The bumpy regulatory road
One reason for the unpredictable nature of the market is the capricious approach of politicians and regulators, who are often accused of pulling banks in different directions. The exasperation at what the participants feel is disjointed thinking from politicians and regulators was palpable.
“The regulatory landscape is very unpredictable, and it can have huge consequences that take time to work through the system,” Ciancimino says. “Good intentions by a politician wanting to deal with one problem can create other, unforeseen problems.”
Kent-Kershaw goes further. “Regulation is a mess. I’m not convinced most of the banks are taking Basel III seriously at the moment. Many have bigger problems and they see it [Basel III] as some distance out. A lot of regulation that’s come in isn’t aligned with other bits of legislation – indeed, it’s often competing. Basel III and Insolvency II are at odds. Solvency II wants insurance companies to hold shorter dated paper. Basel III wants banks to issue longer dated paper.
“In many cases it’s down to politicians or jurisdictions who aren’t close to the capital markets. A lot of the European legislation that’s come in has been voted for and ratified by countries that don’t have capital markets; they don’t have securitisation markets.”
Even at a political level, much of the direction given to the banking sector has been contradictory. “Governments are saying, ‘Please lend more to support small businesses, and oh, by the way, shrink your balance sheet at the same time.’” Says Ciancimino. “If we find banks’ behaviour at times bizarre, is it any wonder when they have so many competing imperatives forced on them?”
But delever they must. But the expected raft of assets has yet to materialise. “In terms of the secondary market, there’s not yet enough stress in the system to have forced major sell-offs,” argues Jenkner. “There’s been some selective portfolio sell-offs from some of the UK, German and Irish banks for instance, but little of significance.”
“It’s a pure cost of capital issue,” Mundassery adds. “Where they’re being forced to be active is where they don’t provide capital. Anything that requires some kind of a reserve, or accounting treatment which is penal, they shy away from, at least for now. That can change. I certainly don’t think the banks are irrelevant, they’re just in a tight spot right now.”
On top of problems of a more transient nature, many of the issues currently afflicting the markets have deeper roots. Paul Rolles, founder of AgFe, explains: “You need to differentiate between things that have occurred because we have structural problems right now, and things that were wrong before the credit crunch. Quite a lot of the stuff that’s going on now relates to people trying to address issues in the debt markets that were fundamentally wrong in the first place.”
But an unusual transformation is taking place, Rolles believes. “In a weird way, it feels a bit like the early 90s again. A lot of current financing techniques are being put together for the first time, and people are going to take a bit of time to get themselves properly organised and work out what they’re going to be doing in the medium term. There’s obviously market dislocation today and lots of interesting opportunities, but a lot of themes – bank disintermediation, investors more actively accessing some of these situations directly for example – are fundamental changes, which may well be permanent.
“There’s a huge wall of capital and a huge wall of opportunities, but the wiring diagram has fallen to pieces and people are just starting to work on the rewiring, basically – the connections need to be made again. If you go back to 1990, there wasn’t a deep securitisation market, there wasn’t a CLO market, and a lot of asset managers had systems which couldn’t manage certain kinds of investments even if they had wanted to. Now we’ve moved forward to 2012 and a lot of those themes are back again.
“When we talk to investors, many of the issues that come up aren’t just about credit, they’re about internal process; operations; regulation; and IT. A lot of this stuff is simply being worked through, and we are very optimistic about the future. There’s a dam breaking, and there’s a big change going on at the moment in terms of where the capital to fund many opportunities is coming from. It’s simply a matter of time,” Rolles concludes.
So how are alternative providers of debt capitalising on banks’ retreat from the market? And more importantly, how are they able to do so despite all the uncertainty around them?
“There’s been a step change in people’s ability to deal with uncertainty,” Ciancimino argues. “A few years ago the sort of stuff we see regularly now in the newspapers would have caused major anxiety, and now it’s just ‘We’ll add that to the list of stuff to deal with’ and life goes on. None of these things are going to get resolved anytime soon. The Eurozone crisis, for example – it’s not a next 6-18 months situation, it’s one that will take years to sort out.”
In such an environment, flexibility and nimbleness are important attributes, and it’s here that the new breed of boutique private debt fund managers excel.
Sanjay Mistry, a director at Mercer, has been tracking the private debt market for a long time. “There are different participants in this space, and that’s what makes it so interesting: CLOs, banks, investors taking different roles. Even amongst asset management groups, there are so many boutiques, each operating in their own niche. However, the fact is that if you can’t deliver successfully in this environment you will really struggle in the future to raise capital. Some may say the market is dysfunctional because people are all doing slightly different things to address the problem, but I think the variety of ideas is healthy and important to create longer term stability.”
Allocating to private debt
But how to sell the opportunity to investors? One challenge is working out where it fits into an investor’s portfolio. Does an allocation to private debt come at the expense of other alternative assets like private equity? Or does it come at the expense of equities, for example?
Even managers aren’t quite sure how best to go about it, Rolles says. “We’ve been talking to a lot of investors about private debt – what bucket does it go in? What part of an institution can do this? Lots of institutions buy into the idea that it’s a good thing to do, but it’s just taking time to work out the best way to do it.”
Ciancimino concurs. “You can’t look at these things in isolation. The old days of being a firm that just does one tiny niche type of financing are gone.”
If an investor does ringfence some capital for private debt, it’s more likely to have come from a pool previously earmarked for high yield or equities, Mistry says. “Assets have been switched out of equities for a number of years, and that’s largely down to schemes de-risking. They’ve been switching into fixed income and alternatives. They’re moving out of riskier assets in favour of liability-matching ones, but those are now yielding such poor levels of return, they’re asking if there’s anything else they can do that can help them move in that direction without compromising too much of that return and de-risking too soon. That’s where private debt comes in – it’s a step towards fixed income. It provides an equity-like return with a fixed income base, it’s a halfway house.”
Many investors were already exposed to private debt – they just didn’t realise it, Rolles believes. “You have to remember that a lot of people who invested in fixed income assets were essentially investing in private debt already, albeit indirectly. They were either buying securitisations, which are basically just ways of bundling certain types of private debt up and making it ‘notionally’ more liquid – and also they’ve been investing in bank and financial institutions’ paper, which is essentially an opaque indirect way of taking exposure to private debt since it is sitting on banks’ balance sheets,” Rolles says.
“The demand for financial institutions paper – such as bank senior debt – is not what it was. People are thinking hard about their sovereign exposures too. This is driving demand for high yield, private debt and other strategies. A lot of the time, institutions are investing in assets that they were invested in already, albeit indirectly, they just didn’t focus on it, or didn’t care, or were basically relying on the ratings. So a lot of what’s going on is essentially connecting real money to assets which were indirectly funded in a more direct, obvious, and transparent fashion.”