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Illiquidity and the Attraction of Alternative Credit

Alternative credit has been an attractive source of diversification and yield, but the illiquidity premium powering its returns may not last forever.

Alternative credit assets hold an intuitive appeal for long-term investors struggling to find yield and diversification in this low-interest-rate environment. This growing alternative credit buzz merits a closer examination of the asset class, including the characteristics and risks inherent in these assets and, more specifically, the prospective sustainability of their returns.

As the reliance on banks as suppliers of long-term financing since the 2008–’09 financial crisis has evolved, forms of alternative credit, characterized by private origination, have become more prominent. These assets share defining spread, risk and liquidity qualities. Here in this post, we define alternative credit as encompassing private and distressed debt and infrastructure debt, as well as asset-based lending products such as leasing and real estate debt.

Default risk can be hard to pin down, as most small- and middle-market borrowers lack credit ratings. Public high-yield debt and leveraged loans are a good point of comparison, though.

That said, because lenders are often more closely involved in alternative credit, anecdotal evidence suggests that lower default losses and higher recoveries may be expected relative to public markets. Spreads — or the yield compensating investors for the risk they undertake beyond the benchmark risk-free yield on government debt — in alternative credit have historically tended to overreward investors for their willingness to tolerate some uncertainty. We think of this as a credit risk premium. That doesn’t fully explain the higher yields that alternative credit offers, however. In fact, asset liquidity may have a material impact on credit spreads.

For patient institutional investors taking a buy-and-hold mentality, the asset class would seem tailor-made to suit their preferences. The question, however, is whether there are any potential liquidity pitfalls posed for even those very long horizon investors. If those investors encounter forced liquidations because of unforeseen cash flow requirements, they may face adverse prices, further complicated by possible liquidity mismatch and leverage issues. It’s thus critical for investors to consider risk management in alternative credit transactions, including strict underwriting criteria, broad diversification and strong deal structures.

This form of transactional liquidity risk is presumably rare for buy-and-hold investors. There are other risks that could test the staying power of alternative credit investors, though, such as systematic illiquidity, in which the value of all assets is dragged down by external conditions, and more idiosyncratic issues, such as term interest rate risk.

When we think of assessing what we call the illiquidity premium, we look at it as an up-front discount that pays investors for locking up their money. By some measures, that discount translates to as much as a 3 percent annual excess outperformance over more liquid public markets. This outperformance potential derived from the illiquidity premium could be even greater in niche areas of alternative credit.

Alternative credit generally commands premiums. But are those premiums sustainable for institutional investors? In our view, the jury is still out.

Segments of the alternative credit market have pro-cyclical characteristics that should help them sustain outperformance over market cycles. It’s conceivable that spreads in areas such as midmarket direct lending will continue to erode over time as a function of rising structural competition from both the banking sector and public bond markets. Although bank lending is widely acknowledged to have shrunk since the 2008–’09 financial crisis, investors shouldn’t write off the banks just yet — the commercial banking business model is still underpinned by structural strengths.

In the past few years we’ve observed spreads on infrastructure debt tightening considerably as a result of institutional investor demand. Looking forward, we expect the capital charges considerations in Solvency II ?to act as a catalyst for more demand. These are both factors that may eat away at premium returns on alternative credit.

There’s an argument that the illiquidity premium may be more sustainable for distressed and mezzanine debt, given their combination of high cyclicality and elevated credit and illiquidity risks, but this will continue to be shaped by forces of supply, demand and competition.

If we can’t necessarily rely on alternative credit to deliver a sustainable, intrinsic illiquidity premium, then institutional investors may look to outperform through security selection, superior risk management and niche expertise. In private equity, the dispersion of returns between top and bottom managers has been shown to be enormously significant. Extending that same analysis to alternative credit markets renders some interesting conclusions about the possible sources of alpha.

Using data from 2015 mezzanine debt fund performance, we have determined that the dispersion of returns is about half as large as we see in private equity, with top-quartile mezzanine managers having previously added more than 300 basis points of annualized internal rate of return. This suggests that differentiating sources of alpha in alternative credit may include deal origination expertise, strong underwriting standards, robust negotiation of deal terms and covenants, debtor monitoring, strong refinancing processes and timing of positions and trading prior to maturity. These interlinked competencies accruing to more skilled alternative credit investors can make the difference ultimately in outperformance.

Alternative credit should continue to gain popularity as a source of much-needed diversification and yield for institutional investors. The illiquidity premium to be harvested in alternative credit is real. But it may also be increasingly fleeting.

Antti Suhonen is professor of practice in finance at Aalto University School of Business in Helsinki, and Declan Canavan is head of alternative investment strategies, EMEA, at J.P. Morgan Asset Management in New York.

See J.P. Morgan’s disclaimer.

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