Asset AllocationDecember 17, 2015

Towers Watson: Illiquid Credit Presents ‘Compelling’ Opportunity

By taking on the role of private debt lenders, institutional investors can open their portfolios up to new sources of return and diversification.

Reported by Featured Author

With banks under strict regulation, investors have been given the chance to take on the illiquid credit market—and the diversification and potential for returns that come with private debt.

According to a new report from Towers Watson, stringent regulation of the financial sectors has led to a decrease in bank lending capacity, creating a “compelling” opportunity for institutional investors to move into illiquid credit.

“Only through discipline, selectivity, and skill will the benefits of illiquid credit be successfully exploited.”The consultant firm argued that private debt provided access to underutilized return sources such as illiquidity, skill, and complexity premiums. Additionally, the asset class can diversify a portfolio’s sources of credit risk, providing exposure to middle market corporates, consumer credit, commercial real estate and infrastructure, as well as “niche and difficult-to-access credit risk” such as non-performing loans.

While some investors are already exploiting the illiquid credit space, the combination of the sheer size of private debt markets and the “capital vacuum” created by retrenching banks means there is “significantly greater scope for investors to consider illiquid credit as a meaningful part of both low-risk and returning-seeking portfolios.”

In 2015 alone, PricewaterhouseCoopers estimated European banks sold an excess of €100 billion ($110 billion) in assets—assets that institutional investors now have the opportunity to acquire, according to Towers Watson.

Illiquid credit as an asset class is also fairly broad, with a scope that ranges from less risky infrastructure debt to high-risk (and high-return) distressed debt. According to the report, illiquid credit can deliver both the “secure, long-duration cash-flow stream” suitable for a liability-matching corporate pension and “a return target akin to (or indeed above) that of equities.”

However, there are challenges as well: Towers Watson said private debt investments come with less familiarity, greater complexity, and the governance associated with being an early mover. Additionally, the firm noted that “not all illiquid credit investments are created equal,” with value varying “wildly” across the component asset classes.

When implementing an illiquid credit investment, therefore, investors should consider aligning the liquidity of assets and liabilities, favoring a portfolio of specialists over a single multi-strategy manager, and utilizing a top-down informed view in order to “successfully identify those ideas offering the most attractive total return potential.”

As the report concluded, “only through discipline, selectivity, and skill will the benefits of illiquid credit be successfully exploited.”

Despite Towers Watson’s positive stance, data published earlier this year from Preqin suggested that private debt funds were experiencing similar headwinds to those faced by private equity and infrastructure investors. In particular, Preqin reported that managers were struggling to deploy the cash being invested in their funds.

illiquid credit 2 Source: Towers Watson’s “Illiquid Credit: Playing the role of a (good) bank”