By William Nicoll
When ancient Sumerian farmers needed tools they leased them from local officials. And when the officials dutifully noted down who had borrowed what and when, they unwittingly created the first recorded lease agreements.
Now, 4,000 years later, pension funds are doing something not too dissimilar. They are providing money for the sort of lending that enables businesses, housing associations and economic projects to function more effectively – and at the same time offer attractive levels of risk, return and security.
This is private financing. It is based on the age-old principles of lending money and brings clear benefits to both borrower and lender.
These investments tend to fall into three camps. Some are long dated and pay a fixed or inflation-linked income, others have a medium term life and offer floating rate returns that are linked to interest rates, while still others pay unusually high returns to compensate for their complexity and small pool of available buyers.
Just about everything that a pension fund could invest in today, tomorrow or in five years’ time was once seen as a natural loan for a bank to make.
Now, pressured by regulatory and commercial considerations, banks are finding loans such as these to be too expensive or too unattractive to renew and are pulling back from vast chunks of the market.
Their loss is a pension fund’s gain. Investing in these assets can provide an institutional investor with an income stream in excess of that from corporate bonds, from risks not available in public bond markets.
For nimble investors, with the discipline and patience to secure attractive prices, additional returns from illiquid credit are generated by three factors – sometimes individually, sometimes in combination.
Firstly, there is a premium for the hard work of creating investment opportunities. Often, an owner of a hard asset wishing to raise debt finance but unsure of the best structure to do so approaches an asset manager to structure the transaction.
Second is complexity, where investors need to be well-resourced in order to understand the structure and the risks they are taking. For example, long lease property requires credit expertise to understand the operating business as well as the real estate underlying the investment.
Illiquidity is a side effect of many of these investments. An investor wants to be compensated for a lack of a secondary market for the asset, meaning it would most likely be held until maturity. Asset classes which compensate purely for illiquidity are mature, with a number of investors willing and able to hold the assets. Leveraged loans and private placements are good examples.
Understanding these assets and the security they provide is essential, but knowing what to buy and when to buy it is equally as important. To that end, success will likely come to those willing to work hard and then wait until pricing is at its most favourable.
Pension funds are attracted to the reliable, predictable and fairly secure income stream illiquid assets can offer. The process of sourcing private credit assets can be a resource-intensive, intricate and convoluted process. Those with the appetite and skills for private credit can exploit these factors and achieve higher returns than from comparable, more popular liquid assets.
William Nicoll is co-head of alternative credit at M&G Investments
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