Private debt in a post COVID-19 world

In the first part of this Insurance Asset Risk / Russell Investments roundtable, insurers discuss the impact of the pandemic on their views and appetite for private market investments

Vincent Huck: Prior to COVID-19, insurers were increasing their allocation to private market investments, and especially to private debt. Looking at what happened in the first half of 2020, do you still feel the illiquidity risk is worth the premium, or has the pandemic reasserted the importance of staying liquid?

Emily Penn: Where insurers are investing in illiquid assets, it is against illiquid liabilities. Of course, we have a framework looking at where and how we need to manage our liquidity, but here we are investing against illiquid liabilities. So, we are well aware of the illiquidity risks associated with these assets before investing in them, and I do not think that the current situation has changed that for us.

Andrew Bailey: Credit risk is the key driver. The one thing joining the two threads of credit and liquidity together is that illiquidity is a problem when your view on the credit risk changes.

So, for your private assets, you need to make sure not only that you get the credit underwriting done properly at the beginning, but that you have capability of estimating how it might evolve in the future. Does COVID-19 restrict the range of assets you are going to find acceptable? Uncertainty makes that choice more difficult, but it is not a choice we are going to step away from, because investing to take the illiquidity premium is part of the business. It matches, in our case, pretty much every liability, so it is something we seek, it just makes credit underwriting for the long term even more important.

Corrado Pistarino: I am more concerned about what happens at the epicentre of the crisis. As an example, corporate credit, even the short-duration corporate credit, has performed pretty abysmally during that period. And crucially, market liquidity collapsed.

Liquidity is an attribute of a very limited class of assets – govvies. Anything else suffers from different degrees of illiquidity during a crisis. Then the question is, do I get correctly compensated for that illiquidity risk? I should be more concerned about the performance of a supposedly liquid credit portfolio, for which I receive no illiquidity premium, rather than that of my illiquid credit portfolio, because I may be in a situation in which I need to sell some of these assets originally designated as liquid. Fortunately, it wasn't the case with this crisis.

As Emily said, you do (or should) know exactly what you are entering into when you underwrite illiquid assets. Certainly those are not assets earmarked as storage for liquidity.

Daniel Blamont: I agree with Andrew's point, liquidity matters when your view of credit changes, and for us the biggest thing that has changed is our preferences for certain sectors, rather than our preference for private versus public. Infrastructure supply is a bit limited so we are constrained in our choices. In real estate, it is interesting to see that prime Central London suddenly looks doomed, but out-of-centre shopping centres and office spaces are actually more interesting, for now at least.

It also means that anything that is government-backed in some way, shape or form, offers a bit more comfort, because with quantitative easing and public institution support through the crisis, it means ultimately all government-related entities have a greater chance of being supported through the crisis.

Local authorities might be under some strain, but ultimately they are likely to be supported by the government. So the pandemic has changed the landscape across sectors. COVID or no COVID, people will consume electricity, water, etc., meaning non-cyclicals offer security.

The challenge really is to know how long this is going to last, and whether people are going to go back to their usual lives when this is all over, or will this actually create some long-term changes?

Andrew Bailey: The point about government support is very powerful: to what degree is central bank- and government support of the economy driving the credit worthiness of your assets? The illiquidity is a problem if your view on credit changes, but you cannot afford to change your view on credit if you are holding an asset to term. And if you are relying on government support, you cannot model that. It does not matter whether you are a standard formula firm or whether you have an internal model: your model just does not deal with the presence or absence of central bank/government support.

Nathan Robinson: That is emphasised by the airports and the airline industry more than ever.

Andrew Bailey: That is one example, Heathrow is massively important infrastructure, reliant on shopping and landing charges - what do you do there? And I wonder about the local authorities themselves, and universities. I know some people feel that universities are a safe bet because they will be bailed out by the government, but clearly I wear a risk hat and I am going to question that. The reliance on potential government support is very dangerous, in the current period where the government is running £2trn worth of debt, so 100% of GDP.

Majid Khan: One of the conversations we had a lot at the beginning of the year and all through last year, was: the amount of return available from some of these liquid assets, and how liquid are these 'liquid' assets?

Because ETFs, bonds, daily-dealing high-yield funds, daily dealing crossover funds etc., they are getting bigger and bigger, and we were making the point that actually to hold some of this credit exposure, it is better to have a stronger hand and have it locked up for a little while, so you are not shaken out.

As we were going through the COVID crisis, even the government bond market at one point really froze, and there were a couple of days when there were very few trades taking place, even in the 10-year Treasury market, which is really worrying.

I wonder how much that experience, taking into account that the credit exposure is managed well, is going to push investors more towards private debt, and away from the more liquid [assets], just because the 'liquid' really is not liquid when you need the liquidity.

Coming into this year, spreads were so tight the return available was pretty minimal. So at that point, instead of maximising the yield, what we were thinking about was having more stable yield which might be a little bit lower, and so that naturally drew you to a handful of sectors, which were a little bit less impacted by things like recession or cyclical turns.

And nobody could foresee COVID coming, and the dust still needs to settle, but when you look at some of the private debt managers out there right now, the ones who are handling the crisis better are the ones who did not rush to put that money to work in yield-maximising deals. A question would be, do you think that you would increase that allocation to privates, versus the liquid from this point, despite the COVID shock?

Corrado Pistarino: I think there are two dynamics at play here. On one hand, this crisis has hit specific sectors, like leisure or aviation. In my view, this is a temporary shock. A rebound will take place, after a wave of restructurings.

On the other hand, we are observing an acceleration of trends that were already happening before the COVID induced shock, and that the pandemic made more prominent.

I am talking about structural, irreversible changes to the prevailing economic model. For instance, the appetite for certain real estate assets – will pricing evolve for prime offices in Central London? Or the very fact that we are now having this debate on a Zoom call, which is an instance of how the idea of workplaces will change in the years ahead. We need to be able to differentiate between short- and medium-to-long term effects of this pandemic when we consider investing in assets, whose balance sheet life spans over seven to 10 or more years.

Andrew Bailey: This is sector choice, and that is the very beginning of our private asset selection process. This is where you have an opportunity for your investment team to make some judgements, make some big calls. Do you believe that Central London offices, or just offices in general are going to fall from favour? Or do you believe that the reasons why offices came into being in the first place are still valid?

This is long-term structural change, if you are buying into Central London office debt now, payable in 20 years' time, the asset might appreciate. You are getting a good yield now, but you have to be a bit brave, and you have to make some really strong decisions that might go against the herd, and that is where the opportunity to make some money might be.

Emily Penn: The same plays out in the retail sector as well, where there is quite a big difference between different retail assets at the moment; retail parks, high street, warehouse distribution. People see the word 'retail' and shy away very quickly. But actually, when you dig into it and understand the real dynamics of the particular investment, there can be some really good opportunities.

With regards to private debt versus liquidity, what we are seeing at the moment is the ability to drive really strong covenants on assets; you have a real kind of bargaining power on that side, which when you start to compare the risk and return attributes of a private debt asset, versus where you might otherwise invest in liquid markets, the strength of those covenants is very attractive.

Although we comment on the lack of true liquidity in the so-called liquid markets, there is a lot more liquidity in that market than there is in the private debt market, and for instance, if you are starting to experience a credit migration on your illiquid assets, while you might be comfortable with that from an economic perspective, it is going to hurt you from a capital perspective, and there is very little you can do to manage that. Whereas on the liquid side, over time, you can rebalance that portfolio to improve the credit position back up again.

Vincent Huck: Andrew said that maybe if you are brave now, it might pay off in the long term. So, where are you being brave at the moment? Where are the opportunities at the moment that you are actually putting the money into?

Andrew Bailey: Emily mentioned warehouses. I think that was a good comment. There is always going to be a need if people buy stuff.

Emily Penn: Yes, but that is what everyone wants, so you are not going to get a significant reward versus investing in some of the 'braver' assets, like selective retail, so it is still a risk/return trade-off.

Majid Khan: Sentiment can change so quickly at the moment. I take the point that nobody is massively bullish on Central London offices anymore. Supply has been massive and clearly demand has gone down a little bit, but only six months ago, WeWork was a hot company with a super-high private valuation coming up to a record-breaking IPO. Very quickly, the shine came off, the valuation crumbled and the firm and CEO became pariahs. Now, as various companies look to re-assess their office footprint, flexible office space companies are again becoming very popular as some companies would switch away from having a permanent office, or have a combination of a permanent office and WeWork space.

Generally, we are in this kind of 'dust needs to settle' stage, which could last maybe a year or so, before we can really make an accurate bet, which is not too binary.

Andrew Bailey: That is where Emily's comment about being brave comes in. How brave is down to the quality of the risk analysis and the credit analysis that I talked about earlier on.

How do we treat private assets? Carefully – that is really what it comes down to. WeWork is a diversion, you are effectively looking at being a bank for offices, by borrowing long and lending short, it just does not work; it is too risky, you have too much mismatch.

For an insurance company, we are looking for that right balance, to get the assets at the right duration and the liquidity becomes less of a problem for us, in that respect, because you have done the credit analysis correctly.

We need to look through sentiment and long-term trends. The people who are first on the bandwagon, the leading edge companies, are not really the people we want to lend to anyway, because they do not have a stable credit history. We are looking for much more – the economy as it is, and how it might change gradually.

Part II is available here: Sourcing and stress testing private assets

Part III is available here: Private markets: The good and the bad of regulatory oversight