Institutional investors like pension funds and insurance companies allocate a substantial part of their assets into fixed-income products: the return is stable while risks are relatively low. But the internal structure of fixed-income markets in the EU has altered quietly. The enthusiasm for public debt subsides while private placements start to reveal its magnitude. Looking at Germany for instance, the main restriction offering and selling public debt securities is the requirement to publish a prospectus approved by the Federal Financial Supervisory Authority (BaFin). In contrast, offers of debt securities to specified „qualified investors”, which means private placements, are exempt from the prospectus requirement.
High Flexibility and Safety
The contract of a private loan is negotiated between the investor and the borrower mutually. That is, documentation and reporting requirements are limited and that gives the possibility to customize the debt issuance in order to suit parties’ needs. Since private placements of corporate debt are non-standardized investments, specified clauses such as interest structure, notional, representations and warranties can be tailored according to bilateral appeals.
Creditors can set protective covenants to protect their investment. In the EU private loan market, prescriptive documentations include: loan proceeds only used for specific purpose; borrower does not increase certain risks to service and repay the loan; borrower is monitored and gives early warnings of stress; events of default dictate circumstances in which a creditor can early terminate the loan or take other actions to reduce risk.
Better return but less volatility
Institutional investors started to prefer private placements in recent years. For example, Legal & General, Britain’s largest pension fund manager, announced that it wanted to begin investing in private placements joining M&G, the investment arm of insurer Prudential, long active in this area. The promise of decent yields and diversification could have broad appeal. There is further interest from large pension schemes, such as BAE Systems’ and other insurers like Italy’s Generali. A research from Preqin shows that European institutional investors in private debt targeted returns between 7% and 13% in 2014. At the same time 10-year German government bond yields were less than 1%.
As for volatility, the debt capital market in Europe in 2015 was characterized by widening credit spreads, which was driven by investor concerns related to another Greece bailout, a weaker Chinese economic outlook and interest rate decisions from both the Federal Reserve and Bank of England. In fact, the iTraxx Europe Crossover 5Y Index volatility decreased from 4.26 in 2014 to 2.41 in 2015, the reduction in price volatility still seems too inconspicuous compared to its gloomy annual return of 3.32%. But for private debt, due to the detailed representations and warranties, potential risk can be reduced obviously to individual risk appetite in the covenants. Not only some financial targets can be set up for the borrower, but it could also enable creditors to early terminate its loan or take other actions to reduce risk in events of default.
Growing Market
Up-to-date data shows that private placements are becoming prevalent among German Mittelstand corporates. This tide is boosted by the scarcity of bank liquidity for small- and mid-sized German corporates and the fact that institutional investors are searching for alternative investments.
While banks are happy to see their loan books shrinking in the wake of regulations like Basel III, German private placement volume has reached €18 billion in 2015. Against this background, private placements come into institutional investors’ sight with its superiorities. Emerging regulations are driving them to build a more robust capital structure. For example, the Solvency II Directive in the EU sets minimum capital and solvency capital requirement for insurance companies to reduce risks, which encourages insurance companies to seek more optimized investment opportunities like private placements. Meanwhile, even though more pension funds and insurers are becoming part of SME financing in Germany, they are invested in less than 20% of the volumes originally issued in the public German SME bond market. That is to say, market potential in private placement is still giant.
Diversification
In Germany, only 30% of corporates funded with private placements have a public credit rating. The majority of the unrated issuers are either household names or companies operating in industries with little exposure to cyclicality, such as utility and real estate industries. Industry diversification is only one aspect. In recent years European Commission devotes to achieve an integrated market for financial conglomerates and initiates the “single passport” plan, which allows financial services operators legally established in one Member State to establish/provide their services in the other Member States without further authorization requirements, this passport gives private investment service providers more geographical space to invest into private placements. By investing into private placements, institutional investors improve their diversification characteristics of their portfolio.
So, the outlook for private placements in Europe is promising, not only because the public debt market is shrinking in wake of tightening regulations, but also private debt itself has many advantages that will draw further institutional investors’ attention.
Thomas Roell, February 2016
