a guide to european private and illiquid credit · 2017-07-14 · 4 a premium for illiquidity and...

A Guide to European Private and Illiquid Credit

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William NicollCo-Head of Alternative Credit, Fixed Income

Foreword

Opportunities in European non-traditional lending markets have proliferated since the Global Financial Crisis and new opportunities continue to emerge. For long term, institutional investors that can tolerate illiquidity, these diverse markets present a rich seam of opportunities to achieve a variety of investment outcomes.

The attraction lies not just in higher levels of income that compensate investors for accepting less liquidity or higher levels of complexity. These assets can also generate a range of quality cashflow types that can offer diversification and inflation protection, and satisfy an array of liability-matching requirements. This is in addition to the enhanced information flow and structural credit protections that these opportunities can offer.

However, non-traditional investments require a high degree of expertise, a broad network of relationships and considerable investment discipline to effectively capitalise on the underlying opportunities. Investors will need to approach these markets opportunistically and prioritise asset value over availability to achieve optimal results.

In this Guide, we offer a comprehensive introduction to these disparate markets, focusing not just on the opportunities, but also the key investment considerations. Investors with some knowledge of these markets will also find it useful to refer to the 10 individual strategy profiles in Part 2.

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Part 1: An Introduction to European Private and Illiquid Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

Part 2: 10 Key Strategy Profiles: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Asset-Backed Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Direct Lending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

Distressed Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

European Leveraged Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Long Lease Real Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Private Placements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Regulatory Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Senior Commercial Real Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Infrastructure Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Impact Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Part 3: A Summary of the Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Contents

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A premium for illiquidity and better protection for investors

Private and illiquid credit spans a broad range of assets offering a variety of fixed, floating or inflation-linked cashflows over a broad range of maturities. In exchange for accepting a higher degree of illiquidity on the principal invested, private and illiquid debt assets can offer attractive yields, better documentation and stronger investor protections.

Below we show the typical returns and investment horizons of a variety of European private and illiquid credit asset classes. In addition to time and total return, the chart also indicates the kinds of cashflows that each strategy can deliver and typical credit ratings. The chart highlights the huge diversity and the breadth of outcomes that the private and illiquid credit universe can support.

Opportunities in Fixed and Illiquid credit

Diverse range of maturities and risk/return profiles

Trade Receivables

Leasing

Insurance Risk

Private Placements

Distressed Debt/Specialist Situations

Specialist Property

Social HousingGround Rent Debt

Infrastructure Debt

Regulatory Capital Trades

CLOs/Mezzanine ABS

Long Lease Property

Swap RefinancingIncome Strips

Local Authorities

Ground Rent Ownership

High GradeABS

Senior Mortgages

Leverage Loans

Junior Mortgages

Corporate Direct Lending

Complex Direct Lending

0

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1 6 11 16 21 26 31 36 41

Tota

l Ret

urn

(%)

Investment Horizon (Yrs)

Pan-European markets Developing European markets

Key

Fixed Rate

Floating Rate

Inflation Linked

Fixed Rate/InflationLinked

Key

AA

A

BBB

BB

Non rated

Key

Complex Sectors

Bank Replacement trades

Developed Sectors

Longer dated assets with ‘matching’ characteristics

Source: M&G illustrative, Bloomberg UK Sovereign curve. Graph indicates total return of asset classes. *Gilt curve is shown for reference only. (Gilt Curve I22 GBP UL) as at 3 February 2017

Part 1: An Introduction to European Private and Illiquid Credit

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A continually evolving opportunity setGrowth in European non-bank debt markets has significantly lagged more mature counterparts in the US where companies are estimated to raise 80% of their financing in capital markets1, including private debt markets. The US leveraged loan and private placement markets are long-established and efficient, and continue to meet the financing needs of corporate borrowers globally2. Conversely, the borrowing landscape in Europe is less developed, due largely to the supremacy of bank lending prior to the Global Financial Crisis (GFC): historically, 70-80% of European companies’ finance came from bank loans, with only a minority of debt and equity sourced from capital markets3.

Institutional investors have been active in European private corporate lending since the late 1990s in areas such as leveraged loans and private placements– see the bottom left hand corner of Chart 1. These were attractive routes for corporates to access debt finance without the publicity or cost associated with a bond issue. Today, European private debt investment ranges from these more established markets to newer areas such as mid-market direct lending and other areas of asset financing, which have evolved since the GFC.

As a result of bank dominance, the GFC had a very disruptive effect on European credit markets. Chart 2 highlights how, from 2008, investor concerns regarding bank creditworthiness pushed up bank borrowing costs relative to corporates. Resulting higher funding costs and stringent regulatory developments combined to drive broad-based bank secession from a number of areas in the corporate lending market. Chart 3 illustrates the slowdown in bank lending to corporates in Europe in the wake of the GFC.1 Long Term Finance and Economic Growth (Group of Thirty) Washington DC 20132 In 2015, non-domestic issuance in the US private placement market amounted to just under half of total issuance in the year (source: M&G, various).3 Economist Intelligence Unit

Pressures on banks have disrupted the funding markets

Capital much more expensive for banks

0

50

100

150

200

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300

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500

Mar 00 Mar 02 Mar 04 Mar 06 Mar 08 Mar 10 Mar 12 Mar 14 Mar 16

.

Fina

ncia

l cre

dit b

orro

win

g co

sts

vers

us th

e w

ider

mar

ket (

bps)

2000 – 2008Banks perceived as “risk-free” andare able to borrow from marketsmore cheaply than corporates.

Banks can therefore make loans tocompanies and make a profit from the

di�erence in funding costs.

2008 – 2016 Investors understand that banks are not risk free.

It costs banks more than corporates to borrow from the market. Bank lending model forced to change.

European Investment Grade Corporates European Investment Grade Financials

Source: Bloomberg (BofA Merrill Lynch, EB03, EN03), 31 March 2017

Direct Lending post-recession

The 2009 landscape

% a

nnua

lised

cha

nge

in b

ank

lend

ing

to n

on fi

nanc

ial c

orpo

rate

s

Growth in bank lending

Decline in bank lending

-15

-10

-5

0

5

10

15

20

25

GermanyFranceEurozoneUK

Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Jan 17

Sources: Bank of England and European Central Bank.*Non seasonally adjusted data

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In 2009, M&G was the first4 of a wave of European non-bank investors to exploit the lending vacuum created by bank retrenchment, initially by providing bank replacement financing to medium-sized, lowly levered companies, at that time known as ‘direct lending’. However, today, the accepted definition of direct lending (or mid-market direct lending) can also refer to loans to similar-sized companies sponsored by private equity firms. Loans can be as small as £10 million or as large as £300 million.

Non-bank lenders such as M&G are continuing to perform the role traditionally performed by banks in that market, allowing a higher percentage of returns to go to clients. Moreover, a more diversified direct lending landscape in which banks and non-bank lenders can collectively offer a variety of different loan structures can be an advantage for companies looking for greater flexibility and certainty to meet their borrowing requirements when needed.

Another key development is the growth of liquidity in the European leveraged loan market. While most private loans are normally be held by investors to maturity, the investor base in that market has grown to the extent that an active secondary market now exists.

The opportunity set will continue to shift as illiquid and private debt markets evolve. Higher levels of competition in maturing markets typically squeeze the available illiquidity premia and weaken structural protections. However, better terms can often be found in more complex or esoteric markets where fewer investors compete to enter the market. The premia offered on opportunities in non-standard, bespoke and under-served markets can often yield impressive returns – but only for investors that have the necessary expertise and resources to capitalise on them.4 M&G launched the M&G UK Companies Financing Strategy in 2009, the first of its kind

4 investment advantages

Private and illiquid assets can be attractive additions to institutional portfolios for a number of reasons.

1. They can provide higher levels of coupon income when compared to similarly rated public debt to compensate investors for the lack of liquidity, namely the ability to sell at a desired price at any time, as is the case in most public debt markets. This is often described as an ‘illiquidity premium’.

2. Information flows are significantly enhanced compared to those available from publically traded companies. Investors are often provided with comprehensive management information on financial reports and accounts, often on a monthly basis, allowing them to engage very quickly with borrowers to discuss steps to address any deterioration in their creditworthiness.

3. The structural protections available in private debt are typically more robust than those found in public corporate bonds. Lenders negotiate directly with a borrower prior to investment, which typically allows them to agree covenants and protections that are individually designed to be appropriate to the risks of the investment.

For example, if a borrower fails to achieve specific revenue targets relative to their debt position, a covenant can trigger a clause requiring the borrower to step up the level of interest payments or pay down some of their debt to reduce the risks to the borrower. Because of the immediacy of this information flow, this action can take place before the health of a business deteriorates to critical levels.

4. These assets can offer a range of maturities, from 2 to in excess of 25 years. Longer-dated cashflows provide contractual income streams that are well suited for long-dated liability matching purposes.

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Investment considerations

1. A significant application of resources: Private and illiquid debt opportunities are often sourced and originated on a bespoke basis and assets are frequently one of a kind. Origination is therefore a highly resource-intensive process, requiring specialist knowledge and experience, as well as strong relationships with market participants to access the best deals.

Investors also need to apply significant resources to credit research and asset valuation. The lack of public ratings and uniformity in these deals makes them difficult to understand and evaluate, particularly in more complex segments of the market. Illiquidity premia are not stable or defined and the absence of a secondary market means that investors frequently have to use model valuations. In addition, different deals will require different approaches to valuation and specific expertise.

2. Focus on cashflows: Private and illiquid debt opportunities are best seen as fixed income strategies – not as alternatives. The stream of reliable, predictable cash income that they generate is its primary source of value and the return profile is typically known at the outset as the sum of all interest payments and the principle. This is especially true of the more illiquid assets, which have no price conferred on them by a market. These transactions are therefore best viewed as a source of fixed income rather than a bet on price appreciation and its consequent requirement to generate performance through a well-timed sale.

3. An opportunistic approach: It’s crucial that investors are not forced buyers. Approaching these kinds of assets with an asset allocation strategy can be impractical as investors may need to compromise on value to make any investments. Instead, investors will need to source and value each asset individually, ensuring that value remains the principle decision-making driver to optimise long term investment outcomes.

First movers achieve the best prices and investors will therefore need to be patient, flexible and disciplined. Private and illiquid markets can be lumpy, pricing structures can deteriorate, changes in supply / demand dynamics can be fast while negotiations can be slow and complex. All this means that private and illiquid credit opportunities can take years to bear fruit. However, investors need to be able to move quickly to capitalise on a deal when conditions turn favourable.

Considerations for building a portfolio extend beyond returns and include seniority, security and, crucially, the type of coupon – fixed, floating or inflation linked – on offer. Below is a list of some of the building blocks available for constructing private debt portfolios along with some of their investment characteristics.

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Private and Illiquid Credit: key characteristics at a glance

Market spreads Basis Ratings Seniority Security Complexity Liquidity Investment horizon Currency

Shor

ter d

ated

Corporate direct lending 3-6% Floating rate BB-B P P Medium X 5 years GBP

Mezzanine ABS 3-10% Floating Rate BBB - B X P High X 5 years EUR / GBP

European leveraged loans 3.75-4.75% Floating rate BB-B P P Low P 7-8 years (but often repay early at c. 3yrs) EUR / GBP

Leasing 3-8% Fixed and floating BBB P P Medium X 4 years GBP

Trade receivables 2.5-7% Fixed and floating BBB P P Medium X 4 years EUR / GBP

Senior mortgages 1.5-2% Floating rate A P P Medium X 4 years EUR / GBP

Junior mortgages 8-10% Fixed and floating BB-B X X /P Medium X 5 years EUR / GBP

Regulatory capital trades 8-12% Floating rate BB-B X P High X 4.5 years EUR / GBP

Mortgage Opportunities 3-6% Floating rate A-BB X /P P High X 5 years EUR / GBP

Distressed debt 8-15% Fixed and floating N/A X /P X /P High X 3 – 7 years EUR / GBP

Long

er d

ated

Private Placements 1.5-4% Fixed rate A-BBB P X /P Medium X 5 – 12 years EUR / GBP

Swap refinancing 2-2.5% Index-linked/ fixed rate A-BBB P X /P High X 10+ years GBP

Long lease property 2.75-3.5% Index-linked A-BBB P P High P 15+ years EUR / GBP

Income strips 0.75-1.75% Index-linked A-BBB P P High X 25+ years GBP

Infrastructure debt 0.75-2.5% Index-linked/ fixed rate A-B P P Medium P 25+ years EUR / GBP

Social housing debt 1-2% Fixed rate AA-BBB P P Medium X 25+ years GBP

Residential ground rents debt 1.5-2% Index-linked/ fixed rate AA-A P P Medium X 25+ years GBP

Local authority debt 1-2.5% Index-linked/ fixed rate AA-A P P Medium X 20+ years GBP

Where do the returns come from?

The illiquidity premium is the label commonly used to describe the difference between the returns of liquid and illiquid assets. Illiquid assets are typically less well known, they do not trade on an efficient secondary market and investors are less comfortable investing in them. More tenacious buyers who are prepared to tolerate the risks often associated with bespoke, illiquid investments can therefore command higher yields.

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However, any premia that a transaction offers will more likely reflect a lack of competition among investors to lend, either because an asset is complex or because it requires origination. Complexity can arise in situations where a borrower is distressed or where the size, type or geography of an asset makes it harder for lenders to understand or value. Moreover, potential buyers often need to find the assets themselves, which can be a resource-intensive and intricate process, outside the investment comfort zone of all but the most committed investors.

In addition, interest in various markets can ebb and flow and and premia can disappear if many market participants become motivated buyers. Indeed, some illiquid assets are so sought after that their illiquidity ‘premium’ is actually negative. For this reason, a flexible approach allowing a manager to avoid popular asset classes and to capitalise on unique and specialist lending opportunities can offer higher risk-adjusted returns.

The chart below illustrates how particular strategies derive their excess returns relative to traditional market returns.

Where do returns come from?

Illiquidity

Complexity Creation

• Regulatory Capital Trades • Insurance Risks• Sale & Leaseback• Income Strips• Infrastructure Debt

• Corporate Direct Lending• Leasing• Trade Receivables• Senior Mortgages• Social Housing• Ground Rents• Private Corporate Debt

• Debt Opportunities• Solar Power Transactions• Complex Direct Lending

• High Grade ABS• Mezzanine ABS

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Underlying investments

European asset-backed securities (ABS) are credit instruments, issued by financial corporations and secured against a pool of assets – typically residential or commercial mortgages but also corporate or leveraged loans.

Chief characteristics of the asset class

• Higher yields than traditional fixed income assets of comparable credit risk. A portfolio of AA-rated securities currently yields approximately Libor +2% per annum

• High levels of security – every issue is backed by a discrete pool of assets

• Very strong credit performance with low default rates – 2015 default rate across European residential mortgage-backed securities (RMBS) was just 0.1% compared to 7.8% for US RMBS*

• High levels of liquidity on high grade ABS


Rigorous and detailed credit analysis prior to investment in ABS is crucial, due to the differing security and structural features of every deal – even those from the same issuing platform. As a result, investors with the resource and capability to understand this diverse asset class are often rewarded by higher returns than can be found in corporate issues. The floating-rate nature of ABS means duration risk is reduced compared to most corporate credit issues.

Market size

Current estimates are that €400-450 billion of European ABS is outstanding. However, the sterling market has been experiencing significant redemptions in recent years with more than £10 billion of cash being returned to investors. The UK government has been actively seeking to run down the mortgage-related assets taken on as

part of bank nationalisations undertaken during the 2008 credit crisis. Quantitative policy measures implemented by the European Central Bank (ECB) and the Bank of England (BoE) have provided both direct and indirect support for the European ABS markets. This has included direct support in the form of the ABS Purchase Programme from the ECB. The BoE has provided indirect support through the Term Lending Scheme, which has reduced the incentive to issue ABS by creating an alternative cheaper form of term funding for assets, such as residential mortgages for commercial banks.

Building a portfolio

High-grade ABS exhibit excellent liquidity characteristics, which enables a diversified portfolio to be constructed rapidly (within four to six weeks for a portfolio of approximately €200 million). Spreads in Euro ABS remain elevated relative at historical levels, in most cases at multiples of levels that prevailed prior to the 2008 financial crisis. We believe this is largely due to the regulatory response and, in particular, Solvency II, which has made ABS expensive to hold from a capital perspective. Investors without capital constraints and those seeking pure absolute return while minimising risk, can take advantage of these spreads.

M&G and ABS

We are one of Europe’s largest ABS managers, with a presence in the market extending to more than 15 years. Our team of 4 specialist fund managers and 11 career analysts currently manages more than €5 billion of dedicated ABS mandates for institutional investors and a total of €20 billion of ABS for all clients including our parent, Prudential plc.

M&G launched the first of its dedicated ABS funds in 2008 and also manages other structures across a range of different risk and return characteristics. None of these portfolios has ever suffered a default and to date all of them have significantly exceeded their performance targets.

Part 2: 10 Key Strategy Profiles

*Source: S&P, June 2016

Asset-Backed Securities

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Loans to mid-sized companies made on a bilateral or club basis usually without the use of bank arrangers / intermediaries. Each deal has a unique structure and terms are privately negotiated as part of the bespoke transaction. Loans typically range from three to seven years, with interest payments on a floating rate basis.


• Lending to smaller companies with typically less than £350 million debt

• Senior positions in the capital structure, with full covenant package• Floating rate target returns, with margins around 4-6%*• Diversification against public securities – companies that raise

finance from long-term institutions in this manner tend not to issue public debt or equity securities

• Limited secondary market • Some pre-payment protection for early years


The traditional direct lending market has evolved to better serve the needs of mid-sized companies both privately-owned and owned by private equity sponsors. Today, direct lending encompasses a wide range of target returns and risk appetites through capital structures in which senior risk with 3-5x leverage and ‘unitranche’ loans with as much as 6-7x leverage can be funded.

Since mid-market direct lending is both private and illiquid, it is vital that a non-bank lender fully evaluates and prices the credit risk associated with the borrower to ensure investors are compensated for the risk they

are taking on. Intensive due diligence and, often, negotiation is also required to ensure the structure and terms of a deal provide sufficient security and a strong suite of covenants to create reassurance of recovery in the event that an investment does not perform as expected.

Market size

It is not possible to calculate the total universe of investments that could be made in this manner due to the private nature of the assets. M&G, a first mover in a growing market, has invested £1.41 billion** in this asset class.


Portfolio construction can take time as each loan needs to be separately sourced, negotiated and structured with the company. Portfolio deployment is typically two to three years to access a diversified portfolio.

M&G and direct lending

In 2009, M&G launched a direct lending fund for mid-sized UK companies, which was expanded with another round of fundraising three years later. Both funds focused on direct origination, structuring and execution with non-sponsored corporates. In late 2015, M&G entered into a partnership with Royal Bank of Scotland (RBS) to access senior mid-market direct lending from private equity-owned companies. Working with RBS gives M&G the option, but no obligation, to invest in their pipeline of originated deals.

*Source: M&G Investments, as at January 2017 **Source: M&G Investments, as at November 2016

Direct Lending

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M&G’s view is that distressed credit is not an asset class, but an investment strategy that exploits compelling value opportunities in the discounted debt of commercially viable but over-leveraged companies, from across the full universe of European credit.


• Successful distressed credit investing requires a blend of credit analysis, restructuring expertise and the ability to construct a sufficiently diversified portfolio of compelling value opportunities

• At the moment, the greatest value is to be found in loans, corporate bonds, securitised structures (such as commercial mortgage-backed securities) and restructured equity (including warrants)

• M&G’s distressed credit fund aims to deliver returns of around 15% per annum


While each distressed credit investment differs in many ways, the opportunities themselves tend to fall into three categories.

The first is adding to existing positions, which can involve taking advantage of attractive entry prices after a sentiment-driven sell-off. Second is exposure to new, highly illiquid names, where a position may be built in the interests of influencing future restructuring negotiations. Third is ‘new money’ to companies under duress and whose debt is experiencing price volatility.

Market size

It is difficult to quantify the size of this opportunity with accuracy. However, in 2021 more outstanding European loans and high yield securities will mature than in any other year. This means debt securities valued up to approximately €235 billion will require refinancing before then, some of which will require restructuring and could be classed as distressed credit investment opportunities.


As a significant European fixed income investor, M&G has visibility over virtually all European restructurings and distressed situations across all major asset classes. This, coupled with good relationships with trading counterparties provides access to opportunities in the secondary market. More recently, an increasing number of new money opportunities are appearing, where a distressed company is in need of financing to support it through a period of financial underperformance. These are brought to us by contacts in the advisory community who recognise M&G’s excellent reputation as a long-term investor.

The illiquid nature of the assets means that the portfolio is steadily built up as assets are sourced, with a drawdown period likely to last two years.

M&G and distressed credit

M&G has significant experience investing in distressed credit. Its market size and standing mean it typically has an allocation to better quality debt issuers before, or as they enter, a restructuring situation, enabling M&G’s investment professionals to identify new investment opportunities. The company has three pooled funds that pursue this strategy, which are all closed to new investments.

*Source: M&G Investments, as at January 2017**Based on Standard & Poor’s (S&P) LCD European Leveraged Loan Index (ELLI) data***M&G Investments estimates

Distressed Credit

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Loans issued by sub-investment-grade companies – typically to finance acquisitions or leveraged buyouts by private equity sponsors. The term ‘leveraged loans’ describes loans, ranging in issue size from €200-2,000 million, typically with a coupon in excess of 250 basis points per annum (p.a.) over Libor, that have been syndicated to many investors.


• Downside protection: security over assets and / or equity of the issuing companies, as well as seniority in the capital structure. Historically, leveraged loans have had higher recoveries than unsecured high yield securities in the event of default or restructuring

• Natural hedge against rising interest rates: low duration and floating rate returns of 4-5% over Libor*

• Stability and sustainability of return expectations: income-driven returns dampen volatility of future returns

• Supportive market backdrop: demand and supply are in equilibrium but there is room for institutional investor growth

• Flexible form of financing for companies: borrowers retain the right to repay the loans at short notice. The long-term average prepayment rate is approximately 25% (p.a.)**

• Loans may be traded on a functioning secondary market


The private nature of the market requires specialist expertise and strong networks of relationships to invest successfully. In particular, having long-standing and stable relationships with key market stakeholders (such as private equity sponsors and banks) can give managers unrivalled access to assets and create an ability to be selective. The onus is on lenders to perform the necessary due diligence as part of a robust credit process to help protect returns for investors and minimise the risk of default.

European loans offer good liquidity to investors despite the lack of retail investor participation in the market, thanks to the number of

institutional investors and banks. As European loans also involve a high degree of operational complexity, there are high barriers to entry to new participants.

Market size

The size of the European market is approximately €450 billion*** in outstanding issuance. However, a large part of this market is bank-held; the Credit Suisse Western European Leveraged Loan Index, which represents the institutional subset, is approximately €170 billion in size (as at 31 December 2016), from over 250 issuers (by company). In M&G’s estimation, the addressable market for an established manager is approximately €250 billion, roughly the size of the European corporate high yield securities market.


Diversification and stock (issuer) selection are essential as loans present asymmetric risk / return characteristics. It is important to be selective in the investments made so as to protect a portfolio from default risk (albeit that secured first lien status typically results in superior recovery rates in default than for unsecured debt), enabled by significant scale and flexibility and having good access to assets.

M&G’s view is that a conservative, senior-biased loan strategy will outperform its relative benchmark index over a cycle.

M&G and European leveraged loans

M&G was one of the first non-bank investors in European leveraged loans in 1999, and is one of the largest loan managers in Europe today. Approximately €9.5 billion is managed on behalf of institutional investors across a range of funds in both pooled and other structures, with the majority being for pension funds and insurance companies from Europe and Asia. M&G’s flagship all-senior loan fund was launched in 2005 and is now €3.5 billion in size, with close to 190 institutional investors.

European Leveraged Loans

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Real estate investments with contracted long-dated leases in place – in the UK, typically 20+ years and in Europe, 15+ years. Investments can include a wide variety of assets such as supermarkets, hotels, offices, residential buildings and student accommodation.


• Combines real estate and credit investing to provide rising income secured against real estate and let to good quality, predominantly investment-grade tenants

• Produces a secure rental income stream that can help meet inflation-linked liabilities, in excess of that available from index-linked sovereign securities

• Ownership of the underlying property assets also provides the potential for long-term capital value increases

• In the UK, total returns can be over 4% per annum above inflation* • Robust supply – enables real estate owners (public and private)

to release capital from their property portfolios while retaining long-term certainty over their rental payments by undergoing sale and leaseback. Increasingly, owners are also using this funding tool to develop new properties or large-scale refurbishments

• Leases are typically ‘fully repairing and insuring’ so the investor has minimal responsibility for outgoings, maintenance or capital expenditure over the lease term


This blend of real estate and credit investing requires substantial expertise in both disciplines to evaluate the quality of the property and the credit risk of the tenant or its guarantor. The value of the lease payments and in the physical asset itself over the long term is frequently overlooked by those who are real estate or fixed-income specialists, but not both.

Market size

The long lease real estate market developed initially through insurance companies finding the steady income stream attractive for their annuity portfolios. These investments are not typically made public and so the exact market size cannot be determined. In the UK, the first of an increasing number of third-party, pooled funds investing in long lease real estate was launched in 2004 and CBRE conservatively estimates that the UK market is currently in excess of UK £17 billion in assets under management.**


Sourcing long lease assets requires a wide network of contacts. M&G believes the best way to access this asset class is through a pooled fund (rather than a direct investment), which can offer investors greater diversification, reduced cost and complexity, as well as effective governance and risk management. A larger fund is also able to access larger assets, expanding the investment universe and allowing capital to be deployed more rapidly. It can take up to 12 months to fully deploy an investor’s capital in a good long lease fund.

M&G and long lease real estate

M&G has made in excess of £8 billion in long lease investments since 2000 and is a market leader in the UK, launching its first third-party fund in 2007. In 2015, M&G launched a sister fund investing across Europe, which we believe is the first proposition of its kind.

*Source: M&G Investments, as at June 2016**Source: CBRE, as at December 2016

Long Lease Real Estate

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Private placements are unlisted senior corporate fixed income securities offered directly to a limited group of qualified institutional investors rather than via public markets. The issuers tend to be mid- to large-sized companies that may not wish to gain a public credit rating or may not need to raise sufficient debt to make a public bond issue economically viable. Private placements can provide investors with secure, stable cashflows that almost always come with the additional benefit of enhanced documentary protection.


• Typically fixed rate and with a maturity of between 3-15 years, although longer maturities are available for some infrastructure, utility or contracted asset projects (such as real estate)

• Most issues are US$100 million or larger (up to $1 billion for the strongest issues), but bilateral transactions can be as little as $30 million

• Strong financial covenants protect investors and result in high recovery rates, similar to those in the bank loan market and significantly higher than public securities

• Private placements usually pay a premium to public securities to compensate for the relative illiquidity of the asset class and the increased due diligence needed for companies which do not have readily available rating agency research


As with all credit investments, investors need to carefully analyse the credit, structure and pricing of a deal before investing. This is particularly important for private placements as most participants in the market hold to maturity so secondary market is limited. Ongoing monitoring and relationship management with the borrowers allow investors to understand any changes to the company strategy and to be involved in conversations at an early stage to aid the best outcome for the debt.

Market size

Due to the private nature of the market, it is difficult to estimate market size. However, bank data indicates that annual global issuance (including non-US, cross-border deals) has increased significantly since 2009, rising from approximately $29 billion to $52 billion in 2015. UK bank Barclays estimate that the private placement volume issued by European companies in 2015 was roughly equal to the primary issuance in the sterling corporate bond market.


Asset accumulation is driven by the issuance in the primary market and an investor’s geographic, size and rating constraints. Successful investing is best achieved through a long-term view on participation in the market to allow a diversified group of companies to come to market.

M&G and private placements

M&G has been investing in private placements since 1997 and is one of the largest and longest-standing European investors with £2.9 billion* invested.

* Source: M&G Investments, as at end June 2016

Private Placements

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Regulatory capital trades sit within the asset-backed securities (ABS) market, where institutional investors are paid an attractive coupon to take junior risk positions in large pools of banks’ corporate loan books, while retaining a portion of each risk position themselves to align interests. These trades allow banks to receive capital relief on that portion of their corporate loan book helping them to meet regulatory capital requirements.


• Ability to invest in assets such as small and medium-sized enterprise (SME) loans normally held only on bank balance sheets

• High running yields from the assets backed by large pools of underlying assets

• Transactions are ’club deals’ sold by the issuer only to a limited range of skilled institutional investors providing a barrier to entry for competitors


Regulatory capital trades are not new. When banks are structuring ABS, they typically sell the senior 90-99% of risk on a portfolio of assets such as residential mortgages. As SME loans become more expensive to hold from a capital perspective, selling, for example the 1-10% more junior piece of the capital structure becomes efficient. Therefore, many of the analytical skills required are similar to those employed for ABS transactions as they have many structural elements in common. The key risk to be analysed alongside structure is the corporate loan underwriting capability and process of a sponsoring bank and this is rigorously researched.

Market size

The market size cannot easily be quantified as these transactions are only marketed to a select few investors and are not widely publicised. M&G estimates that €5 billion of these transactions were made in 2016.


Portfolios can take longer to build than traditional ABS products as the deals are made less frequently. There is some limited secondary market activity in these assets and, in late 2016, we acquired two assets in the secondary market. However, the assets should be considered illiquid (albeit fully transferable) and portfolio building will be driven by primary market activity. As deals are also only marketed to a selection of investors, a capable manager is required to successfully invest in this asset class. Diversification across approximately 15-20 positions per portfolio is achievable.

M&G and regulatory capital transactions

M&G has invested almost €500 million in regulatory capital transactions since 2000, as of December 2016, and it launched a dedicated portfolio in early 2014, which is fully deployed.

Regulatory Capital Transactions

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Senior commercial real estate (CRE) debt is a private asset class comprising of investment grade, first-ranking loans secured against commercial property. At M&G we invest in, and originate, senior CRE debt predominantly in the UK and Europe. Senior CRE loans have seniority in the capital structure, with a first-ranking claim on both interest payments and ultimate repayment of principal. Loan interest is paid from the rental or operating income of the commercial property securing the loan, and ultimate repayment of principal comes from a refinancing or sale of the property.

Each loan is bespoke but typically has a term of three to seven years, with interest payments either on a fixed or floating rate basis. There is also an emerging, albeit smaller, market for long-dated, fixed-rate, senior CRE debt with maturities of 20+ years.


• Strong credit standards: loan-to-value (LTV) ratios typically in the 55-65% range, meaning that senior CRE loans are able to withstand a 35-45% decline in the value of the underlying property before loss of capital

• Downside protection: loans incorporate a comprehensive suite of financial covenants, including LTV covenants that are typically triggered if property values fall by 10-15%, allowing lenders time to resolve temporary performance issues before capital is at risk

• Asset-backed security: loans are secured against the commercial property via a mortgage, meaning recoveries are typically high in the event of a default on the loan

• Stable income: ability to generate regular contractual cashflows, as interest is paid from the rental or operating income of the commercial property via a coupon

• Attractive relative returns: senior CRE debt can offer yields of 50-100 basis points above similarly-rated, unsecured corporate securities


Loans are bespoke and illiquid, with limited secondary market trading. Investment in senior CRE debt should therefore be considered as a buy-and-hold strategy, with investors accepting a degree of illiquidity in exchange for the additional returns on offer compared to public securities.

It is important that lenders expose every transaction to a rigorous credit rating and due diligence process. This resource-intensive approach along with a capacity to originate new loans directly with the borrower can give lenders access to good quality credits and create an ability to be selective.

Market size

Europe’s commercial mortgage loan market is deep and well capitalised, with around €500 billion* of CRE debt expected to mature and need refinancing in the next three years. The CRE debt market is established and mature in Europe, however, there is a growing range of opportunities available to institutional investors, in what used to be a bank-dominated sector.


Portfolio construction can take time as each loan needs to be separately originated, negotiated, underwritten and structured with the borrower. Portfolio deployment is typically a two to three-year process depending on the type and size of the loans an investor wishes to structure into their portfolio.

M&G and senior CRE debt**

M&G was one of the early movers in CRE debt after the global financial crisis, and key members have been investing together since the team’s inception. M&G invests in senior CRE debt for internal also external clients across a range of funds in both pooled and other forms. Since 2010, M&G has invested over £5.0 billion (€6.0 billion) in senior CRE debt.

* Source: CBRE “European Commercial Real Estate Finance 2016 Report”, January 2016.** Source: M&G Investments, as at 9 December 2016. Figures include senior funds, segregated mandates and Prudential internal investors.

Senior Commercial Real Estate Debt

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Infrastructure comprises essential economic assets and forms the backbone of a country across four main categories: transport networks, utilities, energy initiatives and social infrastructure development. Investors in private markets can gain access to the infrastructure debt asset class by lending directly to infrastructure corporates based on the business as a whole, or by providing limited recourse financing to specific projects. Corporate infrastructure debt is usually in bullet form while project finance debt is generally amortising, so the average life of an investment is likely to be less than the final maturity of the debt.


• Businesses have high barriers to entry for competitors and to exit for customers

• Majority of the returns are expected to come from the steady, predictable fixed or floating rate cashflows, which may also have an inflation linkage

• Loans are typically long-dated, often 20-30 years but as the principal is often amortising, the average life of an investment may be less

• Very high historic recovery rates following default or impairment, compared to corporate bonds

• Low correlation to the economic cycle or other asset classes • Investments may be senior or junior, investment grade or

sub-investment grade, depending on investor preferences • Investment grade quality assets are usually well-protected from

adverse events. Loans against specific assets have strong covenants and/or security over shares in the borrower, their assets and key contracts

• Typical private deal sizes of between $25 million and $200 million though deals may be larger


Transactions may be sourced to suit a variety of investor requirements but M&G seeks to capture long term value and aims not to be a forced

buyer. As well as different coupon types, they may be senior or junior debt within the capital structure and be denominated in a variety of currencies, usually sterling or euros. They are originated through a strong network of industry contacts and researched internally and completed in-house by our team of experienced infrastructure debt and project finance professionals.

Market size

The broader market for infrastructure financing is now well established, with opportunities arising in many areas, such as transport and renewable energy. Estimates suggest that in excess of $50 trillion of infrastructure investment may be needed globally by 2030, while the European Fund for Strategic Investments (EFSI), also known as the Juncker Plan, aims to promote €500 billion of infrastructure initiatives across the European Union. As bank capital requirements continue to rise, institutional investors should be well positioned to provide a greater proportion of the necessary financing.


Key to building a successful portfolio is patience in sourcing appropriate assets, not paying too high a price for those assets and undertaking the extensive due diligence to ensure all the necessary protections and covenants are in place. Equally important is ensuring that ongoing monitoring and management of the assets is undertaken by a skilled and experience team, given the likely long-term nature of each asset invested, and their relatively illiquid nature.

M&G and Infrastructure debt

M&G’s infrastructure debt team has been in place since the late 1990’s. 16 investment professionals originate, source, and analyse both public and private markets and M&G manages over $60 billion of infrastructure debt assets, across those markets over a range of sectors, as of 30 June 2016, and across both public and private debt markets.

Private Infrastructure Debt

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Impact investing refers to any investment strategy that aims to bring about a positive environmental or social impact in addition to a competitive financial return, although priorities can vary. Investors can allocate to impact investments in several different ways. At M&G, we believe that private and illiquid assets are particularly well suited to impact investment, offering institutional scale, a broad opportunity set, measurable impact and attractive, stable coupon income.


• Private debt offers an illiquidity premium over investment in public corporate bonds and superior access to “pure-play” impact assets

• A broad range of different sectors allows for the creation of diversified portfolios. Sectors include: social housing, health and social services, education, renewable energy generation, energy efficiency, green buildings and green transport

• Loans range from 2 years to 20+ years. Spreads and deal sizes can vary significantly, depending on the sector and underlying asset

• Private debt assets can offer strong diversification benefits while long time horizons defend against cyclicality

• Assets are often investment grade and usually senior and secured, offering greater protection to investors’ capital in the event of default


Investors can target sustainable fixed income opportunities via a range of public bond funds, including those that use ESG rankings or negative screens. In our view, these funds rarely target or deliver real and measurable positive impact. Conversely, private debt investing can take a multi-focus approach across a broad opportunity set of pure-play impact assets and offer increased scope for setting and negotiating sustainability criteria and impact measurability. However, private debt investments also require a depth of expertise and experience in credit analysis, structuring and covenant negotiation.

Market size

The impact investing market is relatively new and can be difficult to quantify but the Global Impact Investing Network estimates the size at $77bn, based on its 2015 annual survey. The Fixed Income market makes up a smaller part of the universe, and the scale of funds is generally small. The average size of fixed income impact funds in the market is $22m (2016 GIIN report).


Building a successful private debt impact portfolio requires not only patience, discipline, a bottom-up, value-driven approach and strong network of relationships to source the best opportunities. It also requires an excellent knowledge of the environmental and social aspects of a deal across a range of sectors, and managers will need to provide metrics that can demonstrate positive change over time, as well as an attractive return. Bespoke assets are often considered buy and hold investments, requiring careful agreement and regular monitoring to ensure the quality of both the credit and the impact remain high throughout the investment’s life.

M&G and Impact Financing

M&G has a long and successful track record investing in private impact assets, with over £6.5 billion of private impact credit assets under management. The M&G Impact Financing Fund offers institutional scale and diversification. Each asset will be assessed for social and environmental impact against criteria developed in partnership with Sustainalytics. In addition to quarterly investment reports, an annual impact report detailing the positive environmental or social impact achieved by the fund’s investments will also be provided to investors,

Impact Investing

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• Taken together, illiquid and private credit strategies can perform a variety of different investment roles in the portfolio of long term institutional investors.

• Potential outcomes can include growth, steady contractual income, diversification from bond portfolios and greater structural protections to protect investors from losses in case of default or credit deterioration.

• Markets are constantly evolving and the best opportunities are often found in non-standard, complex and underserved markets, which require a high degree of expertise and experience to navigate.

• Discipline, patience and flexibility are crucial in the development of private debt portfolios. Investors must avoid being a forced buyer to ensure that value is prioritised over asset availability. They will want to be a ‘first mover’ when real value appears.

• Access to assets is vital to provide sufficient choice to be able to be highly selective, and requires well-developed networks of issuers and market intermediaries from which to source new investment opportunities.

Part 3: Key Points to Remember

M&G: A wealth of experience in private and illiquid asset investment M&G began investing in private debt in 1997 in order to source attractive assets offering additional returns and diversification away from Sterling corporate credit. Since then M&G has continued to drive the development of the private debt markets in Europe whether in the leveraged loan, private placement or direct lending market through consistent investment and pioneering products. M&G is now the largest private debt investor in Europe and the fourth largest in the world, according to Private Debt Investor.

The scale and experience of our resources enable us to identify value from the widest possible opportunity set and to make investments which capture risks when they are most rewarded. The purchasing power that we can bring to bear is also evidenced in the fact that we are frequently given exclusive access to investments or shown deals before other market participants. In addition to assets introduced by third party brokers or lenders, M&G has structured a number of bespoke private debt platforms offering exclusivity to assets and creating an institutional market for new asset classes.

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For Professional Investors only. Not for onward distribution. No other persons should rely on any information contained within.This guide reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance The distribution of this guide does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority’s Handbook.M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. APR 2017 / IM151

Contact

Marcel De Bruijckere +65 6349 9009 [email protected]

www.mandg.com [email protected]

a guide to european private and illiquid credit · 2017-07-14 · 4 a premium for illiquidity and...

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