Illiquid Assets: Investment Opportunities and Challenges

Illiquid Assets: Investment Opportunities and Challenges

April 2015
BNY Mellon Corporate Trust

How Is The New Financial Landscape Creating Both Opportunities And Challenges For Investors?

With rates at record lows around the world, and still falling in many places outside the US, the ability to generate returns is an increasing challenge for investors. While some have reacted by looking down the credit spectrum at high yield bonds or equities, others have found they can achieve their goals by harvesting the premium available in illiquid assets, says BNY Mellon.

Market and regulatory dynamics have encouraged a massive change in investors’ and banks’ attitudes to illiquid instruments in recent years. This is partly the result of the financial crisis and the regulation that followed, but that is not the whole story. Sophisticated investors have long appreciated the enhanced returns on offer for those willing to give up short term liquidity. Today, a growing number of investors are becoming aware of these instruments and making use of them.

Understanding the impact of regulation, however, is vital. Bank regulation has increased the cost of capital associated with loans and forced many banks to significantly reduce their balance sheets and increase the core capital they hold as insurance against losses. The result has been a banking sector with a waning appetite for holding loans.

Yet loans remain a popular financing tool for many borrowers and ensuring access to them has therefore become a politically sensitive issue. This has created a great paradox in the political debate of the day: politicians that have called for smaller and less risky banks, nevertheless they want to ensure borrowers – especially SMEs – retain access to credit.

The gradual retreat of banks from the loans market has left a vacuum that non- bank financial institutions have been eager to step into in their hunt for yield. With rates having been depressed across the western world for so long, investors have been increasingly emboldened to search for new investment opportunities.

This is a global phenomenon. There has been much talk of US rate rises in 2015, but nobody knows exactly when they will begin. Any sign of adversity on the horizon could spell further delays and when they do start to rise it will take a long time before they reach their long term average, let alone move above that level.

In Europe, while QE is not directly good news for illiquid assets, given their exclusion from the asset purchase programme, the announcement does at least confirm low rates will persist for the foreseeable future.

This should continue to encourage investors into higher yielding instruments, to take on more leverage, which may not appeal to those who were caught out when the last financial crisis hit; or to investing in less liquid assets in order to reap the illiquidity premium.

The New Breed Of Illiquid Investors

What Actually Are Illiquid Assets?

Main Types Of Illiquid Assets Available:

Leveraged Finance

This constitutes the most widely available illiquid asset in the market. Its popularity among investors has increased steadily for many years as demand for capital outstripped supply.

In Europe, before the financial crisis, this game was dominated by the banks, which were happy to provide loans, particularly as they were seen as a good way of broadening relationships with corporate borrowers. Larger loans were syndicated between large groups of banks, each of which was happy to hold that risk on its own balance sheet, earning good revenue streams and ensuring an ongoing relationship with the borrower.

However, in the last five years new regulations relating to capital adequacy for financial institutions have made it increasingly difficult for banks to hold risk on their own balance sheets. Demand for loans remained high, but banks’ ability to provide them has been curtailed.

The solution has been for banks to sell loans on to other investors, or for other investors to lend directly, cutting out the middle man. These institutions are not subject to the same regulations demanding core capital be held in liquid instruments.

For the borrower, the appeal of loans is clear. They offer greater flexibility than other options, with interest holidays or temporary payment waivers much easier to negotiate than would be possible with a public bond and optionality and potential for additional leverage dependent on the requirements.

Private Placements

These can be an attractive option for smaller borrowers as an alternative to the bank market. Where banks do still offer loans to clients they are often used as a way to win ancillary business, and augment share of the borrowers “wallet”, on the understanding that the bank that extends the loan will also be considered favourably in other business opportunities. As such, it is typically the very largest and most sought-after clients that have access to the syndicated bank market.

For those outside that top echelon of borrowers, and for those with no rating, precluding them from a capital markets solution, the private placement is fast becoming the first port of call. The market has been an important part of the financing landscape in the US for years, but is relatively new in Europe – although European borrowers have been no strangers to the very international US market.

Today, Europe’s embryonic, yet thriving, private placement market is positioning itself as an option for a growing number of SMEs or unrated companies without access to bank loans, despite having brands that are well known among European investors. But one day, the European market may compete with its US counterpart for the largest international borrowers.

Real Estate Lending

This lending, either for the purchase or building of real estate, is illiquid because it can be time-consuming selling such assets and the market can be relatively volatile. Real estate lending often involves syndicates of lenders, in much the same way banks have traditionally formed lending syndicates to make large corporate loans.

This has given rise to the emergence of real estate investing via fund-style structures, usually domiciled in Luxembourg, Ireland or Germany and the Channel Islands in EMEA, or outside of this in Cayman or Delaware. Such structures spread counterparty risk among a number of borrowers to reduce the exposure of any one entity, and to maximise the amount that can be lent.

Investors also take exposure to real estate via managed account platforms, which allow big originators of real estate assets to invest on behalf of their clients.

Infrastructure Finance

This looks set to be one of the real growth areas of finance in coming years. The world has massive infrastructure requirements over the coming decades, yet governments all over the world are desperate to cut back on their own expenditure and reduce their deficits and the overall size of the state.

This poses a number of challenges. If governments are unwilling or unable to pay for infrastructure investment, the capital to finance it must be found elsewhere, this means attracting private capital.

Meanwhile, banks are also likely to reduce their involvement with huge infrastructure projects. The costs are prohibitively large, while repayment comes over a long period. This is incompatible with the banking sector the post-crisis regulations are creating.

This creates an opportunity for those institutional investors with long-dated liabilities – again, the pension funds and life insurance companies. These institutions have the resources to provide the large outlays of cash required for infrastructure finance, and for which repayment schedules extending out for decades are not only acceptable, but positively desirable.

The potential partnership between institutional investors with long-dated liabilities and huge, capital intensive infrastructure projects with modest but stable and indefie revenue streams has long been recognised, but has been slow to flourish. Despite being a perfect match on paper, there are considerable challenges in making the pairing work.

Perhaps the most problematic of these is the considerable risk associated with early stage infrastructure financing. Such projects are notoriously prone to cancellation, delays and cost overruns, making financing them a daunting prospect, especially for those without the experience and resources to properly assess them. However, regulators, politicians and financiers understand it is vital to find solutions to these challenges.

BNY Mellon's Role In Facilitating These Transactions For Clients

BNY Mellon has been at the forefront of solutions for illiquid assets for over 2O years. It provides clients with verified, independent and enriched financial data that is essential to those who invest in these asset classes. It leverages its global footprint in a similar way it does for its Global Custody clients. However, in addition to the typical asset administration and fund/SPV administration, it also provides the specialist services of loan closing, facility agent, tax administration and enhanced reporting that is invaluable to large and small clients alike.

This long history was founded in the CDO/CLO space. But when the crisis hit in 2007 the business quickly diversified to support new fund structure types, such as regulated and un-regulated funds, and Seperately Managed Account (SMA) platforms that enabled investors to continue to gain exposure to such underlying assets, as well as working with the Investment Management community to find the appropriate products to meet their investment and yield objectives. Today BNY Mellon has over 1,000 vehicles (in excess of $300bn AUA) that it provides administration to across both regulated and unregulated platforms, in a wide array of jurisdictions, including those domiciled in Ireland, Luxembourg, or Cayman, and separately managed accounts (SMA’s). Its largest clients outsource the administration of illiquid assets and have this delivered across the entire global platform, which enables a single desk to deliver a large single commitment into over 40 accounts.

To understand the services provided and the benefit of partnering with a global leader, the key is to understand the challenges of the asset classes involved. The illiquid assets described in this article are predominantly traded and settled OTC. The register of the investors in each security or loan is held by a network of agent banks around the world, which exceeds 300 institutions, often based in the jurisdiction of the borrower. Consequently there is a huge variance in the type of technology used and the format and availability of information from one asset type to another and from one agent bank to another.

To transform the data from these institutions into verified, independent data that can be relied upon, BNY Mellon meticulously models all assets from the underlying credit agreement for the instrument and creates a ‘Security Master’ on a global platform. This is then used to reconcile daily to the Agent Bank notices and the cash received. BNY Mellon processes around 70,000 notices every month and around 150,000 at the end of each quarter on behalf of its clients.

Pricing, A Hot Topic For Illiquid Assets