Structural changes in banking, regulation and low interest rates are transforming the illiquid loans market. Managers are making hay, writes Christopher O’Dea
With equity markets under relentless pressure and fixed-income portfolios posting low single-digit returns, institutional investors have been turning to credit as a source of income. By investing in funds and listed companies that make direct loans to companies that cannot obtain financing from traditional sources, institutions are, in effect, becoming the new bankers to smaller and medium-sized companies around the world. The most illiquid loans are offering the highest returns along with the highest risk profiles.
The persistence of low interest rates and the ongoing search for yield by institutions has placed alternative credit providers focusing on illiquid situations in the sweet spot. Analysts say illiquid credit represents the biggest single opportunity for some of the largest investment managers in the sector. These include Ares Management, Apollo Global Management and Blackstone.
The credit teams at these firms – backed by ample capital – are filling the void left by banks that are retreating in order to shed risk to stay within tight new regulatory limits. And the long-term holding periods of the private fund structures they manage on behalf of institutions offer smoother return streams – many of the private market loans are not traded and therefore are not marked to market in downturns.
“It’s always dangerous to generalise when you have so many conversations with large institutional investors, but it’s fair to say that the low-interest-rate environment continues to make large global fixed-income investors very, very active in their search for additional yield but yet not capable of meaningfully increasing their global equity portfolio,” said Tony Ressler, chairman and CEO of Ares Management, on the company’s earnings call in March. “What we’re seeing is a meaningful increase in alternatives, that is both real estate and alternative credit products.” Ressler said this illustrated institutional investors taking “an opportunity to substantially increase returns in their fixed-income portfolio, without substantially increasing risk”.
The proposition attracting institutions is clear, Ressler said. “Most of our credit businesses are earning two times or so, more than twice the return of a traditional fixed-income portfolio but yet are predominantly floating rate.” This means they are less exposed to interest rates.
“There’s very strong demand for lending strategies,” says Don Steinbrugge, managing partner of hedge fund consultancy Agecroft Partners. “Small and medium-sized companies are having difficulty getting financing from traditional lenders,” he adds, “and they’re having to turn to hedge funds and other alternative lenders to finance their companies.”
The opportunity in credit is significant, according to Morningstar senior director Stephen Ellis. “Banks are stepping back from lending to certain middle-market and non-investment-grade companies in another effort to shed risk,” Ellis writes in a recent report on Ares. “We expect continued pressure on the banks here, particularly as regulators are asking banks to carefully scrutinise highly leveraged lending practices.”
“Most of our credit businesses are earning two times or so, more than twice the return of traditional fixed-income portfolio”
At the same time, Ellis says, “banks are divesting themselves of risky and complex credit instruments to buyers like Ares because of tougher regulatory rules”. For Ares, Ellis says its “deep expertise and extensive relationships” leave it “better positioned than most investors to acquire these difficult-to-value instruments at a reasonable price from forced sellers, generating excess returns for its investors.” This is not a typical short-term credit squeeze, but a fundamental change in the corporate finance markets. “We see the total opportunity here as sizable,” says Ellis. “Potentially more than a trillion dollars’ worth of assets could be divested over the next decade.”
Managers are moving fast to gather the assets. On Ares’s second-quarter results call in August, president Michael Arougheti said the company was at the beginning stages of what it believes will be a 12-month fundraising cycle.
The effort spans all of Ares’ business segments, including real estate and private equity. In tradeable credit, during the second quarter the firm held the final close on its fourth special situations fund, taking in $1.5bn (€1.3bn) – above the $1.0bn target for the vehicle. The strong inflows came despite a performance blip – Ares second-quarter special situations strategy composite returns were negative, primarily because of the weakness in commodity-related sectors, but Arougheti reported a gross internal rate of return (IRR) of about 18% since the launch of the strategy.
Among other large managers homing in on credit, Blackstone’s credit division reported the second highest growth in its revenues for the second quarter, a 5% increase to $241m, or 20% of the company’s total revenue.
Blackstone manages or sub-advises senior credit-focused funds, as well as distressed debt funds, mezzanine funds, and funds concentrated in the leveraged-finance marketplace. The division’s total assets under management increased by 17% to a record $81.3bn, driven by new product launches, including $2.6bn of capital raised in energy-focused products.
About a quarter of the credit unit’s assets are in rescue lending and hedge fund strategies; the net IRRs on Blackstone’s credit funds has ranged from 14% to 23%.
One aspect of distressed credit investing is that lending strategies are executed through long-lived private-equity vehicles, says Steinbrugge. “The loans are held at book value and the result is a very consistent performance stream. During downturns, marketable security funds are forced to write down some assets below intrinsic value, but the alternative funds with long lock-ups are not forced to sell.” In fact, a market price would be difficult to ascertain for illiquid-credit funds, which concentrate on hard-to-price risks. The trade-off, Steinbrugge notes, is that because there is not much liquidity, the liquidity provisions of the investment vehicle must match the liquidity profile of the loans the manager is investing into.
In short, there is a premium for expertise in illiquid credit investing, says Morningstar’s Ellis: “Apollo looks to be one of the best-positioned alternative asset managers in credit.” To capture that opportunity, Apollo has moved to build permanent capital, and its recent acquisition of fixed-annuity provider Athene “differentiates Apollo from its peers”, Ellis says. The deal gives Apollo a slug of permanent capital of $60bn, about 40% of the firm’s overall assets under management.
While long-dated private equity structures have helped illiquid managers so far, permanent capital confers several additional advantages. The main one is that the capital does not have to be returned to investors, which allows Apollo to earn steadily higher fees as the asset base increases and invests more of Athene’s assets under management into Apollo funds, says Ellis. What’s more, he adds, “there is substantial opportunity to reposition Athene’s assets toward the type of illiquid credit investments that Apollo has been buying up in its own funds.”
Competitors are not standing still. Ares recently acquired Kayne Anderson, which will bring credit assets to 70% of the merged firm’s assets under management. And although Canada Pension Plan Investment Board’s acquisition of GE’s private equity lending unit for $12bn in June led to GE’s termination of a significant lending programme with Ares Capital – which comprised about 25% of Ares portfolio through co-investments – Ares in September announced it had replaced the relationship with a joint venture with Varagon Capital Partners, the lending business of AIG.
As the search for yield goes on, look for alternative credit funds to have increasing appeal to traditional fixed-income investors.