Chris Palmer: Barriers to investment into less liquid assets fall into two camps – internal and external. Internal barriers include the need to resource subject matter experts to create a viable investment proposition when many other insurers are also seeking to staff up in this area. SMEs are needed on origination and structuring, deal execution, portfolio management and loan administration and credit risk management.
Another internal challenge is how to make best use of resources on the actuarial and capital management side of the business. Effective use of these resources is critical for developing internal models, matching adjustment capabilities in order to optimise the company’s balance sheet. Also, anything that requires regulatory sign-off clearly requires proper oversight, so takes time and continual refinement.
"We execute fewer than 10% of the transactions that we review, and this
selective approach helps protect our balance sheet."
External barriers include sourcing sufficient transactions of worthwhile illiquidity pick up to public credit. Ten years ago, few insurers had any illiquid or private credit in their asset portfolios. Now, many have an allocation to private credit, and some have allocations over 30%. That is a huge demand for illiquid credit assets from insurers, which are competing for the same sustainable private credit transactions as wealth funds, pension funds and other investors. Insurers can finance longer maturities than banks, but there is stiff competition for the best deals and that can see returns eroded or underwriting standards compromised.
We execute fewer than 10% of the transactions that we review, and this selective approach helps protect our balance sheet and ensures we can meet our liability obligations through the cycle. As we seek to deploy more, we consider new asset classes, or variants of existing asset classes, to give us meet return goals whilst ensuring credit quality of the portfolios is preserved.
We see investors taking bigger ticket sizes than previously, in some cases investors are refusing to book line items of a few million pounds. Fair allocation processes are starting to include rotation policies for smaller deals.
Chris: In recent years there has been a focus on sustainable investment. This includes investment that is sustainable for society’s wider goals such as inclusion and, in the UK, of levelling up regional imbalances. That trend manifests itself in unsustainable projects being unable to attract finance or being able to do so only at expensive borrowing terms.
In contrast to the problems faced by unsustainable projects those with a sustainable proposition are awash with offers of funding. Investors want to support renewable energy or affordable housing, which mean borrowers in these sectors can command cheap terms or loose structures (e.g., covenant-lite). The demand here is so intense that renewable energy transactions have started to look unattractive, on pricing and structure/rating terms.
"Public credit has moved quicker and is now marked wider than new opportunities
in private credit, for the same rating and duration."
Since Q4 2021 credit markets have begun to move wider from the tight spreads reached on the rebound from Covid-wides seen in Q2 2020. Inflation and quantitative tightening were the first prompts for this move wider but in recent weeks this has accelerated with the terrible conflict in Ukraine. That conflict has seen credit spreads widen by 50bps, with most of that move wider concentrated in liquid investment-grade credit rather than in private credit. Public credit has moved quicker and is now marked wider than new opportunities in private credit, for the same rating and duration – investors or asset managers whose mandate is restricted to private credit are faced with the dilemma of either investing into new private credit at spreads inside those available on public credit or to not invest at all whilst this anomaly exists.
This market dislocation is seen with credit-worthy new private transactions seeing demand, especially from the US, and printing at spreads that are not economic for any investors who are targeting illiquidity spread pick up and/or who can achieve a fixed return objective by investing in public markets.
"Any prolonged conflict in Ukraine could, however, see no public credit
market tightening."
Should the Ukrainian conflict come to a swift end, public credit markets would be expected to tighten back inside current new private credit spreads, re-establishing illiquidity pick up – this is what we saw in 2021 as Covid concerns receded. Any prolonged conflict in Ukraine could, however, see no public credit market tightening but instead private markets may slowly reprice new transactions wider than spreads currently observed in public credit markets – this was our experience in the middle of 2020.
Chris: The recent speech by John Glen MP, Economic Secretary to the Treasury, was welcome. We are hopeful that the Solvency II reform will deliver opportunities to invest further in Building Back Better and Greener and to deploy more capital to support the government’s Levelling Up agenda.
"Maybe the right reforms will facilitate deployment into asset classes
that are outside scope currently."
We don’t think the changes will impact strategy, but they might help us consider a wider range of transactions that helps improve diversification within existing asset classes such as infrastructure, commercial real estate, and social housing. Maybe the right reforms will facilitate deployment into asset classes that are outside scope currently – enabling us to invest additional capital, whilst also further diversifying the balance sheet.
Chris: The Ukraine disaster will have a knock-on effect on credit and inflation markets. Medium term, with hopefully a peaceful resolution, we are likely to see inflation re-emerge, not least on higher prices for longer for energy and soft commodities, i.e., for foodstuffs.
On sustainable investing, society will need to reconsider or rebalance its desire for renewable, green energy supplies versus its need for additional energy security.
