Sane lender, open for business

M&G Investments’ fixed income division manages £143 billion ($232 billion; €168 billion) of assets for its range of institutional clients. When a fresh-faced Simon Pilcher joined Prudential in 1998 after nine years at Morgan Grenfell Asset Management, the business oversaw just £25 billion.

Back then, he was head of fixed income at Prudential Portfolio Managers. Six months later, the insurer acquired M&G and Pilcher soon became chief executive of its fixed income division. A former colleague spoke to Private Debt Investor and gave this appraisal: “Simon is a very impressive character. This shouldn’t be taken the wrong way, but he could have gone even higher in M&G than he has done – he’s a very accomplished performer.”

Pilcher has overseen a period of extensive growth. The fixed income team has swelled from 30 people back in 1998 to 230 today across its various offices. One of its claims to fame was that it was the first non-bank in Europe to invest in the loan market.

How has the firm achieved this level of growth, Private Debt Investor asks as we settle in for an interview at the firm’s London headquarters?

Pilcher’s sunny disposition is at odds with the torrential rain beating against the glass outside. He evidently takes pride in what the firm has achieved – the stellar growth, but more importantly, the strong returns on which that growth was predicated.

“We have a simple philosophy: the only commodity that we have to offer is investment performance. If we deliver investment performance then our clients will entrust us with more money and new clients will want to come and join us. It’s really that simple,” he says. All the firm’s institutional public debt funds have comfortably outperformed their benchmarks over the last three years, while actively managed fixed income mandates for external clients have met or beat their benchmarks over the same period. The €2.2 billion M&G European Loan Fund run by its leveraged finance team has returned 5.17 percent YTD, and its £1.6 billion Secured Property Income Fund is currently the top performing fund in its segment of the IPD UK Pooled Property Funds Index.

That performance has seen third party investors flock to M&G’s door to the extent that at group level, M&G IM now manages slightly more on behalf of those investors than it does the Prudential’s own money.

“It’s the third party side of the business that’s seeing the fastest growth both on the retail and on the institutional side,” Pilcher adds. It’s not all via co-mingled funds either – M&G now manages a number of individual segregated accounts which are “Well North of a billion”.

As well as diversifying its investor base, the firm has also branched out into a bewildering area of market segments. The group’s fixed income division overseas a panoply of different investment areas, from public debt (government and investment grade corporate bonds) to direct lending (to SMEs), taking in leveraged finance, infrastructure financing, private placements and real estate debt in between.

Educating the market

Our interview happens to coincide with the fifth anniversary of the collapse of Lehman Brothers, which heralded an unprecedented level of turmoil for global markets. But as investments banks in particular have reeled in the face of significant losses and sweeping regulatory changes, M&G appears to have quietly and methodically gone about its business. The firm, like Pilcher himself, isn’t brash, and it doesn’t make too much of a song and dance. It simply aims to deliver superior returns to its investors in the most efficient manner possible.

The firm has however played an important role in explaining to investors the merits of private debt as an asset class, as Pilcher explains.

“We’ve had to do a lot of education.  There was very limited appetite from European investors for private debt prior to 2008, during the credit crisis, and I think very little understanding of the advantages that well structured, well covenanted debt can bring in terms of downside protection. 

“Since 2008 the prospective returns from private debt relative to public debt – given the way spreads have tightened in recent years as a result of quantitative easing – have meant pension funds and their advisors have grown dramatically more willing to look at private debt strategies than was the case previously. They’re significantly more willing to do so today than they would have been even two years ago,” he adds.

Results seldom lie, and M&G’s patient approach has meant it’s been able to demonstrate to potential LPs its ability to deliver on its promises. “I think people are more willing to listen when they can see the things that you’ve just spoken to them about in the past have performed as you’ve said they would, that they can see that there is a strong alignment of interest and that we eat our own cooking,” Pilcher says.

Branching out

Pilcher’s thesis when he joined Prudential was based on an uncomplicated belief – that the core competence you needed to be successful was the ability to manage corporate credit risk. Prudential, he said, had that expertise in abundance because of its long history of lending in the UK, developing its capabilities in both the public and private corporate debt arenas. “The latter was almost unique and the former was very unusual”, he says.

“It’s been a matter of developing that capability as we look to invest money initially on behalf of Prudential, identifying new opportunities, new areas, new markets and offering higher risk adjusted returns. But then we’ve taken that capability and that capacity externally to third party investors, with quite a simple message which is; ‘We think this is a smart way of running money, we are investing our parent’s capital, would you like to invest alongside them?’  Really it’s been a story of clients liking the strong alignment of interest between themselves and ourselves and having had a good experience with us in terms of delivering what we said we’d deliver,” Pilcher continues.

It helped that pension funds, insurance companies, banks and sovereign wealth funds have grown “increasingly receptive as they look at the opportunities both within the mainstream public bond markets and increasingly outside in various private categories” he says.

Developing a corporate identity and shared ethos is tough at the best of times, but it’s even harder when a firm is growing and diversifying at such a significant rate. Has that been a challenge?

“The culture of M&G is critical to our success and when we’re recruiting that’s right at the top of the priority list in terms of who we’re willing to recruit. The culture is one that says ‘We’re here for the long-term and we only want to build businesses, we only want to do deals, we only want to take on clients where we think that we can provide good investments over the medium to long term.  If it’s a fad and we don’t fundamentally believe in the investment proposition we won’t do it. 

“The logic then for us is that we want to hire people who similarly have that longer term mindset. We are building the business for the medium to long term and we’re prepared to do things that are genuinely in the client’s interest.  Clearly a key part of it is hiring high caliber people, but they’ve got to be people who will fit into what is a very collegiate culture and people who are interested in building for that longer term,” Pilcher says. The firm will typically identify and move existing team members across into faster growing areas, which helps to maintain the M&G corporate mindset, he adds.

The firm’s inexorable growth and evolution has occurred against a backdrop of profound structural changes in the capital markets. Banks have altered their own lending practices, for instance, with Pilcher citing commercial mortgage lending as an example. “Prior to 2008, banks were willing to give very high loan-to-value loans at very skinny margins. Since 2008 they have recognized that their own balance sheets were disproportionally comprised of commercial mortgage lending, so they just had too much of it full stop,” he argues.

“Second, what they’ve written was far too risky.  Third, the amount of capital that they put up against it was far too little and fourth the regulators were on to them.  The dynamics of that market have shifted dramatically such that safer loans can be originated, with much lower LTVs, much better covenants and so on. The margins available are substantially higher.  We’ve taken the decision to ramp up our activity resulting in substantial recruitment, so the scale of our activities in that market has grown frankly exponentially.  We had three people, now we have about 20 and still growing fast.”

The trouble with Funding  for Lending

Regulation has played a key role but M&G hasn’t had things all its own way.

Pilcher believes the UK’s Funding For Lending Scheme, for example, is hindering the development of non-bank lending in the UK rather than fostering it.

“Effectively it’s a cross subsidy from the taxpayer to banks as they continue to make loans against corporate credit,” he says. As M&G manages two funds which lend directly to mid-cap corporates in the UK (the second of which, in should be noted, benefited from a commitment from the UK Treasury via its Business Finance Partnership scheme), it is in direct competition with the banks.

“It’s an unfair playing field, in that banks have a cheaper cost of finance than they otherwise would have done without the scheme.  We are making what we consider to be attractive loans but the rate of growth of our market share in that area is slower than it would be if we didn’t have this unfair playing field,” Pilcher says.

Nonetheless, M&G is making headway, albeit not as fast as Pilcher would like. “I think we remain attractive for borrowers because we can provide longer term finance than their banks are willing to.  Corporates like dealing with M&G because they know that they’re dealing with a long term, stable, sane lender, so I think we have a big advantage,” he said. “Relationships are very important and we have a history of lending that we can point to.”

Borrowers burnt by the crisis are also looking to diversify their funding streams, Pilcher believes. “They don’t want to be in the dire position that some of them found themselves in 2008 of suddenly finding that their sole provider of funds from within the banking sector may not be able to provide them the funds that they need,” he says.

The market needs building

Yet for all the progress the firm has made, it’s still a nascent market. “Direct lending to corporates is very much in its infancy across Europe,” Pilcher argues. “We raised the first fund in the depths of the credit crisis and we were looking to continue that in terms of bringing more than just the Prudential’s capital to bear. Having funding from the Business Finance Partnership has been very helpful in ensuring that we remain a significant presence in that market. What the government needs to do is to encourage a market first of all, and then you want to see growing competition.”

“So the challenge for the market is to get more competitors in there and I think the way in which the insurance regulations develop will be quite important.”

When asked to name M&G’s closest competitors, his answer is illuminating. “It’s really US houses: Pricoa and MetLife, New York Life and to a lesser extent Aviva. Those are the key competitors in the low levered private company and more public company world.”

There are very few organisations able to boast the scale and breadth M&G has. Pilcher points to a recent deal as evidence of M&G’s ability to offer bespoke solutions. “We did a landmark residential property transaction with a housing association at the beginning of the year that started off as a private placement run by our social housing lending team, but they discussed a range of finance options and it turned out that actually the real estate team was probably better equipped to run that deal.

£1 billion, no syndicate

“That demonstrates the breadth of funding solutions that we can offer.  Increasingly, our USP is actually just the scale that we can provide. If we look at the commercial mortgage market, typical bite size for a bank would be in the region of £50 million, maybe £75 million, unless they’re going to syndicate it.

“But we’re now in a position where we look at the money that we manage on behalf of Prudential, together with the third party client money, and we can contemplate half a billion, even a billion pound transaction without syndicating it, taking it in its entirety.  Again, relative to the world of pre-2008, we’re able to contemplate transactions that banks currently can’t begin to contemplate because of the breadth of our client base and thus we’re able to offer certainty of execution. With a consortium of banks, it is really very risky and you need to get all of them to the table.”

The real estate lending arm of M&G’s fixed income group has been one of its real success stories. It’s the fastest growing business area, according to Pilcher, and covers a range of investment types from social housing through to commercial real estate. Pilcher is very proud of both.

Recent fundraisings have underscored the level of appetite for the firm’s product. In the CRE space the firm is having to turn away investors, for example.

The firm has just raised two new funds in the stretched senior and junior commercial mortgage space, and had to turn some investors away. The stretch senior fund is a £750 million vehicle, while the junior debt fund’s size is undisclosed at present because the fundraising was still live at the time of the interview.

Senior debt in particular is playing very well with investors in Europe, thanks to the scale of the market opportunity and the risk-adjusted returns on offer: around a trillion Euros-worth of commercial mortgages need to be reinvested in Europe over the next four years so that represents a sizeable opportunity for firms like M&G to gain market share.

Massive demand

Are there any market segment Pilcher and his team regrets not moving into, or moving too slowly? “At the risk of sounding arrogant… no,” Pilcher says, smiling. One gets the sense that this is a man, and indeed a firm, which knows its mind, and won’t chase fads unless the business proposition is watertight. Perhaps it’s the insurer DNA that seeps into the firm via its umbilical link to Prudential, or perhaps Pilcher and his team are just doing what good credit professionals do best and take a very rigorous look at every opportunity.

Those hoping for some secret sauce, or insight into the next big area, will be disappointed.

“It’s very hard to predict more than 18/24 months out because the truth is I have no idea what the next opportunity is and in a sense you don’t see it until its there.  All of the things we have done in the last 15 years have started with an investment idea that we have spotted.  Typically they’ve been in markets or in sub-markets that fall between the cracks, between different sets of market participants. So a lot of things that we’ve done in recent times have been in between the world of  fixed income and real estate and where fixed income investors might have said, ‘Well that’s real estate,’ and vice versa – the real estate guys would have said, ‘Well that’s fixed income.’

“Quite what the next opportunity is I don’t know.  We have massive client demand for inflation-linked cash flows.  There are a number of different areas where we are sourcing them typically in the private debt arena. The brake on our growth is not a lack of client appetite it’s the lack of assets.  I see considerable growth for us from the European side of the equation, not just in the UK. Our investment activity in infrastructure, in commercial mortgages and leveraged finance will grow on a Pan-European basis.  For example, I think there is probably scope for us to be doing more in corporate lending in Europe whereas our focus has been more on the UK hitherto.

“Every couple of years there’s been some completely new idea that’s come up…,” he adds.

Most importantly, in Prudential, Pilcher and his team have a client that is willing to look at new ideas, and where there’s a strong investment rationale, they’ll back M&G to pursue them. “That backing enables us to build an infrastructure and then take that capability and commercialize it,” Pilcher says.

There must be some drawbacks to the Prudential relationship though, surely? “I think it’s generally very mutually rewarding and beneficial,” Pilcher says. “They have had terrific investment performance as a result of the variety of things that we’ve been doing and the relationship has enabled me to kick start activities..

“Culturally, we’re very clear that they are a client and we are an investment management business – we’re not the investment division of an insurance company – and I think having that very clear cultural distinction has been critical to our ability to innovate and our ability to attract and retain the right staff, so long may that relationship and that arrangement continue.”

Pushed to name a highlight of his time at M&G, Pilcher concludes with a very diplomatic answer, the sort you might expect a politician to give (and there’s certainly something of the statesman about him).  “For me the real highlight is the fact that we have delivered to our clients what we said we’d deliver: strong investment performance, consistently.”