Mercer Investment Consulting has predicted that the next “big things” in the alternatives market will be private debt, insurance-linked securities, and aircraft leasing. “We’ve recently experienced an alternatives bubble as investors, chasing ‘alpha’ or above-index returns, sought greater exposure to alternative asset classes such as hedge funds – many of which haven’t delivered,” according to Mercer IC’s alternatives research manager, Dragana Timotijevic. Private debt investments are currently offering above-average returns, relative to history, because of capital scarcity and the credit market dislocation. Timotijevic describes private debt investments as “highly idiosyncratic” because almost every one is unique and so must be researched individually.

Skilled active managers can add value, says Timotijevic, but generally Mercer finds little attractive about the beta of private debt. However, the current beta opportunity for private debt investments is more compelling, because banks have withdrawn from debt funding. There are now only 85 active institutional loan buyers in the world, compared with 261 at the end of 2007, according to Timotijevic. As well, a massive refinancing wave is coming in the next five years with US$1 trillion of high-yield and leveraged loans maturing between now and 2014. “It’s a great opportunity for investors to provide capital,” says Timotijevic. “If you can identify the companies, you can control the terms.” On an absolute basis, expected returns from the asset class are between 10-15 per cent annualised in the current credit environment, which Timotijevic said was at the high end due to the lingering effects of financial market stress.

The components of this return may include: 1. Up-front fees for the lender once the deal closes (1-4 per cent) 2. Fixed-income style cash interest coupon paid quarterly or semi-annually (generally bank bills plus 6-12 per cent) 3. Purchase of the security at a discount to par (2-7 per cent in primary issuance, and up to 20-35 per cent in secondary markets) 4. Equity-linked component through participation in warrants and/ or direct equity co-investment 5. Pre-payment penalty (1-10 per cent) The timeframe for investors to exploit this opportunity is over the next two to five years, says Timotijevic, and manager selection is crucial. The second alternative investment, insurance-linked securities (ILS), is for sophisticated investors only, says Ryan Bisch, senior associate at Mercer.

“This is the true alternative, totally uncorrelated to the market, and related to huge events such as hurricanes or earthquakes. Investors in catastrophe insurance are taking rare but extreme risks.” ILS transfer insurance risk off an insurer’s balance sheet to a capitalmarket- based security which is separate from the insurance originator. ILS can take the form of catastrophe bonds, life settlements, weather risk, industry loss warranty derivatives, and other overthe- counter securities. “This is a market where capital is so scarce that you are paid a premium for taking on that risk,” says Bisch. That capital became much scarcer during the financial market dislocation of 2008, according to Greg Hagood, the founder of one of the more successful catastrophe bond managers in the Australian market, Bermuda-based Nephila Capital.

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