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 However, the current beta opportunity for private debt investments is more compelling, because banks have withdrawn from debt funding.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.
Spreads had blown out not because of any catastrophe but for financial reasons, such as AIG – which was a buyer and seller of reinsurance risk – “blowing up its assets and its liabilities”. Within the ILS world, there are two main categories, catastrophe bonds and structured contracts. The first is a small part of the market, the second is a much larger space where most of the investment opportunities exist. “Both can vary considerably in the perils they cover and in their time-horizon and trigger-points,” says Bisch, but what they have in common is “strong negative ‘left-tail’ skewness.” So, the usual problems of meanvariance analysis are worsened, and investors in catastrophe securities must give explicit attention to tail-risk. Investors must be able to withstand rare, but possibly significant losses, and so the investment size in a portfolio must be quite small, possibly 1-2 per cent. The third Mercer preference, aircraft leasing, should be an even smaller part of portfolios than the ILS element, says Bisch.
The aim here is to invest in a portfolio of aircraft leased to commercial airlines within the equity component of the financial structure. Aircraft leasing could become popular because it is a moveable asset and its long leadtimes can be countercyclical, Bisch predicted. Investors in high-quality airlines, such as Qantas, can look forward to returns in the mid- to high-teens, according to Bisch. But, it’s not an investment for the faint-hearted, he adds. “It’s a compelling investment opportunity for sophisticated investors with tolerance for illiquidity.” Very tight capital markets at present are benefiting this alternative asset class for two reasons, Bisch says. Cashed-up airlines are preferring to lease aircraft and thus keep them off the balance sheet, and the two-year lag between order and delivery allows investors “to counter-balance the cyclical nature of the airline industry”.
Turbulence has hit the aircraft leasing business recently due to the withdrawal of players such as Babcock & Brown, Allco Finance Group, RBS, ING, Fortis, West LB and HBOS. Bisch is quick to say this was due to financial concerns at parent company levels, and was not related to the leasing businesses “which continue to perform strongly”. Returns are projected at 12-15 per cent, split 50-50 between income/ distributions and capital gains from the sale of the aircraft. This split varies with each deal, with longer deals being more income/distribution dependent. Two key risks stand out: the credit risk of the underlying investment, and the asset risk of the underlying aircraft assets. The first is the credit risk of the airline defaulting or going bankrupt. But, Bisch notes, “the benefit of aircraft as an asset is that if conditions worsen in one country, then you can move the aircraft to another country, and you can’t do that with infrastructure.” The second risk is in the residual value of the aircraft, which typically will be leased three to four times during its life. Thus, the value of the aircraft at release or sale is a critical component of the return. The valuation methodology will be critical, says Bisch, as will be the ongoing maintenance costs.
