Bank deleveraging in Europe creates an opportunity for institutional and private investors to enter direct lending to a range of sectors, and there are plenty of new approaches and structures emerging.

Ever since eurozone banks began to face a funding squeeze in 2010, there has been a growing expectation that Europe – where 80% of corporate credit traditionally came from banks – would begin converging to the US, where the same proportion of corporate financing comes from capital markets instead. The record levels of European investment-grade corporate and high-yield bond issuance in 2012 were the signal of that trend unfolding. Even when banks complete their deleveraging, they face challenges writing new business within the current regulatory constraints, which drives a further shift to the originate-to-distribute model.

“Our biggest conviction for the coming years is that the real economy will ultimately be funded more by asset managers than by banks. That is because Basel III for banks, Solvency II for insurers and national moves such as the UK Vickers Report and French Moscovici reforms, although not coordinated, are all happening at once,” says Alain Bokobza, head of global asset allocation research for Société Générale Corporate & Investment Banking (SG CIB), who also worked as an asset manager for eight years before he joined the bank.

New areas

While banking sector reforms make the capital allocation for credit more expensive, the insurance reforms favour holdings of credit over equity or private equity. Yet to date, European insurers hold a far smaller proportion of their assets in loans and private debt than their US or Japanese counterparts (see chart). Instead, their growing proportion of fixed-income assets is dominated by sovereign and investment-grade corporate bonds. In an environment of ultra-low European interest rates and pressure on sovereign finances, these holdings are not able to deliver the returns needed to meet pension fund and life insurance policy liabilities.

Against this backdrop, Mr Bokobza and his team have identified five areas of European lending activity that institutional investors could begin to move into on a growing scale as new asset classes. These are trade finance loans backed by government export credit agencies, commercial real estate lending, direct lending to small and medium-sized enterprises (SMEs), and project finance loans for both the energy and transport sectors. He believes there are potentially €100bn of new assets available in each of these five classes individually. And loan assets should outperform bonds thanks to an illiquidity premium that he estimates at about one-third – in the case of leveraged loans, almost 100 basis points (bps) over a typical euro high-yield bond spread of 330bps.

Insurers and pension funds can assume this illiquidity premium because they do not have short-term liabilities as a bank does, and will typically hold loans to maturity. Moreover, risks should also be lower because covenants on loans are usually tighter.

“When you invest in loans, you have a new efficient frontier because losses in the event of default should be lower. Recovery rates from 1987 to 2010 were significantly higher for defaulted loans – about 80% compared with 64% for senior secured bonds,” says Mr Bokobza.

Finding the right fit

The loan market is not homogenous, and institutional investors appear to regard different types of loans as having different purposes within their portfolios. Infrastructure and project finance lending is typically long duration, which is particularly attractive under Solvency II regulations that will give insurers capital relief for matching long-term liabilities such as life policies with long-term assets. Even so, infrastructure sponsors will still need to make some adjustments to suit insurance company lenders compared with the traditional bank loan structures.

“The market will need to adapt to the characteristics that we like as institutional investors. We prefer fixed rates, whereas banks would take floating rates. Also, we do not like early repayments, so we would want to negotiate penalties with the sponsor to provide protection, especially on the longer term deals,” says Wim Vermeir, chief investment officer at international insurance group Ageas, based in Brussels. The firm signed a deal with French investment bank Natixis in mid-2012, under which Natixis will originate infrastructure loans in which Ageas will participate up to a final target of 5% of its total portfolio, equivalent to €3bn.

Infrastructure loans can also be attractive as a natural hedge for liabilities that rise with inflation, especially final salary pension schemes and life policies. The rise of liability-driven investment by institutional investors over the past decade had focused on long-term inflation swap arrangements, but the shift to central swap clearing will significantly increase the cost of these transactions. Central clearing counterparties accept a narrower pool of collateral for cleared swaps, and banks face high capital charges for uncleared swaps, so that collateral requirements for clients will “balloon,” according to Eric Viet, head of financial institution advisory in SG CIB’s cross-asset solutions group.

“We project that institutional investors will need perhaps 30% to 40% of their portfolio to be in liquid assets to support a large derivatives programme. That makes it much more cost-effective to hedge long-term inflation through real assets with a yield pick-up instead,” he says.

Out of the picture?

In March 2013, UK-based fund manager M&G, which is part of insurance giant Prudential, provided part of the financing for the £167m (€195m) Alder Hey children’s hospital in Liverpool. The deal was inflation-indexed to match an insurance annuities book. M&G had earlier closed inflation-linked deals to fund schools in the UK.

“Our priorities are always getting the right price for credit and protecting investors and pensioners, and even in the days of monoline wraps we always looked at the underlying asset. That means we want core infrastructure such as essential services, transport and government buildings. The public-private partnership pipeline is gradually restarting again, and we believe the [UK] Treasury is keen to explore other non-bank funding avenues,” says Tim Huband, head of infrastructure and project finance at M&G.

That does not mean banks are out of the picture in infrastructure lending. There will always be elements of project finance that are more suited to the short-term funding structures of banks, such as revolving or undrawn credit lines. Natixis is retaining part of the exposure on the loans distributed to Ageas, and M&G worked with Japanese bank Sumitomo Mitsui on the Alder Hey deal.

“Some of the largest institutional investors have dedicated infrastructure teams, but the rest will prefer a bank partner to provide the relationship lending franchise and to take on risks such as construction delays and early repayment,” says Albert Loo, global co-head of fixed-income sales at SG CIB.

Mr Huband says M&G, with its in-house project finance team and about £20bn in infrastructure debt assets, is prepared to take on construction risk in the right circumstances. Even so, he will work with banks provided there is a fair division of labour, skills and fees.

“We are always ready to take on construction risk if it is a proven technology such as an old-fashioned building project, but we would be more reluctant to take a risk on a new construction company or a specific new technology. The real risk over a 30-year loan is often the lack of visibility further out, so we need a structure that ensures cash flows will run smoothly to repay the debt,” he says.

Yield pick-up

By contrast with infrastructure lending, trade finance, corporate and real estate loans tend to be of much shorter duration, typically three to seven years, and will normally be floating rather than fixed rate. This means that they fulfil a different role for institutional investors.

“Insurers and pension funds are not typically holding commercial real estate and SME debt to match their liabilities, but instead buying them more on a relative returns basis, for the pick-up over sovereign and corporate bonds. That means there is also less pressure to shed pre-payment risk,” says Pete Drewienkiewicz, head of manager research at investment adviser Redington.

Alternative credit fund Aalto Invest has recently launched a £1.5bn commercial real estate lending strategy, with £500m backing from European pension funds. Founding partner Mikko Syrjanen says he is targeting loans of up to seven years in line with the market. Anything longer would be difficult to source.

“You would need to find an asset with longevity such as prime London office space, a strong tenant with a long lease and an owner with a long-term view – private equity real estate investors looking to sell on the property will not want to provide lenders with three-year pre-payment penalties,” says Mr Syrjanen.

Although their assets are shorter duration than infrastructure lending, the new-generation real estate lenders are still adopting a very different approach from a credit hedge fund, to cater appropriately for risk-averse institutional investor clients. Aalto is looking to hold loans to maturity rather than making short-term trades, and would not lend against poor-quality properties or real estate with very high loan-to-value (LTV) ratios or undesirable locations.

“We are looking at yields of about Libor plus 350bps, so a pick-up to corporate bonds but without taking excessive risks. Our niche is not the most conservative LTVs that might only pay 200bps, but the broader core plus opportunities, and we would be ready to take some reletting risk on a good property with a recognised sponsor,” says Mr Syrjanen.

Some of the loans are directly originated from sponsors, but Aalto also has close relationships with about six banks with strong real estate lending activities. Mr Syrjanen says that to maintain portfolio diversification he would not normally want to exceed £50m for a single loan, which tends to mean agreeing to take a piece of a larger loan alongside a bank. The presence of a fund investor sharing the load can make bank risk committees more comfortable with the loan commitment.

Digging deep

Lending to SMEs, including trade finance, is the area most closely associated with banks and at the earliest stage of development for institutional investors. While infrastructure and commercial real estate sponsors may already have extensive experience of investor relations and deal structuring, SMEs are much more dependent on relationship banking.

“Infrastructure loans may be more internationally distributed, but SME lending is likely to stay a domestic market. It is illiquid, but it is also simple and well established, which is what institutional investors like about it. And even if 10% of current SME lending by European banks switched to the originate-to-distribute channel, that would be equivalent to about the size of the European high-yield bond market in 2012,” says Mr Loo at SG CIB.

A significant number of managers have launched fundraisings for SME direct lending, although finding investors has been tough for newer managers. High-profile fixed-income manager BlueBay closed one of the largest direct corporate lending funds to date in May 2013, a €800m pan-European fund managed by Anthony Fobel. He is targeting mostly senior loans of up to €100m for mid-market companies of up to €500m annual turnover.

“The investor base is well diversified from liquid credit and institutional investors that are ready to carve out a separate bucket to lock up five- to seven-year funds and earn the illiquidity premium, through to private equity style investors that are used to illiquid investments and have decided that relatively low-risk, all-cash returns in the mid-teens might be better than seeking higher returns with leveraged equity,” says Mr Fobel.

New relationships

At the smaller end of the scale, Prefequity, co-founded by former private equity investor Theo Dickens, is building a first fund of up to £125m to make debt investments of about £10m per company. Both of these funds are in the domain of genuine disintermediation, carrying out extensive private equity-style due diligence, offering companies most or all of their financing needs and originating deals directly through financial advisers such as accountancy firms or through buy-out sponsors. Prefequity is looking for a seat on the board and possible minority equity stakes if appropriate.

“We call this self-sponsored mezzanine finance, we are essentially filling the gap between equity and bank or super-senior finance. The opportunity is not just about the volume of financing needed, but also about the terms – banks are typically offering one to two times earnings for one year only, we are ready to go up to three or four times earnings with a five-year duration,” says Mr Dickens.

He does not see this kind of labour-intensive private debt business fitting comfortably into a high street banking franchise and believes the pre-crisis era when banks were ready to squeeze pricing this far down the credit scale was an aberration.

By contrast, banks still have a central role to play in the larger middle market, even if they need to distribute part of the lending to free up balance sheets. French insurance giant Axa appears to be leading the way here, having signed partnerships to co-finance mid-cap companies with French banks Société Générale and Crédit Agricole, and most recently Germany’s Commerzbank. The target market for the French partnerships is companies with turnover of more than €250m needing loans of up to €100m.

Given continued political focus on SME lending, it is to be expected that policy-makers will facilitate the entrance of non-bank providers. However, progress appears to be slow. Mr Viet points out that in many countries, insurers must use wrappers, such as the French fonds commun de titrisation securitisation vehicles, to make investments in loans admissible and avoid paying withholding tax. In the UK, a treasury business finance partnership scheme allocated £1.1bn for mid-cap co-financing and £100m for SMEs. But almost all has so far been disbursed to fund leveraged buy-outs at established companies, and none has gone through new entrant debt fund managers. The transition to non-bank lending in Europe looks set to take some time.

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