LGIM: A secure way to generate stable cashflows

27 May 2020

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With pension schemes increasingly turning cashflow negative and interest rates sitting at record lows, could secure income assets provide the returns they need? portfolio institutional spoke to a panel of experts in Legal & General Investment Management’s private credit team to find out.

How would you define a secure income asset?

Stuart Hitchcock: The Alternative Investment Management Association defines “private credit” as debt that is “not publicly traded such as many corporate bonds and is originated or held by lenders other than banks. It takes various legal forms including loans, bonds, notes or private securitisation issues”. At LGIM, our secure income proposition is driven by private credit, and we have expanded the above definition to all non-public transactions. The opportunity within private credit is very broad and can be characterised by either return maximising or capital preservation strategies through debt investment that generates long-term secure cashflows.

A key attraction of the asset class is the provision of (and ability to negotiate) agreed protections. This differentiator from public credit often leads to better experience in default cycles, where recovery rates for private credit tend to be much higher.

Private corporate debt encompasses financing to companies borrowing outside public markets. Examples of particularly vibrant sectors issuing private corporate debt at present include housing associations, higher education institutions and utilities.

Infrastructure debt is the debt financing of infrastructure assets such as energy (including renewables such as wind farms and solar), transportation and social infrastructure (e.g. education and healthcare).

Real estate debt involves lending secured against all manner of property sub-sector types (office, industrial, retail, residential (including build-to-rent, mixed use and alternative) where the rental income supports interest payments and the property provides security.

What impact has Covid-19 had on these assets?

Hitchcock: Private markets have operated as we anticipated. There are two principle ways to look at impact – new issuance and existing asset performance.

 Generally speaking, private debt markets are not “window” markets in the way that the public markets tend to be, partly because of the breadth of borrowers across the private asset classes and the covenant and structural protections, which investors truly value.

Overall, private markets have remained open, a dynamic we also witnessed during other major economic events, including the global financial crisis. Inevitably, markets were quieter during the latter part of March, with issuance principally driven by less-cyclical sectors such as utilities and consumer non-cyclicals – these receive very positive interest when markets are more volatile. Momentum has quickly increased. Some fantastic investment opportunities are coming through and we have been deploying for our clients to take advantage of credit quality and returns offered. Our focus remains on the companies that we believe have a defensive business model, robust capital structure and access to sufficient liquidity to see them through the short-term disruption. In the UK, this notably includes current opportunities in utilities, housing associations, higher education, transportation (backed by committed lease payments for essential assets) and major city real estate (office) spaces.

From an asset class perspective, private corporate markets remained open throughout, offering funding without the execution risk that can exist in other markets.

New issuance in infrastructure has been impacted by Covid-19. Transport has been in the spotlight as rating agencies have been quick to react, particularly on airports and related assets. More broadly, most operational assets have strong liquidity positions, specifically those providing essential services to the economy. Opportunities in the near term include renewables and we expect to begin to see activity in the digital/data centre space. It is interesting how Covid-19 has highlighted certain dynamics (e.g. working from home) that are likely to create an array of opportunities for institutional investors. Arguably, the real estate space has been the most affected over the short term but the pipeline of high-quality opportunities remains strong. Some sizeable transactions have been put on hold because financing is often related to purchases of large assets by sponsors and there is currently a level of valuation opacity. Notwithstanding, we have been able to commit to financings during the period, notably for existing borrowers, which underlines the advantage of an established investment base.

 In the context of asset management, Covid-19 has intensified focus but also reinforced our selective investment approach over the past few years. We have been focused on stability of income and the robustness of companies over cycles. There has been a benefit, of investing in good credits, supported by structural protections that give us early warning signs of performance trending and, importantly, an ability to “get to the table” and engage early with borrowers.

 Overall, the portfolio has performed in line with expectations. Whilst recognising that economic volatility can lead to sudden and significant movements in business profile, it is very pleasing to confirm that there has been no interruption to income.

and no expected impairment or loss; to my mind, this means the portfolio is delivering in line with our investment thesis.

So, despite the crisis it is business as normal?

Hitchcock: Broadly speaking, that’s right. We are inevitably focused on how the crisis will unfold and, as I mentioned, markets have been a bit quieter in certain spaces (as expected), but ultimately are continuing to move along as we anticipated. We have a strong pipeline.

What returns can investors expect in these markets?

Hitchcock: The overall aim of our Secure Income Fund is to generate an average return of Gilts plus 250bps.

Over the past number of years, we have been able to generate a return of more than 50bps to comparable assets in the publicly traded markets. In the current markets, the premium range is wider at approximately 30 to 120bps+, and with spreads north of where they were, the ability to generate strong returns to public markets has increased.

What is your modus operandi in this market?

Hitchcock: Our modus operandi is to optimise portfolios for our clients and to invest in a thoughtful way that generates good long-term returns that are stable and secure.

We do this through investment in a variety of private debt asset classes. This provides more than simply the opportunity to harvest illiquidity or complexity premia. It offers diversification by sector and company, and enhanced documentary protection, which combine to provide through-the-life returns typically above public benchmarks.

As long-term buy and hold investors we are not overly concerned about short-term fluctuations in value that are driven by wider markets. Over time, portfolios benefit from access to better structured transactions and with a diversified investment mix.

One of the advantages we have is that we are resourced in a way that enables us to source and manage sizeable portfolios of investments. We employ experienced sector experts who can source extensively and innovate structurally (in a low risk way). Our scale and expertise means that we can invest in a range of attractive asset classes and, furthermore, analyse the relative attractiveness of those investments so as to deploy monies prudently.

How are you sourcing these assets?

Hitchcock: We are not driven by a particular channel of origination, although there are clearly advantages of accessing the markets in certain ways. Overall, we think there are advantages (and disadvantages) with each of different approaches. However, since our fundamental driver is seeing the widest possible universe of opportunity, to allow us to be selective in deployment, we are channel agnostic. We believe there are three principal methods of investment sourcing: i) agents (e.g. banks)/advisers, ii) sponsors/advisers, and iii) direct (borrower).

In various ways, the methods of sourcing are not independent and market participants overplay the channel argument. Some of our competitors focus on direct origination because they believe it achieves larger allocations – they might also argue for better structural protections and returns, although practical experience suggests this is debatable. The playing-field of investors able to successfully and consistently originate directly is further limited by the resource and experience required. In reality, some of the most attractive investment spaces focus on more traditional sourcing from bank agents. Not only does this provide access to the widest possible universe of opportunities but it also maintains relationships with the organisations that bring opportunities. As one of the largest investors in our markets, the method of origination is far less important than attaining the right investment opportunities for our clients.

Laura Brown: Our scale in these markets is hugely important. A big part of our business is managing secure income assets for Legal & General’s annuity business. With that scale we have a lot of market access that allows us to get into these processes early and shape transactions.

How are you managing risk in this market?

 Hitchcock: We take a stringent approach to ensure we engage with all borrowers, and that we are analysing and stress testing the potential impacts of cycles, and looking at potential impacts on performance.

Our asset management policy requires regular analysis and reviews on all of our investments and communication with all borrowers. We are constantly monitoring our assets and ensuring that we are positioned in case action is required.

PI: Where does secure income sit in your clients’ portfolio?

Amie Stow: Secure income assets are a core part of a cashflow-driven investing strategy.

Many of our clients will already have liability-driven investment and buy and maintain credit portfolios. Secure income strategies sit alongside those.

 It has long been the case that large pension schemes have been able to access these assets, but we have been looking over time to extend access to a wider range of pension schemes. That has been a big part of the work that we have been doing, to package these investments into a fund that can be easily accessed.

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