Roundtable: Private Senior Loans – The search for yield and capital efficiency
Private senior corporate loans could offer insurers an attractive mix of stable yields and new capital efficient solutions was the key message for participants – a mixture of insurers and regulators – at the latest exclusive breakfast roundtable hosted by the Insurance Investment Exchange. This was run in partnership with Natixis Investment Managers and its affiliate, MV Credit.
The presentations and discussion focussed on the current dynamics and opportunities in the middle market corporate loan space in the UK and Europe, which has changed significantly in the wake of the financial crisis. Before 2008, it was dominated by banks, which issued leveraged loans and then syndicated them.
The tightening up of bank capital regulation has gradually squeezed them out of the small cap and mid cap markets, where they have been replaced by unitranche lenders such as Ares, Alcentra, Hayfin and Bluebay as well as direct lending.
This has broadened the scope for insurers to get involved. The attendees debated how there was a need for a degree of caution if insurers are to fully realise the benefits of embracing private corporate loans. Among the potential pitfalls were financial reports and projections full of adjustments and carve outs, which are often indicative of unrealistic owner expectations. It is also essential to maintain close relationships with borrowers as it is the best way of proactively guarding against defaults, especially as the market cycle starts to tighten in this late phase.
The relative merits of different sectors were also explored, with the challenges of investing in capital intensive sectors such as oil and gas and the automotive industry making them less attractive than sectors such as health care and subscription-based IT. The latter sectors have the attraction of being less cyclical and generating relatively stable recurring revenues – an attractive feature when it comes to ensuring sustainability of debt coupons and repayments.
ESG (environmental, social and governance) considerations also play an important part in identifying the best firms to lend to, as data shows that firms with a strong ESG awareness present a better risk when it comes to preserving downside protection. They tend to be more aware of the risk that governmental regulation could impact poor but profitable environmental practices, and are also better at protecting workers against unsafe working conditions. Nevertheless, this is not an easy area to manage as there is still no consistent taxonomy despite regulators talking about the need for one. Further work also needs to be done in identifying where diversity sits and how you assess its impact on a firm.
Structuring was a key consideration and topic of debate, particularly given the focus on the matching adjustment by life insurers. The discussion focussed on some of the key questions insurers always ask: what is the quality of the assets and how liquid are they?
The loans are typically below investment grade, and often also too small to interest the big three ratings agencies. This can create complications, particularly for those who need some form of internal ratings, and there, solutions are beginning to emerge.
Some noted this was not necessarily an insurmountable problem, as the Bank of England has stated that not every asset has to be in the Matching Adjustment portion of the portfolio. If an asset makes economic sense, insurers can still invest in it.
The liquidity issue provoked some controversy given the desire of insurers wanting long term assets with a degree of guarantee about yield, and some noted the potential for maturity mismatches in the underlying. However, illiquidity contains a premium, which is still desirable in the current climate of constrained yields. There was agreement that this was about insurers better understanding the risks around different assets and where they should sit in their portfolios. It is a concern that should be addressed upfront when considering this asset class, so that structures and duration can be tailored to the specific requirements of different insurers.
Please click here for a full list of upcoming Insurance Investment Exchange, including our June Seminar examining the changing nature of asset allocation and the rise of ESG considerations.Category: Commentary