Erik Vynckier, Investment Committee Chair, Foresters Friendly Society: We have been successful investors in private assets over the dry spell in fixed income markets, which have had negative rates and meagre credit spreads that made no economic sense. Outside of public markets, we have focused on commodities trade finance, invoice financing, private debt, and transitional or project real estate. Private markets have worked out well for us through the COVID-19 disaster, the burst of inflation, and high interest rates – better than public markets have. This new market situation however has led us to further increase the return thresholds we expect before we step into a new asset. Our conditions for investing now look for higher benchmark returns than in the past.
We haven't invested in venture capital because that sector has serious issues. A lot of this investment is in FinTech and the ‘brave new world’, and it has frankly not been done on the back of good due diligence but rather on uninformed enthusiasm – and many of these new companies will not make it.
"The success of private equity over the last 10 years has been
due to cheap leverage."
When it comes to real estate, valuations are under stress. However, I do not see insurers stepping out of this massive part of the economy. They should apply more due diligence and possibly apply mark downs on the assets that they own, but I don't think people will step away from the real estate market. There are also the effects of COVID-19 on this sector. We all know that there are many empty offices in financial centres around the world, but I’m including commercial, industrial, warehousing and residential development, for which there is a real need in the UK and other countries too. In two, five, or 10 years from now, real estate will be as significant an economic sector as it is now. The insurance sector will, with more due diligence, care, conservatism, and prudence, continue to invest in real estate.
However, the private equity side is going to struggle. The success of private equity over the last 10 years has been due to cheap leverage. It’s been a performance driver for portfolios, with portfolio companies having been restructured using high levels of debt. But debt has become a lot more expensive now.
Basel III continues to push lending out of the banking sector. We have a funny regulation that means Solvency II tries to convince insurers not to insure customers, and Basel III tries to convince banks not to lend money to customers. So, we're looking at necessary economic financing activity being orphaned under these regulations and people with fewer regulatory constraints and less or no capital cost are taking advantage of that bottleneck, which presents an opportunity to them. This also means we will continue to invest in private loans. We will continue to invest in commodities financing, and we'll look at invoices. We'll continue to look at financing real estate and Collateralised Loan Obligations (CLOs). It’s difficult to do under Solvency II, but you can do it under a US or Bermudian reinsurance contract away from European regulations.
With all these markets, economic pressure is less than it used to be five years ago, as we’re past that dry spell of zero nominal interest rates and negative real interest rates.
Erik: Inflation is an additional parameter. Is high inflation over? It isn’t for me: we still see the economic impact. Prices today are up massively from 2019, and consumers are still trying to cope with that. Families’ wallets must catch up with past inflation for the inflation burst to be truly over. Many economists say there was inflation in 2022-23, but now it’s down on a year-on-year basis, but families are still facing those higher costs from a depleted wallet. The prices did not drop back to 2019 levels. Prices went up and stayed there and are now levelling.
"From a social perspective, we haven't seen much unemployment.
It has stayed at a low level, with persistent open vacancies."
Also, there is a difference between core inflation and full inflation. For analytical insights, macro-economists try to define the drivers of inflation – by excluding energy prices, food, housing and so on – but that’s not the full bill consumers have to meet. This will have a continuing impact on the economy. We are in a stagflation period in the UK and Europe. There's not much economic growth and even shallow recessions.
From a social perspective, we haven't seen much unemployment. It has stayed at a low level, with persistent open vacancies. Yes, unemployment has picked up, but it's not at the level that causes extreme hardship to the economy or society. Rather there are issues raised about the rate of participation to the workforce and productivity.
These factors mean we are looking hard at inflation. If you want to buy inflation, you're probably too late because the market’s already priced in expected levels in inflation swaps and index-linked bonds. You have to pick up undervalued assets.
Erik: The issue that poses the most challenges is that visibility on cash flows and valuation is limited, and, for private equity and venture capital, visibility is even less than for real estate or private debt.
Regarding real estate, if one of the commercial valuers – say Jones Lang LaSalle – gives a valuation based on rental income, often the market will accept that valuation as a best estimate. Whereas, if you have a private equity instrument, you end up with an external auditor in Luxembourg or Ireland who will annually proof the valuations, and for valuation you need a gauge of what the actual return is going to be, from cash invested into cash from exits, so to speak.
This leads to certain issues. You have drawdowns now. You part with cash for seven to 10 years. You think it’s going to ultimately yield a 10% to 15% internal rate of return (IRR) and the Net Asset Value (NAV) tries to post a reasonable value in the interim, but NAV doesn't pay the bills. Cash flows that will make it possible to pay bills are the biggest challenge.
"Having an Investment Committee and approving what the general partner
does in such an instance, is a worthwhile approach."
These funds have signed partnership agreements, and, when they want to adjust their operation to new, different circumstances, they need approval from their limited partners and their investors. So, for instance, I have recently approved an investment to deviate conservatively from international financial accounting standards. They hold warrants from the companies to which they lend, and IFRS would want to value those warrants based on the Black-Scholes Model. We would rather keep them at zero value until we know that the company is worth more than the strike price of the warrant.
This is the type of situation where you have an explicit conversation with the general partner who manages these things. Having an Investment Committee and approving what the general partner does in such an instance is a worthwhile approach.
Erik: Commodities trade finance can be attractive, but you need the right partner to do it because these are short-dated contracts, and they mature every two to three months. The partner needs to be in this specialist market constantly. If you’re in that space as an on and off amateur, it won’t work. A second reason is that it remains interesting because banks have exited this space following Basel III.
There is also Basel III telling banks to stop lending in the same way that Solvency II tells insurers to stop insuring. Consequently, banks are in the market for offloading loan risk and loan capital through significant risk transfers to more willing investors in such risk. So, we’ve started looking at the junior piece of bank loans. The return can be from 10% to 15% per annum. That would have been a brilliant return five years ago, and it’s still a very good return with a material risk premium compared to public fixed income today. Banks do this because they save Basel III capital, but again, you need due diligence capacity and should do it with a specialist partner.
Catastrophe (or cat) bonds are another interesting area, but only for a select few because they consume insurance capital. P&C insurers shouldn’t get involved, because they already insure that type of risk and shouldn’t double up on underwriting property risk. For life insurers though, it’s a nice, diversifying asset that gives attractive returns, because the entire reinsurance market is very short of capital at the moment. It’s a provider’s market: the reinsurers dictate their terms and push out contractual terms further to their benefit. This area is for a life insurer with some excess capital who wants to make 10%-15% on that extra capital.
