In the past decade, as the quest for yield surged, the exposure of investors has increased substantially to private assets. Are there some lessons learned from the previous decades and previous epidemics? What do we need to do?
Here are my thoughts in these trying times:
After severe stress, there is likely to be economic growth
Leading indicators suggest a severe disruption of some businesses already. Airline passengers are down by 30 to 40 percent for some carriers, hotel reservations are at a 10-year low, large events have been cancelled, even in less impacted countries. In many economies, like Italy, the situation is very difficult. The predominant worry around Europe is this: will neighbouring countries follow suit? Are we lagging a few weeks or just a few days behind?
As we are learning what our global interdependence means in practice, we have entered unknown territory. There seem to be no road maps of what will happen. Besides business implications, for the first time in our lives, many of us feel physically threatened and see Darwinist patterns evolving. One thing is for sure – it is not business as usual.
Unlike the 2008 crisis, the situation today did not stem from financial engineering and excess leverage. It is impacting companies across many sectors and it is threatening human life. When and how it will end, we don’t know.
If we look at history, evidence indicates that the economic impacts of the 1918 influenza (referred to as “Spanish flu”) were short term. Some businesses suffered severe revenue losses by up to 50 percent, but they were able to recover in subsequent quarters.
During the SARS epidemic in 2003, tourism suffered in Hong Kong. Across the entire region, tourism declined by 20 to 70 percent, according to the World Bank, but society recovered quickly. The patterns are always different, and history does not repeat itself, but it rhymes. Lessons from history show that policy responses need to be aligned between the private sector and governments to make this happen.
Liquidity is at risk. We need to waive automatic triggers that were invented to work in business as usual environments
What made the 2008 crisis bad was the downward spiral and selling pressure that were built in for illiquid instruments in illiquid markets.
As I have highlighted before, asset classes change behaviour if the investor base and the structure of the investment vehicle shift.
In each investment segment in alternative lending (leveraged loans, commercial real estate, infrastructure, private debt, direct lending, mortgages) today, the investor base is different. It is broader and larger. The search for yield drove institutional investors and private investors to invest in coupon payment instruments.
To some extent, the new investment vehicles are open-ended funds, built for collateralised loan obligation, and in segregated mandate form. CLO leveraged loans are currently already frozen, combined with a widespread credit problem. There is a very high risk of fallen angel BBB corporate bonds entering into forced liquidation resulting from rating downgrades. The market is trillions in size.
Many institutional investors inserted measures linked to net asset value and liquidity, which will not work in the current market and will contribute to pro-cyclicality, fear and will likely to make the crisis a lot more severe.
Will investors panic and liquidate in the illiquid market? Several reports have been warning about open-ended structures offering liquidity (risk related to liquidity transformation). These exposures add to the risk of pro-cyclical behaviour in times of stress.
A bail-out should happen to address the downward spiral resulting from illiquidity. Now. To address these issues, coordinated support from lenders and policy responses are required. Rating actions should not trigger an automatic downward spiral where everyone loses.
ESG 2020: it is time to be a financial doctor, not a financial police agent
We have a few burning challenges and the ecosystem we created in (alternative) lending can provide quick solutions to channel the necessary financial support. As doctors cure patients, our responsibility is to cure and help the sick to recover. This is environmental, social and governance in practice in 2020. It is time to waive, cure and show goodwill.
How can we address key challenges during this time?
|Pain point||Potential solution|
|Liquidity issues||Payment holiday/moratorium
Liquidity support despite covenant breach, potential covenant break
Waive actions linked to ratings and rating downgrade
Waive automatic trigger linked to internal and external ratings
Close open-ended vehicles to protect all investors
|Defaults||Waive rating necessity until situation consolidates
Waive trigger levels linked to leverage
Create alignment focused on long term
Aside from over-analysing facts and creating models, we need to rely on our survival instincts and creativity now more than ever before. Only with a principle-based approach will we maximise long-term value for all involved. Rules we made in the past for certain scenarios may not apply this time.
Defaults will rise. Value should be maximised.
Defaults will inevitably happen. The severity depends on how prolonged the crisis will be and at the moment, nobody knows.
Hardly any company can sustain a 30 to 40 percent drop in turnover. Which ones will default? It will depend on their:
1) Flexibility: financial and operational flexibility
2) Behaviour: lenders and sponsors
3) Support policy: Policy responses (tax deferral, rate cuts, new TLTRO liquidity facilities, demand stabilisation)
I believe there will be many companies that will need liquidity and potentially run out of cash without breaching any covenants. They may not be the most highly levered companies that will default but the ones that lack flexibility combined with operational stress.
|Most impacted industries*||Opportunities and industries impacted positively|
Service (entertainment, personal services)
Industries relying on global supply chains (manufacturing)
Healthcare (testing, diagnosis, disease control)
Infrastructure investments (healthcare, ESG)
Local/regional supply chain – relocation
Diversify supply chain
Providing liquidity support to companies
*Based on assumed declines in case of a pandemic in the eurozone
Lenders should find solutions for impacted industries.
At the height of the SARS epidemic, Asian countries made various efforts to mitigate the impact: refunding employment taxes, concessions on utility bills, short-term loans, shouldering medical costs, extending subsidies.
Recent examples: (i) Ant Financial stopped updating credit rating scores in January 2020 until the situation consolidates; (ii) Italy has frozen mortgage payments for customers until the lockdown is lifted.
Further, securing corporate financing will be essential in the next weeks and development banks/policymakers can use the digital alternative lending infrastructure for efficient distribution of support funds. Quickly and efficiently.
The crisis will further increase the importance of private markets and digital-based lending
I believe the crisis will offer many interesting value opportunities for investors. The banking sector is likely to have huge issues to deal with and will need to shed assets further due to constrained lending capacity. On the other hand, there are high levels of dry powder in private equity and private debt funds, which will help make the shift towards non-traditional financial lenders.
The coupon-paying nature will offer attractive investment opportunities to retail and institutional clients in an environment where base rates are expected to remain low and value opportunities are present.
Though there is much negative publicity about private debt and leveraged loans, there is a substantial equity buffer in the capital structure. Many fundamentals remain strong. Credit investing is about long-term vision and we need to maximise the value for investors and support companies in difficult times, for the benefit of all stakeholders.
Extraordinary situations require extraordinary measures. Preventing asset prices and companies from unnecessary collapse is our collective responsibility. Consequently, lenders, policymakers, central banks and rating agencies should carefully weigh their actions.
The impact to our economy largely depends on our actions and the support we give to companies and customers today. We need to think about unintended consequences.
Someone once remarked, “A banker is a fellow who lends you his umbrella when the sun is shining but wants it back the minute it begins to rain.”
Whether there is a grain of truth to that remark or whether it is just a general perception, today is the perfect time to practice true ESG. The rain is pouring out there. Let’s give umbrellas to those who need them and eliminate measures that make the situation even worse. We need to apply a different mindset on how to preserve value.
Gabriella Kindert is a member of the supervisory board at Mizuho Europe and senior adviser to CVI, the private debt fund manager in Central and Eastern Europe