Illiquid asset classes surge in popularity

Private equity, infrastructure and private debt appeal amid volatile markets

European fund selector sentiment towards illiquid asset classes surged in the third quarter, according to Last Word Research, as investors grappled with increasingly volatile equity and bond markets.

All illiquid asset classes surveyed – private equity, infrastructure funds and private debt – jumped into the top five most liked asset classes among pan-European fund selectors in Q3 compared with Q2

Private equity was the most popular out of the three and second most popular out of 26 asset classes.

The quarterly asset allocation survey found that infrastructure funds moved into fourth place from sixth, and private debt jumped to fifth from 10th.

A quarter of fund selectors surveyed said they were looking to increase their allocation towards private equity over the 12 months to September 2019, 26% to hold their current allocation, 3% to decrease, and 47% did not use the asset class.

“There is a lot of appetite for private equity funds especially in Spain, Finland, Portugal, the Netherlands and Italy,” the research said.

For Spanish selectors 41% looked to increase their allocation, 26% to hold, 3% to decrease, and 29% did not use the asset class.

According to NN Investment Partners’ (NNIP) outlook for 2019, 46% of European institutional investors favoured illiquid assets in terms of risk/return. This asset class came in third out of nine with equity strategies (55%) and sovereign debt (47%) being more favoured.

Source: NN Investment Partners

The NNIP report also found that 45% of investors were looking to decrease their risk slightly when it came to portfolio allocation. A further 3% said they would decrease their risk significantly.

The case for illiquid assets

NNIP head of specialised fixed income Han Rijken said that illiquid assets had grown in popularity over the decade since the global financial crisis as bond yields have been low and many banks have been restructuring their balance sheets.

Alternative credit assets can potentially help investors reduce risk as there is less downside and price volatility compared to public credit, Rijken said.

However, he warned that selectors should not use illiquid assets as a tactical play and instead rely on the asset class for diversification.

Rijken added that illiquid assets also offered higher yields and extra premiums for liquidity and structuring risks.

“Illiquid asset classes – such as project financing [for infrastructure] and commercial real estate loans – are not available in the public credit market,” Rijken said. “These investments provide an opportunity to increase diversification in a portfolio.”

“[In project finance generally] you have financial covenants so if something goes wrong with the company leading the project you get to sit at the table with the banks and the borrower in the early stages allowing you get to redesign and restructure the project as a whole.”

Rijken added that documentation was also stronger so in the event of restructuring or bankruptcy, the opportunity to recover your investment was often higher than in the public credit market.

The right illiquid manager

The process for onboarding – essentially signing up –  to illiquid products is different from the onboarding process for investment grade or high yield mandates, Rijken said, adding it was therefore vital that fund selectors worked with capable managers, suited to the task.

Illiquid markets cannot be benchmarked, he pointed out, therefore simply picking the best one in a peer group was not possible.

“You should look for managers who have a good sourcing capability. It’s a limited market so you need them to be able to attract the right loans,” he said.

“Of course, the credit assessment process has to be in order… such as the track record of the asset manager and the people in the team.”

Rijken warned that while traditional corporate bond portfolio managers often moved into the illiquid space and understood credit risk, they may not potentially have the right sourcing ability or understand the most efficient way to execute the loans.

“Within our commercial real estate loan team, for example, we have partnerships with certain banks that gives us access to a lot of transactions in the European commercial real estate loan market,” he said. “You have to make sure you have the right sourcing model and need experts.”

Rijken said he expected a widening of credit spreads in general in the public credit markets next year, which would make private credit markets more attractive.

“We already know from our own research that institutional investors want to allocate more to alternative credit and we expect the amounts involved to rise higher,” he said.

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