Opportunistic Strategies for Navigating a Changing Credit Landscape

Transcription

1 Retirement and Investment Opportunistic Strategies for Navigating a Changing Credit Landscape November 2014 Risk. Reinsurance. Human Resources.

2 Key Points New bank regulations implemented in response to the global financial crisis have led to a reduction in bank lending activity that has long-term implications for the way businesses and consumers borrow. This trend is particularly evident in Europe, where banks have lagged their U.S. counterparts in selling non-core assets and de-levering their balance sheets. The current dynamic presents opportunities for alternative credit providers, such as opportunistic credit investment funds, to step in where banks are pulling out. We believe a diversified, global approach to credit that incorporates a variety of strategies poised to benefit from dislocations caused by this trend offers investors the potential to earn attractive returns in an otherwise low-yielding environment. As more capital has been raised to invest in opportunistic credit funds over the past year, some may question whether the opportunity has run its course. While that influx of new investment supports tempered return expectations, we continue to view opportunistic credit as a multiyear investment opportunity, particularly for managers with the flexibility to adapt their strategies as valuations fluctuate. Manager selection is critical in order to manage the risks of opportunistic credit investing. Introduction The global financial crisis continues to cast a long shadow on the credit markets, causing structural shifts in the way many businesses and consumers obtain credit. The crisis exposed a number of vulnerabilities in the banking system that have been well documented lofty leverage levels, off-balance sheet vehicles that masked liabilities, and an overreliance on short-term funding sources to make long-term investments. Regulators in the U.S. and Europe have since cracked down. For instance, the Dodd-Frank Act was passed in 2010, the Volcker Rule became effective in 2012, and the implementation of Basel III standards got underway in 2013 (the timeline for implementing those standards has been extended to 2019). Facing higher reserve requirements and greater capital charges on certain types of loans, banks around the world have increased the amount of capital they hold relative to their assets through some combination of capital raising, cost cutting, and reducing lending and investment. As banks have cut back on lending, certain industries, individual companies, and consumer groups previously reliant on bank financing particularly those with less-than-pristine credit profiles have found their access to credit hampered. Increasingly, various non-bank investment funds have sought to fill that void. Funds that take an opportunistic approach across corporate and structured credit, real estate, geographies, and different parts of the capital structure have been well positioned to extend financing to businesses and households that find themselves cut off from bank capital. In addition, the banks themselves have provided these funds with a direct source of investment opportunity as they have sought to comply with capital requirements by offloading risk through risk-sharing agreements and outright asset sales. Opportunistic Strategies for Navigating a Changing Credit Landscape 1

3 Background: Spotlight on Europe Bank disintermediation was well underway in the U.S. before the financial crisis. In the early 1980s, U.S. banks provided more than half of the credit extended to all U.S. nonfinancial companies and mortgage lenders combined. As capital markets have grown and alternative credit providers (including governmentsponsored entities Fannie Mae, Freddie Mac, and Ginnie Mae) have increased their market share, that figure has declined to below 25% today. This trend has not advanced as far in Europe, however, where banks still provide roughly 45% of loans to European nonfinancial corporate borrowers. The financial crisis caused bank lending to contract significantly across the U.S. and Europe, which has led to an acceleration of this trend. While U.S. bank lending has begun to expand more recently, albeit at a modest pace, European bank lending has continued to contract, as shown in the following chart Total loans by European monetary financial institutions by destination sector, in billions of euros Loans to Non-Financial Corporations Loans to Households Source: European Central Bank, October 2014 The pace of European bank lending looks unlikely to pick up anytime soon, as European banks are still substantially overlevered compared to U.S. banks. Their total assets to tangible equity are in excess of 20x, versus 10.5x for U.S. banks, as shown in the table below. Tangible Equity Total Assets Leverage Ratio U.S. Banks 1,062 11, x 10.5x UK Banks 304 6, x 21.8x European Banks , x 21.1x (excluding UK) Total 2,048 32, x 15.7x Source: Blackstone, November 2014 Opportunistic Strategies for Navigating a Changing Credit Landscape 2

4 A more immediate catalyst for the acceleration of bank disintermediation in Europe is the move to place all Eurozone banks under the regulatory oversight of the European Central Bank (ECB) beginning in November In preparation, the ECB has been conducting a comprehensive assessment of the quality of loans on banks balance sheets and conducting stress tests to identify capital shortfalls. The ECB announced the results of its assessment in October, and confirmed the view that many banks had been delaying loan write-downs and overvaluing their balance sheets. The review led to an additional 136 billion classified as non-performing exposures, increasing the total non-performing exposures across the Eurozone to 879 billion. It also uncovered a 43 billion capital shortfall requiring additional loan provisioning 1. Banks found to have capital shortfalls have six to nine months to bring their capital ratios in compliance. European banks have already been reclassifying loans on their books as non-performing and selling assets at an accelerated pace in According to PricewaterhouseCoopers, EU banks are on track to shed 100 billion of non-core assets this year, up from the 64 billion they sold in 2013, and 46 billion in That s just a fraction of the total 2.4 trillion of non-core assets that European banks still hold. And while not all of these assets will be sold, they represent a sizable financing gap. Opportunistic Credit Funds Aon Hewitt believes certain opportunistic credit funds are well positioned to benefit from the reduction in bank lending across the U.S. and Europe. Although return expectations have come down somewhat as more capital has entered these markets, we are still finding strategies that are poised to deliver a net internal rate of return (IRR) in the low teens. Those return prospects look particularly attractive relative to public credit markets, where investors voracious appetite for income has pushed the average yield on high-yield bonds down into the 5% to 6% range for the past two years. Rather than focus on funds with narrow mandates that are confined to one geography, the strategies we favor cast a wide net investing across asset classes, industries, and geographies in both performing and non-performing loans and securities. These funds are able to buy assets in the secondary market as well as enter privately negotiated lending transactions. 1 2 Source: ECB Aggregate Report on the Comprehensive Assessment, October Source: PricewaterhouseCoopers: European Debt Portfolio Conference: Deleveraging non-core assets in the new normal, March 25, Opportunistic Strategies for Navigating a Changing Credit Landscape 3

5 Opportunistic credit funds don t employ a one-size-fits-all approach. Some gravitate toward investment themes where an asset manager s in-house expertise gives them a unique advantage. Themes can also change quickly as parts of the market become increasingly competitive, or specific opportunities fail to materialize as anticipated. The following is a sample of investment themes that opportunistic credit funds are currently pursuing: Non-core loan portfolios purchased from banks representing a wide variety of underlying collateral, such as commercial real estate loans, consumer debt, student loans, structured credit, loans to small and medium enterprises, and other corporate loans. Distressed corporate investments in industries that are facing headwinds, such as metals and mining, retail, and health care, or industries that banks are less inclined to lend to, such as aircraft, shipping, and energy. Complex structured credit issued pre-crisis, such as collateralized debt obligations backed by subprime asset-backed securities, where value can be extracted by collapsing the CDO structure and selling the underlying securities. Investments in non-bank mortgage originators and servicers. Direct origination of commercial real estate loans, especially in Europe where the impact of banks retrenchment has been pronounced. Providing financing directly to banks, either through buying preferred securities issued by banks that will no longer qualify as Tier 1 capital under Basel III, or entering risk-sharing agreements that allow banks to retain assets on their balance sheets while the investor assumes a portion of their default risk (also called regulatory capital relief trades ). Because of the illiquid nature of many of the underlying investments and their longer duration, these funds typically lock up investors capital for a period of five to 10 years, which helps prevent an assetliability mismatch that would force managers to sell investments prematurely. Given their finite lives, we are continuously reviewing new opportunistic credit funds that come to market and being highly selective. These funds typically raise capital over a period of six to 12 months, so investors themselves may need to exercise a degree of patience and flexibility when allocating to this type of strategy. Key Risks As more capital has been raised to invest in these strategies, it s fair to question whether the opportunity itself has run its course. Meager yields across fixed income sectors are likely pushing some investors to take on greater risk in less liquid corners of the market in hopes of eking out incremental returns. Low default rates and a benign environment for risk-taking have presented a rosy return picture that may prove unrealistic if private lending becomes increasingly competitive, or if we encounter a severe economic downturn. Meanwhile, asset managers that have stepped up their shadow banking presence may be more interested in growing market share than providing the best possible risk-adjusted returns for their clients. While those concerns are valid, we don t think they warrant avoiding opportunistic credit strategies altogether. They do, however, highlight the importance of thoroughly understanding the risks associated with opportunistic credit strategies and being highly selective in choosing an asset manager that is well equipped to manage these risks. Opportunistic Strategies for Navigating a Changing Credit Landscape 4

6 A manager s inability to source attractive deals in an increasingly competitive climate is one risk that could erode returns. For instance, funds raised to invest in U.S. residential non-performing loans had a very brief window to invest in these portfolios at mid-teen and then high single-digit IRRs in 2012 and 2013, only to see returns plummet to low single digits earlier this year. Within both the U.S. and Europe, managers with significant scope and deep relationships with market participants have an advantage in uncovering opportunities before they become too crowded. The possibility of experiencing capital impairment is another risk, given the nature of lending to stressed and distressed borrowers. And given the lack of common bankruptcy laws across European jurisdictions, which result in varying levels of protection afforded to borrowers, deep knowledge of local laws and regulations is critical. We favor managers with strong capabilities across a range of credit strategies, which allows them to walk away from areas of the market that appear overheated while pivoting toward areas where competition is weakest. Another way to reduce the risk of an opportunistic credit strategy is to carefully choose the vehicle structure. Locking up investor capital for a period of several years helps ensure that funds won t need to sell assets at fire sale prices, and that investors who choose to stay in a fund won t be harmed by those who get out early. Many hedge funds invested in illiquid debt transactions prior to the financial crisis were forced to hold them in side pockets when investors exercised their right to redeem. Conclusion Overall, we believe the restrictive effect of post-financial crisis regulatory reform on banks ability to lend to the private sector is creating an opportunity to earn attractive returns for opportunistic credit funds that can step into that void. Although an increasing amount of capital has been raised to invest in such opportunities over the past year, we expect the opportunity set to remain robust in coming years particularly in Europe, where banks are still overlevered and holding a large quantity of non-core assets. Funds with broad mandates run by asset managers with a global footprint and expertise across a wide array of industries and sectors are best positioned to succeed in coming years, particularly as select areas of the market may become crowded. Given the illiquid nature of many of the underlying investments, investing in a lock-up vehicle that matches the duration of assets is crucial for success. Opportunistic Strategies for Navigating a Changing Credit Landscape 5

7 Contact Information Miriam Sjoblom, CFA Senior Consultant Aon Hewitt Investment Consulting Matthew Plaveczky, CFA Senior Consultant Aon Hewitt Investment Consulting Opportunistic Strategies for Navigating a Changing Credit Landscape 6

8 About Aon Hewitt Investment Consulting, Inc. Aon Hewitt Investment Consulting, Inc., an Aon plc company (NYSE:AON), is an SEC-registered investment adviser. We provide independent, innovative solutions to address the complex challenges of over 480 clients in North America with total client assets of approximately $1.7 trillion as of June 30, More than 270 investment consulting professionals in the U.S. advise institutional investors such as corporations, public organizations, union associations, health systems, endowments, and foundations with investments ranging from $3 million to $310 billion. About Aon Hewitt Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement, and health solutions. We advise, design, and execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability, and wellness. Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit aonhewitt.com Aon Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Hewitt Investment Consulting s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Aon Hewitt Investment Consulting disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Hewitt Investment Consulting reserves all rights to the content of this document. Opportunistic Strategies for Navigating a Changing Credit Landscape 7