EUROPE – An extensive research report into the investment case for direct lending from Société Générale Cross Asset Research paints a picture of a compelling opportunity for Europe's long-term investors, but its authors warn that the industry is under-prepared and has just 12-18 months to organise its resources and infrastructure for the coming supply.
The report – 'In the mood for loans: the keys to discovering five new asset classes' – interrogates the bank's extensive origination data in guaranteed loans to exporters, European commercial real estate loans, energy and transport-related project finance loans and SME loans.
The size of the opportunity is well known, with its origins in the ongoing disintermediation of banks from Europe's credit markets, in particular.
The report looks into this, but also makes a case for institutional investors based on four key pillars.
First, as insurance and pensions regulation steers these investors into assets with low solvency-capital charges or low risk relative to accounting liabilities, floating-rate loans offer a good alternative to bonds as interest rates begin to rise from their record low levels.
Second, they also exhibit low correlation with fixed income bonds, offering the potential to reduce the overall volatility of investors' 'lower-risk' portfolios.
Third, loans offer significantly higher recovery rates for the same default risk as bonds, thanks to the extra protection contained in loan covenants.
And fourth, loans offer a considerable illiquidity risk premium compared with bonds.
Alain Bokobza, head of global asset allocation at Société Générale Cross Asset Research, said: "Our findings regarding the illiquidity premium was one of the real nuggets in the report."
Deploying a purely quantitative methodology, the researchers compared spreads, adjusted for default and recovery rates, using the price-at-issuance of more than 1,000 term loans in the US and Europe with more than 1,400 senior unsecured bonds financing comparable projects, to isolate the premium for illiquidity paid to loan investors.
Comparing transport project finance loans versus US municipal transport bonds, for example, the premium was worth more than 140 basis points.
"That's equivalent to almost the entire yield on 10-year Treasuries just a few weeks ago," Bokobza said.
Energy project finance offers about 40bps in illiquidity premium and the examples of French SME loans the bank looked at offer around 100bps.
Splitting the yield pick up into three elements – the premium for default risk; the premium for the risk that default forecasts may prove incorrect, and the illiquidity premium – Société Générale reckoned that the latter accounts for 32% of the overall spread in European loans and 39% of the spread in US loans.
But as Bokobza noted, one reason Société Générale was able to complete this research was thanks to its 730 loan originators spread worldwide and its extensive middle-office infrastructure dedicated to direct lending.
Considering economic performance in Europe, Bokobza anticipates that loan demand will soon pick up significantly, outstripping its banks' willingness and capacity to meet it.
"The asset management industry has 12-18 months to organise itself and make all the headwinds disappear to meet the challenge and opportunity," he told IPE.
"In North America and Japan, the asset management industry has this capability to assess and score the creditworthiness of the loans they are going to buy, but Europe does not have that capability outside its banks."
His colleague from Société Générale Corporate & Investment Banking, Yann Sonnalier, added that it would be mistaken to assume that asset managers could recruit extensively from those banks, as regulators continue to want to see most loan origination happening there.
Banks are cutting back, not withdrawing completely, he noted.
"A critical part of the know-how within banks is the asset servicing, the agency functions that can seem uninteresting but are in fact a crucial part of managing the credit risk through the lifecycle of a loan," he said.
"The middle office is the place where covenants are monitored, and, in loans, by monitoring covenants, you manage credit risk.
"In terms of IT infrastructure and teams, this is a huge barrier to entry. Asset managers are reluctant to invest in this and still relying on us at the banks to provide these services."
The appearance just last week of a new mid-market credit evaluation product from Standard & Poor's indicated how far there is to go to reach similar levels of transparency between Europe's public and private debt markets.