Finding the opportunities in illiquid investments

Illiquid assets can be an attractive match for insurance liabilities, but firms have to be picky over how they invest, and the burden of governance threatens to diminish the allure, as participants in part 1 of this InsuranceERM/Insight Investment roundtable discuss

Chris Cundy: We have heard a lot about deleveraging of the banks and how that is creating an opportunity for insurers. What sectors are you finding particularly attractive?  And how are you accessing those investments? 

Philip Howard: Banks are still focused on lending but it is much more concentrated and there is less of it, so there are pockets of opportunity all over the place. You have to search them out, rather than generally saying "I will lend to medium-sized companies at Libor plus six percent" or whatever. There are opportunities in trade finance and the non-performing loan worlds.

Michael Leonard: We do not see the banks withdrawing that much in the UK. They are in prominent areas and competition is fierce. You have to identify smaller pockets in order to originate investments.

Philip Howard: In Spain for example, there were 65 banks lending. There are now about 12. The whole Caixa complex has been more or less wiped out, so there are good companies that do not have a banker. We were looking at a transaction the other day where an investment grade-rated company was forced to borrow at an illiquid rate, 10%-plus.

Scott Robertson: Banks generally want to deleverage legacy business, but often it's not a good match for our long-dated liabilities because the structures may not be Solvency II friendly – they have pre-payment options, for example – and so the regulatory treatment can be very penal.

Banks still dominate in certain illiquid asset classes like commercial real estate debt, so when you start dictating the structure you want, the market can get a lot smaller. Therefore, you may consider looking at more niche asset classes, which then creates challenges in terms of operationalising the investment and ensuring you have the relevant investment expertise.

Michael Leonard: If you take commercial mortgage loans (CML) for an annuity fund, you need fixed rates and Spens clauses: that cuts out 95% of the market. We have looked at something like £15.5bn of CML and we have originated £250m in two years. So, whilst there is that desire, the origination and the regulatory requirements still make it very restrictive.

"As part of the Solvency II prudent person principle, you have to have expertise in-house to provide the appropriate oversight"

Gareth Quantrill: It isn't necessary to have a true sale of the asset. We frequently see that banks do not wish to sell investments they made in the low-margin "good times" because they would realise a loss.  In these instances, we find that we can structure a funding programme with massive over-collateralisation – resulting in a high credit rating for the loan but the underlying stays on the bank's balance sheet and you have a well-collateralised position which you are happy to fund at a reasonable level.

Outsourcing and oversight

Chris Cundy: If you have to search out the pockets of opportunity, does that mean you are drawn to using specialist investment managers?

David Leach: We look in particular at infrastructure, commercial real estate and corporate debt. We choose to use external investment managers to benefit from specialist expertise and origination capability.

Philip Howard: We work with specialist firms that identify illiquid opportunities around the globe and sometimes with large asset managers. We do not have enough resources to originate anything specific ourselves.

Michael Leonard: We employ specialists originators and asset managers. But as part of the Solvency II prudent person principle, you have to have expertise in-house to provide the appropriate oversight. When we invested in CML for the annuity fund, the regulator's concern was the mandate and whether we had sufficient oversight.

Scott Robertson: We have looked at both models: going direct to bilateral funding arrangements with the lenders; and via asset managers. However, you need to ensure that you have the right internal resource and governance to provide effective investment oversight.

Access to market

Michael Leonard: One of the key challenges is getting access to the market. For a segregated fund, you need a minimum of half a billion to make it work. If you want to do something like secured leasing, then you have to go through a pooled fund, and we find difficulty in getting sufficient look-through for our reporting requirements. Also, some of the features of the funds – the ability to use derivatives in certain circumstances, for example – can rule them out for us.

Gareth Quantrill: We find any active fund strategies, particularly employing derivatives, difficult. Your expected return is based on average risk, but your capital charging is based on peak risk, so it does become unattractive on a return-on-capital basis.

"The time it takes to do the due diligence and the more intrusive governance means we tend to filter out a lot of opportunities immediately"

Heneg Parthenay: Have you considered syndication to get small tickets? 

Michael Leonard: We have stepped away from syndication with banks because frankly, banks keep the good stuff for themselves. You can look at syndicating with other originators, but that takes a lot of agreement between different people. And if you are going to have a competitive advantage in illiquids, you need the ability to move quickly. 

Gareth Quantrill: You only have to look at the last crisis and the German landesbanks to know that the new guy with deep pockets who goes into a syndication because he has to place money does badly. If you are a minor element of a syndication, you do not have control, so one of your primary reasons for going into illiquids – i.e. security and lower losses given default – is gone. 

The real risks

Scott Robertson: The time it takes to do the due diligence and the more intrusive governance means we tend to filter out a lot of opportunities immediately. So given finite resources, you tend to be very selective in what illiquid strategies you go into.

The deep dive into these illiquid assets leads to a high level of transparency and understanding in the insurer of the risk factors driving investment performance. This analysis is similar to the analysis that a rating agency would perform in deriving a credit rating, for corporate bonds say. However, unlike corporate bonds, we can use this analysis to structure the illiquid investment to suit our needs.

Gareth Quantrill: The level of discourse about my liquid book is much lower than for illiquids, where there is an obsession about being locked in. But fundamentally, the illiquid is often a simpler, better asset.

Michael Leonard: The other key thing is that you have step-in rights on an illiquid asset. You have a large amount of control: if it starts to underperform, you can take actions. On an unsecured bond, all you can do is try and sell it. I believe the actual risk of default is a lot lower on illiquids. 

Scott Robertson: The industry seems to be spending 90% of its time on 15% of the allocation. But the show is not going to stop because of the illiquids in your portfolio – it's the banks freezing up and no liquidity that is going to destroy you. We need to find a balance and make sure we are looking at all our risks.

David Leach: I absolutely agree. If you only have a small proportion in illiquids, it can be challenging to find stress scenarios specific to illiquid assets that break you. What happens to the rest of the credit book is more of a worry.

"The amount of due diligence that is required for these assets ... is so much more than for mainstream investments"

Michael Leonard: We were asked to model the Great Depression scenario for our CML portfolio, but there was no data. That stops you going into these asset classes. You are not allowed to take allowance for any of the collateralisation of the assets that you have, so we treat the vast majority of CML as an unsecured bond.

Is it worth it?

Simon Richards: Clearly the amount of due diligence that is required for these assets, both up front and on an ongoing basis, is so much more than for mainstream investments, even though it is only a small part of the overall portfolio. 

Philip Howard: On the other hand, you are targetting a significant enhanced return.

Michael Leonard: But all these additional costs start eating into it. We have to pay for an independent valuation each year, then the auditors check it, and then we have another auditor check the auditors for consistency.

Chris Cundy: So what is the advantage of illiquids? Is it the diversification?

Michael Leonard: You do pick up some of the credit premium, the size of which depends on your view of what your loss given default is. But given the management time, it is not the great additional pick-up that a lot of people feel like it is.

David Leach: There are hidden costs as well. The management time, particularly if things go wrong, might defer other strategic projects.

Gareth Quantrill: You can end up in a position where you say 'just on pure economics, I end up with nothing better than I would otherwise have got.'  But my loss given default should be better because I actually know the asset and I have security over it. 

Another issue is just getting hold of assets. There is very little sterling issuance in liquid markets, other than social housing. It feels like it's essential to be able to invest in illiquids.

Scott Robertson: You can get a situation where the economics of illiquids still work – the diversification benefit economically should be there – but it may not be reflected in the internal model. That is where you have to make a trade-off between short-term pain and long-term gain.

It does involve a lot of effort. We have hired internal expertise and developed governance committees to oversee investment in illiquids, which has also had the benefit of challenging our asset managers to improve their documentation.

"The real concern about illiquidity ought to be about liquid assets becoming illiquid, as opposed to illiquid assets"

Continuing scrutiny

Chris Cundy: Will this scrutiny of illiquids diminish once regulators and boards become more familiar with the asset class?

Michael Leonard: Insurers have been investing in illiquids for years. There is an overkill of scrutiny on it.

Gareth Quantill: Some of the attention is because it tends to be a relatively large single ticket, even if the underlying assets are relatively diversified, and there is an element of committing to something for a long period of time.

David Leach: As banks pull away from certain areas of direct lending, there is a risk of adverse selection. Insurers with less experience risk picking up loans that don't perform as well as expected.

Philip Howard: The real concern about illiquidity ought to be about liquid assets becoming illiquid, as opposed to illiquid assets.

Click here to read part 2 of this roundtable, discussing the valuation of illiquid assets and practical questions around liquidity, the time taken to invest illiquid mandates, and management fees.