The future of private debt: Aviva on Europe's emerging trends

Q: Where do you see the most interesting private debt opportunities for institutional investors today?

We find that many investors are looking for assets that can be part of their cashflow strategies, designed relative to specific liabilities. They want three main things: enhanced yield through an illiquidity premium; diversifying credit exposure, not necessarily just low risk, but they need to be able to understand, and be comfortable with, the level of risk in the underlying assets; and security – senior, or even ‘super senior’ security is important, with cashflows secured against the underlying assets, and maybe even prepayment protection.

We are usually the lead lender and often the sole lender, which opens the door to deals where we will drive the structuring and deal terms, not just taking secondary loans that come to market. We have underwritten a number of large and varied infrastructure debt deals, including rolling stock, road tunnels and broad- band networks. We have also written a wide variety of non-standard transactions in the area we call ‘structured finance’ which can cover anything from collateral swaps, senior debt on private CLOs to export credit agency loans. We benefit from a strong reputation for undertaking large, complex transactions in short time- frames – working carefully through the due diligence process to fully assess credit risk and unlocking significant enhancements to the illiquidity premia for our clients as a result.

Q: What trends do you think are driving investor demand for private debt?

The largest single driver for investors into private debt is the search for yield. If you are a German insurance company get- ting negative Euribor rates, you want to work your assets where you can. Investors also like the added protections. Private debt can give a yield enhancement for equivalent credit, diversification of borrower type, and for infrastructure debt for example better recovery rates in the case of default – all powerful arguments for investors to go into private credit.

Q: How do you think the private debt market will evolve in Europe compared with the US?

There are certainly significant differences between the two markets. They are at differing points in the macroeconomic cycle, and have potential differing trends in bank regulation and hence lender appetite. The infrastructure market in Europe is larger than in the US; in private corporate credit the US is larger than Europe. European markets continue to move away from the historical skew to bank lending and towards greater provision of debt by institutional investors. In leveraged loans, for example, we are seeing a trend away from covenants in the US and that is feeding through into Europe, but for private placement we don’t see any material differences in the substance, legal form, structure or credit appraisal between the two markets. 

Q What would you say are the biggest challenges when it comes to developing a private debt strategy in the current environment? 

We place a heavy emphasis on the timely deployment of investor commitments. This emphasises the importance of origination teams, leveraging institutional reputation for delivery, and the credit risk capability that is needed to serve that. Building and retaining teams of experienced people is key. 

Q What skills and resources are required to access the most interesting transactions?

Borrowers or project sponsors come to us because they know we can execute – we have a long track record of delivery. This requires a strong brand encompassing market presence; a broad network of sponsors, borrowers and banking relationships; depth and quality of investment teams across a range of asset types and a first- class credit capability – deliver consistently and the deals will keep coming.

Q How can investor mandates be structured to maximise opportunities in private debt?

Increasingly, we engage with investors on a solutions basis, focusing on desired out- comes of the mandate, not just the componentry. The better we can understand their risk profile and how the mandate will form part of their overall strategy, then the greater flexibility we can bring into mandate design. Ideally, a mandate will give the manager discretion to source and execute deals across the universe of private debt, and not be restricted to a single strategy approach. This is because the different underlying asset classes offer differing relative value over time, with the pricing of real estate deals varying from infrastructure debt transactions, for example. Flexibility is the key to being able to maximise value across asset classes and extend the range of opportunities, improving both the risk return profile and deployment timescales. 

Q After several years of spread compression in private debt, how does one balance target returns against risk? 

Investors in private debt face the same challenging backdrop as those in public credit and equity. We do see risk premia of B and BB-rated credits at seven-year lows, and that is encouraging some investors into lower quality, higher yielding assets. We focus on sourcing illiquidity premia for our investors predominantly in high quality assets, and will look to take risk where we feel comfortable with it. In European infrastructure debt for example, we can find Euribor +200 to 300 basis points for financing transport in Spain or Italy, compared to 120-200bps in core markets, such as Germany and France. 

Q What regulatory trends are at the top of your mind right now, how are you preparing for them? 

Solvency II provides a significant incentive for many insurers to invest in private debt. Similar approaches are feeding through to pension funds in how they approach risk budgeting. We are also looking at how defined contribution schemes and master trusts approach private debt; although these assets have not historically been used, they also have many characteristics which make them ideal as part of a diversified portfolio. 

We are also carefully watching developments in banking regulation. Basel IV and ringfencing in the UK already appear to be causing banks to reduce their balance sheet holdings of large debt transactions, providing attractive opportunities for investors to participate in floating rate debt transactions, some of which are sold at a discount to par.

Q How do you think risk management and credit analysis for private debt strategies are evolving? 

Risk and credit are a major focus of clients when doing due diligence on their managers, and it’s not just a box-ticking exercise. They want to know that you have the proprietary risk models and rating tools to be able to make value calls across asset classes; how do you decide to allocate between a private corporate debt deal and a real estate finance loan when both are BBB? 

At Aviva Investors we have devoted considerable resources to building our credit team covering alternative income assets. The credit team work with the investment teams throughout the investment process, providing constant challenge right through to approval. We have to be able to rate non-standard or unusual issues for which standard credit models don’t apply. 

We are known in the market for having that capability, and that is one of the reasons we get to see a lot of deals; sponsors and borrowers know we have the capability to lend to them. Credit and risk management are core components of a successful manager, and have to be able to stand up to being put under the consultants’ microscope.  

Q What private debt investment themes do you see emerging, are there any trends that concern you? 

The trends that we see are driven by our clients. In particular, we are seeing strong growth in multi-asset strategies, with investors looking for the manager to apply discretion in which asset classes to invest on a relative value basis, offer an extended universe of where they can source yield, and not be constrained by a single strategy approach.  

Barry Fowler joined Aviva Investors in 2014. He leads the growth and development of the Alternative Income Solutions business, seeking to maximise opportunities in originating and managing portfolios in the alternatives space of real estate finance, infrastructure debt and equity, structured finance, private corporate debt and multi assets.