Ostrum on the real asset private debt opportunity

Ostrum’s Denis Prouteau provides an overview of the evolution of real asset private debt and explains the ‘immense investment diversification opportunities’ it offers.

debt

This article is sponsored by Ostrum Asset Management.

The real asset private debt market has been in the throes of transformation for the past 15 years. This has been driven by supply, with a decline in banks’ capacity to hold loans on their balance sheets combined with growing refinancing needs; and demand, as a result of simultaneous interest from a wider range of investors in this asset class.

The 2008 financial crisis acted as a catalyst to this transformation, as banks gradually gave way to institutional investors (insurers, pension funds, etc.) who took on the predominant role of financing real assets. This was in light of the difficulties banks faced in financing these assets or holding them with a sufficient return on equity. At the same time, tougher regulatory conditions increased the capital requirements to be held against these assets and imposed more drastic asset-liability management ratios (NSFR).

While private debt real assets became less and less appealing for banks, they became increasingly attractive for institutional investors. The appeal of this asset class can be summarized in four key points: i) attractive diversification and return profile compared to traditional asset classes; ii) exposure to predictable cash flows allowing for more controlled risk; iii) access to long-term assets with a duration of five to 15 years; iv) possibility to on-board ESG criteria when selecting investments, ensuring additional transparency and quality.

While structural changes initially created the conditions for this significant change in lenders’ structure, the evolution of markets since the Global Financial Crisis has further strengthened the shift. We have now reached a market generated-consensus centered on a “forever no yield, no-spread Japanese-style” environment. This has led investors to look to private markets as these can enable them to:

– Capture positive yields, and in the case of European investors, positive spreads above a zero floor on Euribor.

– Provide a credible alternative to corporate unsecured credit products thanks to an increased illiquidity premium and the extra comfort of a secured exposure (proven by the asset class’ high recovery rates).

From an opportunistic approach (“let’s replace banks”), rationale for private debt real asset products has become even more fundamental, both from a liability matching and a return perspective.

Varied yield profiles

There are currently three main complementary groups in the available range of real assets: infrastructure, real estate and aircraft. Real asset private debt investors were initially insurers and pension funds looking for long-term assets to secure long-term liabilities; the field is now expanding to sovereign funds. Meanwhile, family offices, private banks and funds of funds are expected to remain absent from the asset class due to its illiquid nature, and the fact that its duration and spreads reflect low risk.

This real asset market may embed a vast array of specific features, so yields are naturally quite varied. Premiums generally range from double-digit basis points above XBOR for high-quality quasi-sovereign deals, up to spreads of more than 300bps above XBOR for infrastructure financing in less developed countries. With such a wide range of return profiles, investors can target the asset with their preferred duration, risk and amortization timeframe to meet their specific requirements.

Diversifying and assessing risks

Regardless of the return profile, all private debt real asset products benefit from a lien onto an operating asset generating revenue (a commercial building, an aircraft or a solar power plant, for example). The range of countries, technology, security package, seniority or revenue nature (which is either “contracted” thanks to a corporate off-taker, or provided through a state concession, or “merchant” e.g. paid by individual end users) will impact the structure and yield of the transaction. This justifies spread differentials within the same asset class and offers immense investment diversification opportunities. The role of an asset manager will therefore consist of building a portfolio of transactions in line with the end-investor risk appetite and duration needs, while avoiding country, technology or any other risk concentration. Both the capacity to select individual transactions and the ability to look at the bigger picture of a diversified portfolio is essential.

As is the case for all credit products, private debt real asset risk can be measured through two primary metrics: the probability of default and the recovery rate, also called loss given default. Default probability does not necessarily differ from the corporate “liquid” world: for instance, the probability of default for an aircraft transaction could take into account the low rating of one of the airlines operating the aircraft. Yet, the loss given default would be much lower than that of liquid corporate bonds, which are unsecured products. The significant difference is linked to the fact that private debt real asset lenders benefit from a mortgage on the aircraft which is exercised if ever the airline defaults. This allows the lender to repossess the plane and sell or lease it to another operator (lessor or airline). Aircraft debt is one of the most secured debt markets, with a historical recovery rate of more than 98 percent, according to a 2016 Aviation Working Group study. The high recovery rates for aircraft debt implies higher risk-adjusted returns compared to other fixed asset classes.

Illiquidity and spreads

Real asset private debt products have one drawback, however: being based on a bilateral loan agreement between a borrower (usually a special purpose vehicle carrying the operating asset) and a lender, they are governed by terms which are specific to every transaction and may not be disclosed (private). This is unlike publicly-traded and quoted bonds, which are governed by standard language. This means that private debt real asset secondary trading is almost impossible. This is compensated for with an additional yield called an illiquidity premium. While the purpose of this article is not to assess whether credit spreads in general compensate for the credit risk, we will address relative value: is the illiquidity premium sufficient to compensate for the lack of liquidity on a given level of risk?

To answer this question, we must first do our best to omit short-term market moves that could disproportionately affect liquid credit products (for instance corporate bonds) and private debt real assets. The fact that private debt real asset transactions take several months to fully close, as opposed to bonds which are marked to market every day, means that private debt real assets have greater spread viscosity. A fast-moving spread widening (respectively tightening) would automatically reduce (respectively increase) illiquidity. When we compare private debt real assets with other more liquid products we therefore look at data over a long period of time.

This is not enough however; we then need to correct spreads on all credit products by the risk criteria explained above (probability of default and recovery rate). This risk-adjusted spread method allows for an apples-to-apples comparison across all credit products. Whereas adjusting credit spreads with risk criteria will only moderately affect returns on private debt real assets; this will (sometimes dramatically) compress spreads on liquid products. This analysis demonstrates the long-term benefit of private debt real assets. Over the long run, and on a risk-adjusted basis, we believe that the private debt real asset illiquidity premium is sufficient and justifies increased allocation and diversification towards this asset class.

Ostrum Asset Management
Source: Barclays (average Jan 2010-Dec 2017 LOAS and default-adjusted LOAS), Ostrum AM. *Adjusted spread: spread lowered by the cost of risk resulting from default and recovery rates

Ostrum AM in the private debt real asset market

In practical terms, an investor in real assets must have strong sourcing capabilities to ensure stringent transaction selection and diversified portfolio construction. Companies that successfully operate in this market stand out thanks to their expertise in asset sourcing, selection, origination and structuring of transactions right through to portfolio management.

Ostrum AM has an ambitious strategy to develop this market, with off-the-shelf strategies of commingled funds, and a range of tailored solutions. The off-the-shelf strategies span real estate, infrastructure and aircraft debt sectors. Tailored solutions can be created to meet client needs through combined investment solutions through sectors, geographies, risks, ESG and sourcing channel. In order to better address investors’ need to optimize their capital deployment speed Ostrum AM and Natixis have developed an innovative approach through a co-investment scheme. This combines Ostrum’s asset management expertise with Natixis’ worldwide presence in originating private debt real assets. Natixis and Ostrum are affiliated companies, through the common ownership of the banking and asset management divisions by Natixis S.A.

Please refer to www.ostrum.com for information on conflicts of interest.