‘Real Asset’ Debt Evolves, Draws New Investors
bfinance insight from:
Managing Director, Head of Private Markets
Senior Director, Private Markets
Senior Director, Head of Client Consulting UK & Ireland
Among the 485 investors studied for bfinance’s new Asset Owner Survey, 18% have either recently entered Real Estate Debt for the first time (within the last three years) or plan to do so in the coming year. Meanwhile, 21% have recently started or are about to start investing in infrastructure debt.
The changing pattern of investor usage is most evident in one region above all others: the UK, where those figures rise to 39% and 48% and respectively. These “new users” of real asset debt are dominated by defined benefit pension schemes. The Canadian numbers are also slightly above average, with 25% of all respondents proving to be “new users” of infra debt and 21% “new users” of real estate debt.
Source: underlying data gathered for the bfinance 2018 Asset Owner Survey (September 2018). Regional data is displayed for the six largest regions by participation, together comprising >75% of global data.
From an allocation perspective, there are several very different trends in play. The first is a “fixed income replacement” story – a post-GFC theme stemming from low rates, which have underpinned broader increases in exposure to private debt (and alternative credit more broadly) through the past decade. Indeed, the volume of investors that we would classify as “new entrants” to corporate private debt – 40% – significantly exceeds those aforementioned real asset debt figures. This shift from traditional fixed income to private debt has been strongly oriented towards the corporate sector as opposed to real estate or infrastructure, in part because the available risks/returns were significantly more attractive. Yet that balance has shifted somewhat during the past couple of years as the opportunities have evolved.
Source: underlying data gathered for the bfinance 2018 Asset Owner Survey. Further asset classes/strategies can be viewed in the main survey report. (Respondents to this question comprised those who had indicated entry into a new asset class in the previous question; totals can be multiplied by the percentages in the prior chart for an overall figure).
The second, somewhat more recent, driving force is “real asset diversification.” As the market enters definitive late-cycle territory, participants are increasingly looking to gain exposure to real assets at a less risky part of the capital structure. They’re also facing off against declining returns in core/core+ real estate and infrastructure, and broadly attempting to increase allocations to real assets (also evidenced above by the high volume of new entrants to infrastructure and real estate on the equity side). In short, investors have been moving from traditional forms of real asset exposure towards niche real assets, value-added or opportunistic strategies, RE/infra debt, listed infra, or a combination of these four areas (e.g. the addition of opportunistic RE for improved capital appreciation and debt for income). Among UK DB pension schemes, where the proportion of new entrants is at its highest, real asset diversification appears to be the primary motivation. Investment consultants, who have largely been slow to encourage clients towards the asset class (Real Estate Debt: As Good As It Gets? bfinance, July 2016), are now enthusiastic supporters of the move.
The third theme, which only applies to a small proportion of the overall ‘asset owner’ universe, is the regulatory story. Under Solvency II, the asset-backed nature of real estate debt and infrastructure debt implies significant potential accounting advantages for insurance companies and other investors.
While many of these issues are global, the UK has seen particularly rapid evolution in terms of the opportunity set, as explored further below. We see a variety of UK-only funds developing, as well as European solutions with Sterling-based investment sleeves.
It’s worth noting that the US real estate debt market is exceptionally large and many pension funds, endowments and other investors in this region have long invested in the sector, hence the relatively low number of “new entrants” shown above. Yet it is heavily dominated by CMBS and REIT bonds – here, as in Europe, the more private debt-like vehicles are still very much in development.
The real estate and infrastructure debt markets are increasingly varied and complex, with strategies ranging from classic mortgages to the expanding range of private debt-like vehicles. Expected net IRRs on real estate debt can now sit anywhere between 2% and 12%, not far shy of the 5 – 15% now targeted by corporate private debt strategies; in infrastructure debt the figures are somewhat lower, around 2 – 9%. The last five years have seen significant changes, both in terms of the types of loans available and the variety of asset managers offering funds in the space.
Source: bfinance private markets
One notable change in real estate, for example, is the development of “whole loan” structures – a type of lending that has similarities to unitranche in private debt, allowing for higher yields (and higher debt multiples/LTVs) on what are technically a senior loans. While the 200-300bps offered by super-senior real estate in the UK may be attractive for some cases, such as the insurer moving away from government bonds, much of today’s demand comes from pension funds seeking to replace core real estate exposure with something else that offers 6-8% - whole loans are helping to meet that demand. Today, whole loans can also be split into further risk tranches creating a super-senior position and a second-ranking position of that single senior loan facility.
In Europe, today’s real estate debt opportunities vary significantly by country. While post-GFC regulations encouraged banks to retrench from real estate lending in Europe, in much the same way that they reduced corporate direct lending activity, the withdrawal was more patchy and market-specific. German banks continued to be very active in real estate, making this market less appealing for so-called “alternative” lending. Yet it is the UK which – Brexit notwithstanding – appears to be the most attractive market in Europe for the more private debt-like real estate strategies. Among the advantages is a foreclosure regime that is more in line with the US system than many of its European neighbours, facilitating recovery of investor capital.
The story is rather different in infrastructure debt, where competition from banks has remained stronger. That being said, opportunities to invest on the debt side have grown considerably as rapidly rising volumes of capital have flown towards the equity side, including mezzanine tranches that are used to plug the gap between senior debt and equity. It is still difficult to open and run funds focussing on infrastructure mezzanine debt, due to the difficulty in guaranteeing dealflow. There are considerably fewer mezzanine-focused offerings than one would find in real estate debt or corporate debt. Strategies tend to be more concentrated and investors often prefer to access this space through separate accounts and partnership arrangements, so that opportunities can be seized when they arise.
Alongside the development of lending arrangements and structures, we have observed significant changes in the availability of funds. There has been a particularly large increase in the number of managers offering strategies in real estate debt, largely through closed-ended structures. There has also been an increase in fund size, although these are still modest relative to corporate private debt. For interested investors, there are a variety of business models to consider.
Manager business model types
Source: bfinance private markets
Due to recent developments, many managers in these two sectors exhibit short track records; many teams are relatively newly formed. Key requirements that investors should look for include the ability to maintain an experienced team, access to necessary resources, stability and strong alignment with client interests.
Given prevailing forces, we expect to see strong appetite for real asset debt persisting through late-2018 and beyond as the newer strategy types become more established and dry powder continues to compress real returns on the equity side. Yet investors should keep a sharp eye on the true risks of the loans to which they’re exposed and carefully scrutinise managers’ capabilities. In an increasingly complex marketplace, careful analysis and selection will be key to successful implementation.