A PR IL 2 0 1 5
TABLE OF CONTENTS
The new breed of illiquid investors
Changing market conditions have seen
new entrants
2
What actually are illiquid assets?
Defining the asset class
3
BNY Mellon’s role in facilitating these
transactions for clients.
New entrants should understand the
unique characteristics of loans
6
Illiquid Assets
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 nonbank 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.
G LO BA L C OR P OR AT E T R U ST
2 // ILLIQUID ASSETS
THE NEW BREED OF ILLIQUID INVESTORS
The void left by the retreating banks has been filled by a number of different types
of investor. Perhaps the most notable of these have been the large institutional
investors, like life insurance companies and pension funds. These institutions have
the cash available to make such allocations, and the long-dated liabilities that are
well matched by such long-dated assets.
Unlike fund managers or private investors, these institutions do not need their
portfolios to be liquid to ensure they can quickly meet redemptions or free up
cash for other purposes. More important is maximising the yield paid on their
investments and ensuring attractive risk adjusted returns. Illiquid assets often
fulfil these criteria better than other investments.
Alongside the large institutional investors, hedge funds and credit managers have
become particularly active as alternative lenders in the illiquid markets. Among
the most sophisticated players, they have been quick to identify the significant
opportunities these assets present. Decisive and cash-rich, their willingness to
put capital on the table has helped many corporates raise capital while generating
higher returns for themselves.
Alongside the large
institutional investors, hedge
funds and credit managers
have become particularly
active players in the illiquid
markets. Among the most
sophisticated players, they
have been quick to identify
the significant opportunities
these assets present
Hedge funds may be at a disadvantage to the larger institutional players in some
of the biggest and most capital intensive deals. Few have the vast reserves of
capital required to finance, for example, an infrastructure project. But many have
found ways around this. Their extensive connections and ability to source capital
have enabled them to raise large sums of capital in tranches ready to be invested
when opportunities arise, and their ability to provide mezzanine and unitranche
financing solutions may afford borrowers additional flexibility and leverage. They
can also be more nimble, finding it easier to take investment decisions quickly.
There are advantages on both sides, and given the breadth of illiquid investment
opportunities there is plenty of room for everyone.
Such financing deals were harder to arrange in the period straight after the
financial crisis but are now making a comeback. Politicians have come to realise
that they can play a role in reviving the loan market, particularly for mortgages, but
also for credit cards, car loans and SME lending. They are again talking about the
role ABS, CMBS and RMBS can play in boosting lending and revising the economy.
In Europe, groups like AFME have developed new rules and codes of best practice
to restore confidence among investors, and PCS have set standards for ‘prime’
securities that regulators are acknowledging.
Accordingly, investors are once again considering structured products, whose
record speaks for itself. Rating migration of Triple A rated European RMBS is
very low and defaults are unheard of. Such instruments offer diversification in a
portfolio of bonds and loans and are naturally diversified within the asset pool by
nature of their design.
However, for some institutional investors the regulatory treatment of these
securities can be prohibitive, while for others, such as UCITS funds, there may be
restrictions limiting their ability to directly hold certain forms of illiquid securities,
i.e., bank loans. So as an investment proposition, for many institutions it makes
more sense to lend directly.
Providing loans in an illiquid format on an unlevered basis offers an enhanced yield
relative to the bonds on offer in today’s market. But this is not the only appeal.
Investors also see illiquids as a diversification play – and with good justification.
There are many types of illiquid assets to choose from, each with a very different
set of characteristics. What they have in common is the offer of a very different
kind of exposure, with a very different returns profile, to the stocks and public
bonds that dominate most investment portfolios.
3 // ILLIQUID ASSETS
WHAT ACTUALLY ARE ILLIQUID ASSETS?
Illiquid asset markets by definition receive less attention from investors than the
more liquid markets of stocks and bonds, and are considerably less well understood.
The term comprises a broad stable of assets, including leveraged finance loans,
real estate lending and infrastructure finance, SME loans (direct lending) and
private placements note/loan issues.
An illiquid asset does not have a convenient secondary market allowing investors
to quickly sell it for cash. It may be highly bespoke, (i.e. no standardisation of
documentation or commercial terms), having been created according to a certain
set of specifications stipulated by the investor, as is often the case for over the
counter (OTC) derivatives. Or the asset may be a one off with no exact comparables
in the market, such as infrastructure debt.
There are as many differences between illiquid assets as there are similarities.
They are rarely spoken of under an all-encompassing umbrella because the
risk profile, credit stories and institutions involved, and the business practises
between different types of illiquid assets, can be very different.
Each of these asset classes is populated by an almost entirely different set of
institutions, with very few active in all of them. The few big institutions that do
invest across them manage those investments separately, with different teams
analysing the deals. Each has its own sectoral, legal, and jurisdictional nuances
that require expertise. Each is subject to its own risk factors and each requires a
very different set of skills in order to succeed.
But these assets also share important characteristics. Expertise in one area can be
invaluable in better understanding and managing exposures across the spectrum
from an administrative perspective. In most cases the underlying asset will be a
loan, usually in the form of an OTC transaction, paying a premium to the lender,
which for certain types tend to be held to maturity.
Certain illiquid assets may be correlated to indices such as GDP, Euribor and Libor
which provide a natural hedge against future interest rate rises and/or inflation
risk. While that has been a remote concern for most investors in the US and Europe
in recent times, it may become a more pressing issue again in coming years –
especially if the ECB’s recently announced QE programme has the desired result.
Certain illiquid assets may
be correlated to indices such
as GDP, Euribor and Libor
which provide a natural hedge
against future interest rate
rises and/or inflation risk.
While that has been a remote
concern for most investors in
the US and Europe in recent
times, it may become a
more pressing issue again in
coming years – especially if
the ECB’s recently announced
QE programme has the
desired result
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.
4 // ILLIQUID ASSETS
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 indefinite 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.
5 // ILLIQUID ASSETS
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
Pricing is a particularly hot topic for illiquid instruments. The lack of a secondary
market in which such assets can be traded makes them very hard to price,
presenting certain accounting challenges. It may not be possible to mark-tomarket, if there effectively is no market.
Even if there is, extreme illiquidity can cause an unacceptable level of volatility
in the value of the portfolio on a mark-to-market basis. It may not make sense to
account for them in this way if a product is to be held for a period of years, during
which time the investor has no intention of selling. Instead, such instruments
need to be accounted for differently. Sometimes their price can be devised using
a model, which can smooth out market volatility, or sometimes a quasi-market
benchmark makes more sense.
In the regulated fund environment, via which many investors take exposure to
illiquid asset classes, issuers are required to obtain prices from at least two
independent sources which arrive at the same value, within certain tolerances.
There are no universally agreed upon sources for this pricing data, which may be
provided by models from audit firms or technology vendors, or via benchmarks to
more liquid and historically comparable asset classes.
Which option is selected is often determined in large part by the jurisdiction in
which the deal is taking place, and by the nature of the asset in question. A large
infrastructure project is likely to come with some kind of government guarantee
BNY Mellon has been at the
forefront of solutions for
illiquid assets for over 2O
years. It provides clients
with verified, independent,
enriched financial data that
is essential to invest in these
asset classes
6 // ILLIQUID ASSETS
and its fortunes are likely to be closely linked with those of the sovereign of
domicile, making a sovereign benchmark an appropriate choice, for example.
The important thing is that the pricing policy is stated clearly in the offering
documents so that all sides of the transaction are clear what the process is
and know what to expect. In this, and all other aspects of its clients’ business,
BNY Mellon stands ready to offer its many years of experience in managing and
administering illiquid assets.
Whilst size, scale and global footprint are very important in the business, the true
value is in the people who administer these deals at BNY Mellon. It has over 500
professionals around the world working on these structures, who need not only a
deep understanding of the asset classes and the intricacies of the market, but of
clients’ investment vehicle structures. This results in a deeper appreciation of the
hard lessons that have been learned over the years.
7 // ILLIQUID ASSETS
ABOUT BNY MELLON
BNY Mellon is a global investments company dedicated to helping its clients
manage and service their financial assets throughout the investment
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