Future of private debt: ICG on flexibility and diversification

Benoit Durteste ICG 180

Benoît Durteste

Multi-strategy alternative credit investing provides investors with portfolio diversification, tailored to their own risk/return requirements, and offers attractive combined returns when compared with traditional asset classes. The range of assets available in one mandate also makes this a viable, efficient way for resource-constrained investors to access these strategies in one place.

Overall allocations to alternatives strategies remain low in Europe. This is surprising given the very low bond yields and interest rates that have prevailed since 2008. Despite this, many European schemes have yet to act and make an allocation to alternative strategies like private equity, real estate, mezzanine, infrastructure, sub-investment grade debt and private debt.

European schemes have been slower to shift into alternatives like direct lending and private debt funds, post-financial crisis when the low interest rate, low yield environment had become established. There are a number of factors driving this:

– Regulatory constraints: Solvency II has had a profound impact on insurers’ ability to invest in alternatives. In some countries, the ‘riskier’ asset allocation in schemes is restricted by legislation, and many pension funds are not fully funded, and must pay pensions from the operating cashflow. In the UK, defined contribution schemes require daily pricing which is not possible in an illiquid closed-ended strategy, a feature of many alternative asset classes.

– Many of Europe’s pension schemes became highly cautious post the global financial crisis in response to being exposed to devalued assets.

Pension schemes in Europe rely on consultants for due diligence on new asset classes; some of them have been slower than their US counterparts to embrace investing in alternatives.

There is an established culture of investing in alternative asset classes in North America. In particular, the US has a wealth of specialist consultants to advise pension schemes on which alternative asset classes may be suitable for them, which Europe still does not have.

– Complexity: Smaller and mid-sized schemes understandably lack the resources to fully cross-examine the strategies. Thorough due diligence of alternative strategies is a key way in which consultants can assist these investors.

– Scale of manager capabilities: Multi-strategy portfolios should be designed to meet complex investor requirements. Europe lacks the scale of investment managers which can offer a breadth of strategies in the same way that North American managers can.

This is changing as more European pension funds are now embracing alternative investing and multi-strategy investing is one way in which alternatives are becoming more accessible.

Multi-strategy portfolios are tailored to an investor’s requirements. Mandate structuring begins with understanding the criteria of the investment characteristics that need to be met: a detailed exploration of risk appetite, asset allocation preferences and preferred structure is undertaken, and any regulatory considerations around where the mandate should be based are considered. This approach also enables investors to liability-match not just with traditional fixed income, but with alternatives such as private debt.

Within credit, assets are selected from across a range of asset classes including CLOs, loans, high yield bonds, as well as closed-ended strategies such as direct lending and other private debt funds or real estate debt funds. The split of assets is tailored to the scheme in order to achieve the desired balance of risk/return and liquidity at the outset. The range of strategies also depends on preferred geography, capital structure exposure and legal requirements.

As multi-strategy portfolios are dynamic and have many constituent parts, with investments being made at different times, they need to be carefully managed. Investments in line with the agreed objectives of the mandate are made following a thorough assessment and approval of an investment committee that is operated by the asset manager. Throughout the life of the investments the investor is regularly consulted on how the current investment environment is impacting the assets.

All of these requirements mean that multi-strategy mandates can only be structured and operated by asset managers which have the scale and ability to offer both liquid and illiquid strategies across all geographies at the same time.

Multi-strategy investing in credit alternatives offers pension funds a more flexible, tailored way to get better returns than from traditional asset classes. In Europe’s prevailing low yield, low interest rate environment, different and more efficient ways to access alternative credit strategies mean that we can begin to catch up with the US.

Pension schemes in Europe have a much lower allocation to alternatives (UK 15 percent, Netherlands 14 percent) compared with North America (US 29 percent, Canada 22 percent)*. Alternatives cover a range of strategies, including private equity, real estate, mezzanine, infrastructure, sub-investment grade debt and private debt. Typical returns from alternative strategies are 15-25 percent for private equity, 7-10 percent for senior direct lending vs. -0.5-3 percent for government bonds, or -0.5-2.5 percent for investment grade bonds.
*figs from TowersWatson, Global Pensions Asset Study 2015

Benoît Durteste is executive director, head of European investments at ICG

This article is sponsored by ICG. It appeared in the Future of Private Debt supplement published with the October 2016 issue of Private Debt Investor.