios. By contrast, in the US larger insurers like MetLife and Prudential currently invest up to 25% of their assets into loans, while in Japan an insurer like Nippon Life has up to 20% invested in loans. It is a disparity which participants believe will shrink in the long run as European insurers, with their long-term investment horizon, realise the ongoing benefits of investing in this asset class.
With the withdrawal of banks from many traditional lending areas, the continent's loan markets currently provide clear opportunities to drive further growth. Insurers are, theoretically, in an ideal position to take up the slack. The lack of short-term trading pressures on insurance balance sheets—liquidity risk—means that the industry can hold assets for longer periods and through more volatile market cycles than banks or hedge funds. The biggest life insurers in Europe have either recruited teams directly or given mandates to fund managers to tap into the attractive yields on offer.
Popular CRE loan sector
According to research carried out by SG, CRE loans currently offer an illiquidity premium of 123 basis points over commercial mortgage-backed bonds, accounting for default and recovery rates. Energy project finance loans, meanwhile, give a 231 basis point liquidity premium over equivalent utilities bonds, while the liquidity premium for lending to French SMEs is 233 basis points over European high yield bonds.
Currently the most common type of private credit investment has been into the CRE loan sector. Last year was a record for European CRE investment activity, beating the previous high in 2007, with most interest coming from insurers, according to SG. Insurers have been looking to build typically diversified portfolios of CRE loans that have a maturity of five to ten years and an average size of €50m ($55.8m). Larger insurers have been increasing their holdings of the asset on a yearly basis. Germany's Allianz has been one of the bigger players in the market and currently holds €36bn—or 5% of total assets—in residential and commercial mortgages, a figure which increased by 17% in 2015.
While there are opportunities to grow, however, it is not a business to jump into incautiously.
"Each loan sector – be it infrastructure loans, residential or commercial mortgages, aircraft or corporate loans – has its distinct features," says Martin Opfermann, head of credit, Allianz Investment Management. "We are currently looking to increase all segments. However, as we are an investor, we need to reallocate for each loan we buy. Therefore growth in this sector is not a goal in itself. Our investment decision is purely driven by relative value. If we do not see an attractive margin, we pass up the opportunity."
Most CRE loans have a shadow rating of BBB- to A. However, according to Alain Bokobza, head of global asset allocation at SG CIB, the loans have added attraction value since they have a recovery rate that is superior to most senior corporate bonds of similar rating. At the same time, the ramp up time for CREs can be quick, especially compared to other types of private debt like infrastructure and project finance loans, which require a longer due diligence process.
Insurers have, of course, also been drawn by the Solvency II capital charges on shorter- to medium-term CRE loans. Under the unrated module, unrated commercial mortgage loans (CMLs) can benefit from up to a 50% reduction in spread risk when the loan to value ratio is below 75%. An unrated CML with a five-year duration and LTV ratio of 75% would, for example, have a spread risk charge of 7.5%. This compares to a capital charge of 12.5% for a BBB rated bond of the same duration.
"Using the unrated category for commercial mortgage loans reduces your spread risk under Solvency II since it allows the spread shock to be offset against the underlying collateral value of the property," says Gareth Haslip, global head of insurance strategy and analytics at J.P. Morgan Asset Management.
It appears a good trade-off. But not everyone has embraced CRE loan investment. One of the big issues with tapping the asset class is scalability. Getting into the market requires large resources and a sizeable balance sheet.
"As a rule of thumb, one could say that if you do not bring along sufficient scale to build the business – and here I mean sourcing loans, credit analysis, structuring know-how and processes – your advantages will be smaller or even inexistent," says Opfermann. "In this case it probably makes more sense to buy a plain-vanilla bond product than to do the business on your own."
Last year, Dutch insurer Delta Lloyd announced that it had sold its €273m CRE portfolio, citing its desire to reduce riskier assets with "a relatively low Solvency II risk adjusted return".
According to Paul Fulcher, head of European ALM structuring at Nomura, the capital treatment of the longer-dated rated CRE loans in comparison to other similar yielding assets is not always to an insurer's advantage.
"Long-dated credit assets are not that attractive under Solvency II as capital charges increase with duration," he says. "Capital treatment of CREs can be the same as high yield loans though the latter are typically much shorter-dated, around five years in length and capital charge increases with duration. Insurers would argue CRE is much more secure than high yield but this isn't always reflected in the rating, and hence not reflected in the capital charge."
SME lending
The other major area of private credit that has seen interest from insurers the last few years is SME lending. SME loan yields normally start between 7% and 8% and can reach up to 12% further down the capital structure. Loans range across sectors—including finance, energy and industry—and are normally short-term in nature. The investments fall into the same bracket as high yield bonds at around 20% to 25%. With diversification against other insurance risks the capital charge can drop to around 15%.
"High yield SME lending is normally two to three years in duration—that is why it is so capital efficient," says Haslip. "It is short-dated and generally done for refinancing."
Specialist skill-set required
Unlike Europe, direct lending has been popular amongst insurers in the US for a number of years. The US bank lending market is smaller than it is in Europe with roughly 80% of lending carried out by institutional investors as opposed to somewhere nearer 20% in Europe. As a result, US insurers have taken up the slack.
European insurers, by contrast, have been slow to enter this business. While three years ago, the yields on offer in Europe were attractive, nonetheless there are sticking points to growing this particular asset. For one, the due diligence involved in direct lending is generally very intensive and requires specialist skills, which means building a team to handle the task.
"It can be a three-month due diligence process to approve a private loan," says Haslip. "In the public markets new issuance comes along and asset managers make decisions very quickly. If the loan does run into difficulties, you will need to work with the company and restructure or even install new management. It takes a specialist skill set. Trying to bring this in-house is big work for an insurer."
Insurers have been teaming up with asset managers or specialist lenders to boost their direct lending businesses. In 2014, Legal & General acquired a 40% equity stake in Pemberton Asset Management to provide loans and private placements to mid-market companies in the UK. By the middle of last year, this had already grown to a fund totalling €547m in investments in European direct lending.
Paul Forshaw, head of insurance asset management at Schroders, says that credit research required on SME lending means it is a natural move for insurers to partner with fund managers in the search for this type of business. Indeed, in April, Schroders acquired a 25% stake in Dutch SME lender NEOS Business Finance, which provides institutional investors access to an alternative debt financing platform for SMEs as a way to meet insurer interest.
"Direct lending is a fast growing asset class that a number of our institutional clients are taking an interest in," Forshaw says. "The market has grown rapidly since the credit crisis as banks have retreated from certain types of lending. The size of the SME loan market in the Netherlands alone is estimated to be €30bn of issued loans across approximately 5,000 companies."
The growth of the market is likely to take time as insurers make the asset allocation decisions and put into place specialist mandates. Things may be helped it the market were also to see structural changes to make it more insurance investor-friendly, as is currently the case in the US.
"Three years ago people thought the market would evolve like the US where financing is done with prepayment and on a fixed rate basis to suit institutional investors," says Bokobza. "But in the three years you have seen more of a convergence of institutional investors to banking practises. There is no demand from investors to have more structured deals."
Competition concerns
However, there are other concerns. While interest in the direct lending market continues to grow for the long-term, in the near to medium-term, there are worries about the effect of competition into the market. The glut of money pouring into loans has seen a contraction in spreads and a loosening in credit risk standards in some cases.
"You are seeing a deterioration in documentation standards for now," says Desmond English, loan portfolio manager at Pioneer Investments. "Five years ago direct lending transactions had good debt to equity splits, good documentation and healthy risk adjusted yields. Now, the supply demand dynamics are not healthy seeing the avalanche of new money enter the direct lending space. There is a shortage of corporate opportunities to meet this supply, creating an environment with tighter margins, weaker structures and people having to take more risk to deploy capital."
At the same time, insurers have begun to look at other options to the direct lending market. For one, there has been a revival of interest in public high yield deals in 2016, which are more attractive than they were one year ago from a return perspective, currently yielding about 6.9%. Similarly insurers are looking at leveraged loans which, though they might yield around 5% against 6% to 7% for direct loans, appear to offer better value from a risk-adjusted perspective.
"Previously direct lending, with its robust structures and terms, could have been argued to offer advantages over the large leveraged loans market but many of the historical relative strengths have been eroded making direct lending deals more risky right now," says English. "Optically when someone is pitching a loan product, direct lending sounds great but you have got to get your credit analysis right with ten out of ten credits."
English says that, in the long-term, there will be more institutional involvement as banks de-lever but insurers have to account for these medium-term risks now. Newer midsized companies looking to allocate to private credit might reconsider whether to go into something they are less familiar with or the high yield market, which remains one of the more traditional assets for insurers.
Indeed, while Europe is seeing a maturing private credit market with more investment opportunities getting to the same supply and demand dynamic as the US, for example, it appears to be some way off right now. It is a challenge that many will be looking at closely.