Author: Pat O’Sullivan, Chief Investment Officer, Aug 20th, 2015
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Alternative Investment Options and the Search for Yield
As concerns over the “Bond Bubble” rumble on Financial Advisors have looked to alternative strategies to help diversify client portfolios. Many client portfolios now have allocations to absolute return funds, alternative investment funds, multi-asset/ multi-strategy funds, structured bonds, and property funds amongst others. Another asset class that is worth considering is direct lending, that is the provision of credit and loans directly to borrowers, an asset class that many institutional investors allocate to. And one that is now becoming increasingly accessible to Financial Advisors to use in client portfolios.
Credit Disintermediation: Stepping into the Shoes of the Banks
Bank or credit disintermediation is the name given to the role of non-bank lenders and their ability to provide credit and loans to borrowers. There is a wide range of non-bank debt finance instruments and include, corporate bonds, issued debt, such as loan notes, trade credit, personal loans, mezzanine/junior debt, peer-to-peer lending and crowdfunding. Alternative lenders come in many shapes and sizes and range from dedicated private debt funds, private equity funds, pension funds, life assurance companies and individuals.
Banks traditionally dominant in Ireland and Europe
Ireland, like most of Europe, has relied on bank finance, with bank lending playing a significantly larger role in the financing of the corporate, SME and property sectors than other forms of alternative finance. In aggregate, this greater dependence on bank lending makes the Irish economy, especially SMEs, more vulnerable when bank lending tightens, as happened in the financial crisis. However, the level of credit disintermediation is linked to the depth and sophistication of the capital markets in each region. The US has probably the most developed capital markets and traditional banks provide around 20% of the total credit to the US economy, while in contrast, banks provide around 80% of the total credit to the European economy. The development of credit disintermediation and alternative sources of debt financing in Europe (and Ireland) is critical to diversify and mitigate the risk of being over-reliant on the traditional bank financing model.
Regulations and Market Forces
Regulations, government policy and market forces will weaken the dominance of the traditional banks in both Europe and Ireland and alternative sources of finance will gain market share. A new set of bank capital regulations known as Basel III, which was finalised in 2010 and implemented in Europe via the Capital Requirements Directive IV in 2013, will play a key role in restraining the lending appetite of banks. These regulations have resulted in a general increase in capital requirements and stricter criteria for determining risk exposure, essentially making it more expensive for banks to lend aggressively. This will curtail the supply of loans.
Understanding the Capital Structure is Imperative
The capital structure/capital stack of a potential investment will typically range from equity to senior debt with one or more tranches of junior/mezzanine debt filling out the complete structure. The capital structure can be summarised in the following chart.
Capital Stack Chart
Senior debt investors take the least risk, are the first repaid, and have the highest claim on loan collateral. Equity investors take the most risk, are the last repaid, and have the lowest claim on loan collateral. The risk of the intervening tranches in the capital stack will depend on their seniority, with subordinate loans being less risky than mezzanine loans which in turn are less risky than preferred equity.
Senior Loans, Junior Loans and Equity
Senior loans generally have first legal charge over the borrower’s assets and business. As a result, if a company or an asset becomes distressed, senior loans are first in line to be repaid and get paid back before payments to subordinated loans, mezzanine loans, preferred equity and obviously equity. Being senior on the balance sheet and secured by collateral mean that senior loans provide a more protected repayment stream to investors than investments that are unsecured or otherwise lower in the capital structure.
An Asset Class that will grow in Popularity with Retail Investors
Many of the loan notes that Irish retail investors have invested in are generally subordinated loans or mezzanine type loans. While these loans are junior to senior loans, they typically carry a higher coupon or have an equity participation to compensate for the higher risk. Opportunities to invest in senior loans are not as widely available but will increasingly become another investment option for Financial Advisors and their clients.
The fact that direct lending as an asset class has an appealing risk and return characteristics and ranges from very secure, low-risk opportunities to quite high risk, equity-like opportunities, all with varying degrees of correlation to traditional asset classes makes direct lending a very useful tool for Financial Advisors when building portfolios.
Chief Investment Officer
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