Benefits and challenges of investing in alternative credit

Alternative credit has been growing rapidly in the past decade. On the supply side, this is as a result of disintermediation of banks after the credit crunch and the increasing regulatory pressure they were and are faced with. But demand has grown at a fast pace too, driven by the search for yield and the desire to diversify.

A substantial number of pension funds[1] are already investing in alternative credit, and their number is expected to grow over 80% by 2020. ‘Alternative credit’ seems to be a broadly used term. What does NN Investment Partners’ (NN IP) capture in this category and what do they see as the benefits and challenges of investing in alternative credit?

Gabriella Kindert, head of Alternative Credit at NN Investment Partners, said: “Alternative credit is an increasingly important investment category consisting of a broad variety of loans to companies, organizations and projects, outside the regulated banking system. Examples are private loans for residential and commercial real estate, loans to build infrastructure, to fund exports and to finance corporates. Interest durations can be very short or very long; credit quality can vary from AAA to high yield. Within this category, we clearly distinguish two sub segments. First, active asset managers and institutional investors offer alternative sources of credit, either directly or through their clients, like pension funds and insurers, as well as family offices and foundations. Secondly, there are fintech companies offering alternative loans through new business models, such as crowd funding and peer-to-peer lending. NN IP offers the first, more traditional form of alternative credit.”

There are many companies and projects that need funding, but for some reason cannot obtain it from banks or on the public capital market. This so-called funding gap is particularly large for small and medium-sized enterprises (SMEs), but it is also of significance for large infrastructure projects for example. Banks have been discouraged from lending out, predominantly driven by capital constraints. This is an issue, as SMEs are a primary source of economic growth and employ two-thirds of the global workforce. Next to that, there are other reasons to go to the private market rather than pursuing public loans. An important one is the ability by both lender and borrower to to customize loans to their own desires.. Alternative credit loans are negotiated bilaterally or multilaterally and are agreed upon with tailor-made documentation.]

Maureen Schlejen, head of Institutional Relations for the Dutch market at NN Investment Partners: “There is a lot of regulatory pressure on banks. They need to reduce the leverage on their balance sheets. The total amount of consolidated assets in the banking sector has been decreasing almost every year since 2009. The same goes for the number and total value of securitised investments since the credit crunch. Securitisations are relatively complex for banks, the regulations are very strict and the capital requirements can be unattractive for investors. Institutional investors can actually bridge the gap. Because of their long liability structure, they are in effect natural investors in loans. Many of them have a long investment horizon and can afford the lower liquidity of loans. Depending on where you want to be on the risk curve, investors can earn a pick-up varying from 50 to 200 basis points versus comparable publicly traded instruments.”

“We apply the same or even a higher level of fundamental analysis, compliance and risk management as banks. This means we offer the same products as banks, but within an asset management framework and tailored towards our clients. Alternative credit offers investors interesting features, such as low correlation with more traditional investment categories, diversification, attractive returns and relatively appealing spreads. The level of expected returns, of course, varies by type of investment. A relatively underexposed feature of alternative credit is that these loans can be used to match liabilities of pension funds and insurers as well. The more conservative part of these strategies has predictable cash flows, stable returns, high credit quality and still offers a pick up versus the traditional instruments used in the matching portfolio.”

Spread and premium

The price for each asset class is determined by supply and demand. The private market, however, has its own dynamics.

Kindert, explains: “We have to compare loans with bonds. For loans, we focus heavily on downside risks. What is the structure of the loan? Are there contractual protections in place, such as collateral, mortgages and exercise rights? The loans often have complex structures and extensive documentation; this complexity is therefore compensated by a premium. Investors demand a premium for the lack of liquidity as well, the so-called liquidity premium. Furthermore, the spread is affected by market inefficiencies – or how easy or difficult it is to bring buyers and sellers together – and by the expected probability of default and the so-called recovery rates of the loans. Alternative credit generally offers a spread – or private pricing differential (PPD) – of 0.5% to 5%.”

Schlejen added: “The spread is not stable over time. We monitor each individual sub-segment carefully and have dedicated teams in place for the different strategies. On top of analyzing the supply side, we are closely looking at the specific demands of our client base. We see that several pension funds want to build a more diversified portfolio of alternative credits now, and we can support them by pointing out alternatives with a better profile. NN IP invests in a very large number of sub-segments of alternative credit and we therefore have good knowledge of the attractiveness of all segments. We provide both assets and solutions. We have a lot of experience in this area; we have been doing this for our insurer since the early nineties.”

Defensive strategy

Most private loans currently offer a high security in the capital structure. The loans are usually secured by assets and/or shares of the companies in question. Many loans also have floating rates and can implicitly offer a natural hedge against the risk of rising inflation. Moreover, it is possible to diversify.

Schlejen said: “For example, in uncertain times, investors may add exposure to loans with shorter maturities, such as trade finance or factoring. Not only do investors diversify more within alternative credit, they also increase their allocations to alternative credit at the expense of, for example, equities (because they are more volatile) or government bonds (because their yield may be too low and they are sensitive to rising interest rates). This applies not only to pension funds, but also to insurers. Recently, independent asset managers and family offices have been looking at our solutions as well. We are seeing more and more investors showing interest. To meet this demand for education and knowledge building, we have written the guide ‘Alternative credit and its asset classes’, which is available on our website. This guide is being downloaded a lot, which indicates that there is a great need for thoroughly understanding the investment category.”

Kindert said: “Education is very important. We need to explain what can go right and wrong in the alternative credit market as a whole and in the various sub segments. In doing so, we contribute to the development of the market. Not only investors, but also regulators and politicians need our information. In Europe, the strategic direction is evidently related to achieving growth of the capital markets in the loan market. The European Commission’s latest official papers endorse the use of loans as well. The EU has even adopted a capital markets union action plan with the aim to mobilize capital in Europe and channel it to all companies, including SMEs, and infrastructure projects that need it to expand and create jobs. These developments underline the potential of alternative credit going forward.”

 

Gabriella Kindert (pictured) is head of Alternative Credit at NN Investment Partners, and  Maureen Schlejen is head of Institutional Relations for the Dutch market

[1] Towers Watson, 2015

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