Alternative credit can be defined as all credit which is not traditional investment grade, sovereign or corporate debt. This can span from liquid alternative credit strategies such as high yield bonds, bank loans and structured credit to more illiquid alternative credit such as direct lending, more distressed debt and speciality finance.
There are two key factors that are driving the growth in alternative credit, market conditions and investor demand.
Market and regulatory dynamics post-financial crisis have led to an increase in the cost of capital associated with loans and forced many banks to significantly reduce their balance sheets. Moreover, increased capital adequacy requirements imposed by new regulations such as Basel III have caused banks to deleverage their balance sheets.
As a result, the banking sector now has a reduced appetite for holding loans.
This retreat from the loan market has left a gap that non-bank financial institutions have been eager to bridge. As banks have sold off their loan portfolios, a myriad of financial institutions, primarily hedge funds, asset managers and private equity firms have stepped in to offer alternative sources of funding. As the recovery from the crisis continues demand for credit also continues to grow, thus ensuring the growth of alternative credit strategies.
Investors are attracted to this strategy as a means of increasing yield. In an environment of low interest rates and volatility the hunt for yield remains a key theme. Investors continue to take on greater illiquidity and risk in their credit portfolio to compensate for the lower yields in public markets. The aftershocks of the financial crisis have also encouraged investors to diversify in search of income. Performance across the alternative credit sector is proven to show strong yield relative to other sectors. For example, direct lending funds are showing potential IRR returns of between 10 per cent to 15 per cent1.
Allocations to alternative credit has increased significantly over the past decade. According to the 2017 edition of Willis Towers Watson’s Global Alternative Survey2 illiquid credit saw the largest percentage increase over the previous 12-month period, with AUM rising from USD178 billion to USD360 billion.
Institutional investors are the largest investors into private credit making up 85 per cent of the market with private wealth investors making up the balance3. Preqin4 reported that 37 per cent of Institutional investors are allocating to Private Debt strategies with 62 per cent of those surveyed stating that they were planning on increasing their allocation to the strategy in the longer term.
Public and Private sector pension funds make up the largest proportion of investors in the asset class. Preqin further notes looking at public pension increases to target allocations alone would account for additional USD128 billion in capital commitments.5
Before the financial crisis, the US already had a well-established non-bank lending market and North America still remains the region that provides the most financing for alternative lenders – approximately 85 per cent of all finance comes from sources other than banks in the US6.
Allocations to alternative credit have increased significantly over the past decade
However, the move towards a less bank centric model is becoming more prevalent in Europe and this is where the more profound growth is being seen. In Q1 2017, according to the Deloitte Alternative lender deal tracker7, Europe saw the strongest quarter of fundraising ever driven by large funds that reached their final closings. Asia and the rest of the world are also beginning to increase their exposure to this asset class influenced by the success in US and Europe, making up 17 per cent of the active investors in the strategy in January 2017 compared to 12 per cent in January 20168.
The most common domiciles for alternative credit funds are Luxembourg, the Cayman Islands and the US with other popular locations including Ireland, Jersey and the UK.
There is a large diversity in alternative funds in terms of strategy and structure. Strategies include private credit, mezzanine, commercial real estate, infrastructure and senior secured loans. Each sub asset class carries a different set of return drivers and more diversity of returns than traditional credit, thus potentially creating a better risk adjusted return profile for investors9.
Number of alternative credit funds in market by strategy type
Source: Preqin quarterly update10
Funds can typically be structured as open ended or closed ended. Closed ended structures are the most popular with lenders operating fund structures with life spans of 6-8 years, with a 2-4 year investment period followed by a harvesting period. 79 per cent of managers operate in a closed ended structure versus 21 per cent open ended (who operate with lock ups or other liquidity tools to restrict or prohibit withdrawals under certain circumstances)11. Institutional investors who are the primary investors have longer term investment prospects thus aligning to the more closed ended structures with limited liquidity.
Over the past decade the move to alternative credit is a strategy that has grown in popularity and is showing little signs of slowing up. It has expanded its geographical reach with Europe, Asia and the rest of the world looking to alternate sources of financing. This is anticipated to reach USD1 trillion of assets under management by 2020, a more than 20 fold increase since 200012.
HSBC Securities Services
Alternative credit is an important segment for HSBC Securities Services. The growth in the market is reflected in our business, particularly in Europe, and our alternative credit fund book has grown by >50 per cent as of 30 June 2017.
We have increased our stable of third party vendor solutions to help support this asset class and will continue to invest in the future. We have experience with a wide array of alternative credit strategies and fund structures and we are able to offer a range of tailored product solutions to support our clients’ expansion into this market.
2 Willis Towers Watson Global Alternative survey, surveying top 100 Alternative Asset Managers
3 Preqin Investor Outlook: Alternative Assets, H1 2017
4 Preqin Investor Outlook: Alternative Assets, H1 2017
5 Preqin Investor Outlook: Alternative Assets, H1 2017
6 Financing the Economy 2016 The role of alternative asset managers in the non-bank lending environment, published by Deloitte, the Alternative Credit council and the Alternative Investment Management Association
7 The Deloitte Alternative lender deal tracker
8 Preqin Global Private Debt report 2017
9 Financing the Economy 2016 The role of alternative asset managers in the non-bank lending environment, published by Deloitte, the Alternative Credit council and the Alternative Investment Management Association
10 Preqin Quarterly Update: Private Debt Q2 2017
11/12 Financing the Economy 2017, The role of private credit managers in supporting economic growth-published by Dechert LLP and Alternative Credit Council