New wave investors

Institutional investors are driving growth in the private debt markets, industry experts tell Private Debt Investor on a regular basis. Pension funds are acknowledged to be upping their allocations to the asset class. During the first three quarters of the year, 21 percent of allocations from pension funds to alternatives were to private debt funds, up from roughly 15 percent last year, according to PDI Research & Analytics. New research, based on discussions with investment managers in the industry, shows that insurers are set to follow the same path.

Weak economic growth, depressed bond yields and loose monetary policy are forcing these investors to consider asset classes outside their usual remit in a bid to enhance returns and liability-match, fund manager BlackRock explains in a new report called Driving Returns: Global insurers reconsider fixed income and private assets. The work was carried out in consultation with The Economist Intelligence Unit and released at the end of September.

In an income-starved environment, private asset classes are becoming crucial to insurer’s diversification strategy, and private real estate and infrastructure are likely to benefit the most in the next three years.

The survey aimed to find out how insurers are responding to the pressures on their fixed income portfolios and how they view private markets. Of 243 senior executives from insurance and reinsurance companies around the world looking after more than $6.2 trillion in assets, 56 percent of respondents ‘strongly agree’ that private asset investments represent a very attractive option, signalling significant interest. Fifty-one percent say that they offer a diversified source of risk and return.
The report found that by 2017, the number of insurers allocating more than 15 percent of their portfolios to private asset classes is expected to nearly double to 46 percent, up from the current figure of 26 percent.

Three years ago that figure stood at just six percent.

Amongst the main concerns of insurers is the uncertain outlook for interest rates. Maintaining yield is their top priority. Findings show that insurers will look outside their traditional investment grade strategy and increase exposure to high yield corporate bonds and municipal bonds.

The main asset classes to which insurers plan to increase allocations over the next 12 months are real estate, at 36 percent, and infrastructure, at 34 percent.

David Lomas, global head of BlackRock’s insurance asset management unit, says in an accompanying statement: “It used to almost be ‘buy your bonds in the morning and relax in the afternoon’, but insurers are now faced with a far more complex operating environment. This research shows that insurers are making a great migration toward private markets to diversify income streams and maintain returns on equity.”

ILLIQUIDITY PREMIUM

Worldwide, one in three insurers will increase their risk exposure over the next three years, while 15 percent will decrease it. “What is interesting is the level of conviction [chief investment officers] seem to now have towards things like real estate debt and infrastructure assets. Industry leaders seem to be much more comfortable with investing in illiquid private market assets for income,” Lomas adds.

A spokesman for Swiss-based global insurer Zurich Insurance Group told PDI in September that it was evaluating investing in less liquid opportunities including direct lending to corporations, as well as commercial real estate lending. It also emerged that the insurer was preparing to make a significant allocation to private infrastructure debt and would invest with a manager with expertise in the sector. The move was driven by the liquidity-risk premium attached to investing in the asset class and the liability-asset match that would result from the long-dated nature of the investment.

Jim Barry, global head of BlackRock’s infrastructure investment group, explains in the report: “Institutional investors are increasingly attracted to infrastructure debt to provide the long-term cash flows necessary to help them meet their long dated liabilities, while the premium associated with illiquid investing also offers returns above comparable liquid investments.

“Investing in a senior secured position in the cashflows of essential infrastructure assets allows insurers to achieve more positive spreads without sacrificing investment quality. In addition, while the reduced liquidity of the private market was once a deterrent, the ability to lock-in long-term tenor at spreads above comparable public markets is increasingly helping insurers to more closely match their long-term liabilities. We have had many conversations with insurers who are re-evaluating the liquidity they require and determining that taking the illiquidity risk of private assets such as infrastructure debt is a trade-off that is attractive,” Barry comments.

Real estate debt offers similar attractions. Guardian Financial, which provides life and pension products, invested £350 million in commercial real estate debt in October 2013. Paul Dixon, chief executive officer at the group, explains that the main draw to the investment was that “it appears very attractive relative to other fixed income-like opportunities”. Overseeing more than £15 billion of assets, Guardian Financial is now looking at another £350 million scheme for infrastructure debt, “which will edge the proportion of the portfolio invested against annuity liabilities into private asset classes towards 10 percent”.

MORE WORK NEEDED

However, barriers to investing remain high for insurers, the survey found. Forty percent of executives complain firstly of the trouble with portfolio pricing and transparency, and secondly about accessing the right opportunities.

Carlos Wong-Fupuy, senior director at AM Best, a US-based rating agency for insurance companies, suggests that there is a real lack of understanding about private assets among insurers. “I don’t think it’s necessarily the investment manager’s fault. In many cases, some of these products that we call private market assets are simply very opaque.”

The complexity of the schemes on offer or their sheer novelty can mean it’s hard to value the asset. “If you talk about listed shares or publicly traded bonds, you can get a value from the markets,” he says. But with a 40-year rail project for example, the valuation will be “based on a number of assumptions, about which nobody can be really certain.” Traditional risk factors that insurers may use, such as historical data, are unsuitable.

Cecilia Reyes, chief investment officer at Zurich, notes that there are attractive opportunities, particularly in Europe. The underlying risks such as credit risk and default risk are similar to more liquid assets. However, the risk assessment can be more challenging. In her view it is trying to match the funding structure of the insurance company, which is very illiquid in nature, with opportunities from less liquid assets. “You have to be able to decompose the total return for compensation for credit risk and compensation for the less liquid nature of this investment,” she says.

One third of investors are also uncertain over how regulators would treat allocations to private asset classes. “Insurance regulation is very much still biased to favouring liquid and simple traditional assets. So we have to create special structures to hold these investments so that they comply with admitted asset regulation in the various jurisdictions that we encompass, and that is the reality right now of insurance investment regulations,” Reyes says.

Frank Swedlove, chair of the Global Federation of Insurance Associations, thinks regulators need to have a dialogue with the industry to understand the adjustments that need to be made in investment strategy to keep pace with changing market dynamics.

It appears that conversation is already happening however, amid new regulations ensuring insurance companies can partake in a new lending landscape, particularly in Europe. In consultation with law firm Dechert, efforts are being made to address some of the challenges insurers face when investing in private debt. (For an in-depth look at this work, see ‘The Last Word’ on page 44).

As a result, insurance company allocations to private debt will in no doubt become an important growth factor for the market, just as pension funds have proved to be already.