Opportunities in Illiquid Credit

Opportunities in Illiquid Credit 25 April 2013

Opportunities in Illiquid

Credit Pete Drewienkiewicz

David Bennett

1


The Seven Steps to Full Funding TM

2

Design an efficient

investment strategy

Destination for agile

hedging strategy

Transparency to make

timely decisions

Articulate clear objectives

and constraints

Mission Statement

To help our clients achieve full-funding with the minimum level of risk

CLEAR GOALS &

OBJECTIVES

ACCESS TO

DERIVATIVE HUB

LIQUID ALPHA & BETA

STRATEGIES

LIQUID & SEMI-LIQUID

CREDIT STRATEGIES

ILLIQUID CREDIT

STRATEGIES

ILLIQUID ALPHA & BETA

STRATEGIES

ONGOING

MONITORING


Seven Steps to Traditional Asset Classes

3

Step

(2)

Derivative Hub

(3)

Liquid α & β

(4)

Semi-Liquid Credit

(5)

Illiquid Credit

(6)

Illiquid α & β

Collateral

Management Equities Corporate Bonds Infrastructure Debt Insurance-Linked

Hedging Multi Asset Asset Backed

Securities Social Housing Debt Private Equity

Active LDI Sovereign Bonds High Yield Direct Mid-Market

Lending

Infrastructure

Equity

Equity Derivatives Commodities / CTA Leveraged Loans Mezzanine Finance Unlisted Property

Swaptions Currencies Emerging Market

Debt Distressed Debt

Hedge Funds with

Longer Lock-Ups

Gilt Repo Liquid Hedge Funds Commercial Real

Estate Debt

Long Leases /

Ground Rents


Terminal Portfolio Approach

The Role of Credit Within a Scheme’s Asset Allocation

4

Corporate

Bonds

Direct

Lending

Corporate

Linkers

Infrastructure

Debt / Long

Leases

Ground Rents

Gilts

Cash


Introduction: Illiquid

Credit

5


European Bank Distress

6

“Much has been written on the entanglement

between banks and sovereigns in Europe since the

financial 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 assets

and liabilities is such that – in theory – they have

the capacity to threaten the solvency of their

own sovereign.”

Source: Barclays Research, ‘Bank Deleveraging in Europe: Not Done Yet’ (October 2012)


• Recourse to national sovereign in times of crisis

implies that overall size of banking system is

manageable.

• Where this is not the case (e.g. Ireland), deposit

guarantee schemes can lack credibility.

• National regulators in Europe thus have an

important interest in ensuring ‘their’ banks have

sufficient capital to withstand stress scenarios.

Pressure on Banks to Delever

7

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

Barclays RBS Santander BNP Paribas

ING Group Deutsche Bank*

Unicredit

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

JP Morgan Goldman Sachs

BAML Wells Fargo Morgan Stanley

Citigroup

Bank 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 in

life, but national in death”

- Mervyn King


Impact of New Regulations

8

I

Capital and

Liquidity

Basel 3

II III

Risk Mgt.

and

Supervision

Market

Discipline

Narrower range of eligible capital

Increased capital reqs.

Capital Ratio

2019 deadline to complete implementation of Basel III.

Institutions are seeking to demonstrate capital and

liquidity resilience much earlier.

Capital standards require banks to hold more capital of

higher 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 from

8% 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 Ratio

and Net Stable Funding Ratio

Quality of capital:

• Common equity and retained earnings should be the

main component of Tier 1 capital, not debt-like

instruments


Scarcity of Capital in the Face of Robust Demand:

The ‘Maturity Wall’

9

• Recent strong US loan and bond sales have pushed

out the maturity on the corporate debt of the

neediest borrowers to c. 2017.

• $645bn of sub-investment grade maturing in

next five years

• Peak due in 2017

• Macro concerns (e.g. US debt ceiling) could

disrupt financing markets

• Total amount of debt maturing in the next five

years 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’s

0

50

100

150

200

250

300

350

2013 2014 2015 2016 2017 2018 2019 2020

$ b

n m

atu

rin

g

Secured Loans High-Yield Bonds

0

10

20

30

40

50

60

70

2013 2014 2015 2016 2017 2018 2019 2020

€ b

n m

atu

rin

g

Secured Loans High-Yield Bonds

2. European Maturity Wall

1. US Maturity Wall


Current Opportunities

10


Higher-Rated

Lower-Rated

“Shorter-Dated” “Liability Matching”

Infrastructure

CRE Debt

Ground Rents

Long Leases

Aircraft Finance

Direct Lending

Distressed Debt

11


Real Estate Long Leases

12

Maturity Profile 20 years +

Liquid Alternative 20-Year Tesco Bond

Expected Spread / Rate 285bps

Approx. Premium over

Liquid Alternative 108bps

Attractions

• Security over underlying asset provides downside

protection

• Long-dated, inflation-linked cashflows

• Potential to target sub-asset classes (e.g. social

housing) as part of long lease portfolio

Points to Note

• Potential for concentration risk given prevalence of

long-lease deals in certain sectors (e.g.

supermarkets) – also may have exposures

replicated in corporate bond portfolio

• More popular pooled funds have built up capital

queues

Investor

(Lessor)

Rent

Tenant

(Lessee)

Right to

occupy

property

for

duration

of lease

Legal ownership of

property remains with

investor and property is

transferred back at end

of lease


Ground Rents

13

Maturity Profile 99 – 999 years

Liquid Alternative BBB Long-Dated Sterling

Corporate Credit




Attractions

• Long-dated, index-linked cashflows

• Security of underlying asset

• Freeholder has recourse to mortgage lender

in case of tenant default

• Over-collateralisation of ground rent via

property built on land

Points to Note

• Individual rents must be acquired in volume to have

meaningful impact on portfolio and to provide

diversification

• Large-scale supply is limited

Ground

Rent

Mortgage

Leasehold Equity

Ground rents rank higher than any claim on the

leasehold including mortgage repayments


Infrastructure Debt

14

Maturity Profile 15 years +

Liquid Alternative BBB Long-Dated Sterling

Corporate Credit




Attractions

• Long-dated, index-linked cashflows

• Secured lending

• Government support for sector via PFI

• Many projects are likelier to experience lower return

volatility due to the natural bias towards essential

service sectors

Points to Note

• Time to become invested

• Prepayment risk exists (although prepayment

penalties 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


Commercial Real Estate Debt

15

Attractions

• Bank deleveraging has arguably created

fundamental dislocation in asset class

• Falls in LTVs have resulted in cushion on falling

property values to senior loan providers

• Security on underlying asset mitigates default risk

Points to Note

• Diversification of tenants / loans required to

counteract void risk

• Significant allocation required to achieve

diversification


penalties are becoming increasingly common)

Maturity Profile 5-10 years (varies)

Liquid Alternative Sterling IG Corporate

Credit

Expected Spread / Rate 350bps for Senior Loans



Sponsor

(Property

Owner)

Lender

Commercial

Property

Tenants

The lender has a lien

on the underlying

property

Principal + Interest

Loan Advance


Aircraft Leases

16

Maturity Profile c. 5 – 10 years

Liquid Alternative BBB Short-Dated US

Corporate Credit

Expected Spread / Rate 350bps for senior debt



Attractions

• Nature of underlying asset as global commodity

(supports resale value in case of default)

• Opportunity to structure either via sale and

leaseback of aircraft or as asset-backed debt

secured on underlying planes

Points to Note

• Difficult to price residual value of asset accurately

(given depreciation, potential for technological

change, upkeep costs etc.)

• Limited manager universe

• Exposure to business cycle

0

100

200

300

400

500

600

700

800

900

Sep 2004

Sep 2005

Sep 2006

Sep 2007

Sep 2008

Sep 2009

Sep 2010

Sep 2011

Sep 2012

Global Commercial Aircraft Order Backlog (Bn $USD)

Source: Bloomberg


Direct Mid-Market Lending

17

Maturity Profile 24 – 72 Months

Liquid Alternative BB/B Non-Distressed US

High Yield

Expected Spread / Rate 600bps prior to defaults,

450bps after defaults



Attractions

• Attractive spreads available relative to other illiquid

opportunities

• Loans typically secured on borrower’s assets

• Direct origination allows greater capture of loan

economics

Points to Note

• Private-equity style structure of manager offerings

implies high fees (including performance fees)


penalties are common within loan structures)

• Dependence on manager sourcing abilities in

allocating capital

Corporate

Corporate

Bank

Asset

Manager

Bank

Asset Manager

Bank

Asset Manager

Bank


Distressed Debt

18

Maturity Profile Varies

Liquid Alternative BB/B US Distressed High

Yield Credit

Expected Spread / Rate N/A (owing to difficulty in

quantitatively assessing

defaults, and differing

IRRs according to

investment approach)


Liquid Alternative

Attractions

• Large proportion of available deals sourced outside

of public markets – same considerations apply as in

direct SME lending

• Diverse opportunity set, including non-performing

loans, special situations lending, liquidation claims

• Potential for attractive returns

Points to Note

• Wide range of potential opportunities – some are

difficult to analyse / idiosyncratic (e.g. liquidation

claims)

• Importance of manager skill in identifying good

deals and avoiding blow-ups

• Managers differ in extent of control over borrower

desired

Discounted Debt Activist Investing Control Investing

Secure Companies

No Restructuring

Short-Term

Investment Horizon

Lower Target IRR

Companies Under

Pressure

Restructuring

Mid-Term

Investment Horizon

Middling Target

IRRs

Companies In

Deep Distress

Significant

Restructuring

Long-Term

Investment Horizon

High Target IRRs

Spectrum of Control


Implementation

19


Use of Illiquid Credit as Equity Alternative

20

40%

20%

20%

20%

Sample Equity Replacement Portfolio

Risk Parity

Long / Short Credit

Direct Lending (SMEs)

Distressed Debt

Sources of Funding

Developed Equity

EM Equity

Private Equity

50%

35%

15%

Previous Allocation

25%

50%

25%

Replacement Portfolio

Portfolio Weightings: Return-Seeking Assets

• Overall risk in the return-seeking

assets bucket reduced by 20%

• Overall expected return on scheme

assets increased by more than 10%

Equities Credit “Alternatives”


13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

Contacts

David Bennett Head of Investment Consulting

Direct Line: 020 3326 7147

[email protected]

21

Pete Drewienkiewicz Head of Manager Research

Direct Line: 020 3326 7138

[email protected]

Disclaimer

For professional investors only. Not suitable for private customers.

The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference

rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this document is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence.

This presentation may not be copied, modified or provided by you , the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipient to any other party without Redington Limited’s prior written permission except as may be required by law. “7 Steps to Full Funding” is a trade mark of Redington Limited. Redington Limited is an investment consultant company regulated by the Financial Conduct Authority. The company does not advise on all implications of the transactions described herein. This information is for discussion purposes and prior

to undertaking any trade, you should also discuss with your professional, tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is registered in England and Wales. ©Redington Limited 2013. All rights reserved.

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Manager Research Team:

Division of Responsibilities Across Steps 2-7

22


13-15 Mallow Street London EC1Y 8RD

Telephone : +44 (0) 20 7250 3331

www.redington.co.uk The Team

Pete Drewienkiewicz Director | Head of Manager Research

Direct Line: 020 3326 7138

[email protected]

23

Kenny Nicoll Director | Manager Research

Direct Line: 020 3326 7111

[email protected]

Huayin Liu Vice President | Manager Research

Direct Line: 020 3326 7105

[email protected]

Tom McCartan Associate | Manager Research

Direct Line: 020 3326 7139

[email protected]

Aniket Das Associate | Manager Research

Direct Line: 020 3326 7153

[email protected]

Kate Mijakowska Analyst | Manager Research

Direct Line: 020 3326 7106

[email protected]

Greg Fedorenko Analyst | Manager Research

Direct Line: 020 3326 7122

[email protected]

Economy & Finance

Opportunities in Illiquid Credit