UK Institutional Investors – Recent Developments & Impact on the Sterling Private Placement Market
- There have been some significant changes in the Sterling private placement market over the last few years
- Sporadic and in some years declining volumes of listed primary bond issuance has prompted some investors to switch funds to the private market
- Lack of liquidity in the secondary market has eroded the advantage of publicly listed bonds, in many cases removing the illiquidity premium often required for private placements
- Consolidation among traditional UK Investors has led to fewer but larger institutions able to buy private placements of up to £250m with many transactions in the £50-£150m size range
- The choice for borrowers has expanded as new institutions have entered the private placement market.
- The ability to tailor a financing to the specific needs of a borrower including fixing the terms but deferring drawdown has resulted in many new borrowers turning to the private placement market as a source of medium to long term debt finance
Over the last five years there have been a number of significant changes in the nature and composition of business undertaken by UK institutional investors. Many of these changes have occurred as a result of government intervention which in turn has acted as a catalyst for institutional investors to focus on specific types of business and asset classes.
Other changes have resulted from the 2007 financial crisis following which most major central banks embarked on a programme of interest rate reduction and market purchases of government and corporate debt on an unprecedented scale, driving down interest rates, as well as credit spreads for certain classes of debt, to all time historic lows.
The purpose of this paper is to highlight some of the changes that we have witnessed and to examine how these changes have impacted the sterling private placement market.
As with so many precedents in the corporate and financial markets, the United States has provided the lead and established the processes, frameworks and templates that have been emulated in other national and regional markets. No better example is the debt private placement market. For several decades now, US Institutional investors (mainly life and general insurance companies) have provided a valuable source of debt capital for corporate borrowers. Looking to deploy surplus liquidity these institutions actively sought to lend largely to investment grade borrowers for periods of between 5 and 15 years although for the right credit, maturities of up to 30 years were available. To give an indication of scale, there are around 50 active US private placement investors and private placements transactions in the US market now total over $50bn per annum although to put this in context the US public corporate bond market is now over $1 trillion per annum.
FOR INSTITUTIONAL INVESTORS, THIS PROVIDED AN IDEAL WAY OF EARNING A GOOD RETURN BY DIVERSIFYING RISK
For institutional investors, this provided an ideal way of earning a good return by diversifying risk across a wide spectrum of credit and sector; and for the borrowers it provided medium to long term debt capital which was generally beyond the reach (in terms of maturity) of the banks. In addition, borrowers did not have to undertake the sometimes complex and expensive process of obtaining a credit rating and the debt was documented through the issuance of notes under a standard form Note Purchase Agreement. The credit quality of the borrower was assessed by the lending institution and the credit grading from the NAIC (National Association of Insurance Commissioners) was a key determinant for the amount of capital that the lender had to apply to support the credit risk which in turn determined the credit spread charged. During the 1980s and 1990s the largest of the US institutions began an international expansion of their businesses with the leading players such as MetLife and Pricoa setting up European offices to originate debt private placements directly from UK and European borrowers.
UNTIL RECENTLY, SMALL AND MEDIUM SIZED UK BORROWERS THAT WERE LOOKING FOR INTERMEDIATE TO LONG TERM DEBT HAD LIMITED OPTIONS
Until relatively recently, most UK borrowers which wanted to raise medium to long term debt but which were either not big enough to access the public bond market and/ or were not sufficiently large or credit worthy to obtain an investment grade credit rating had limited options. They could either access finance from one or more US institutions failing which there were three UK institutions which were willing to lend on a private placement basis – M&G, LGIM and Standard Life. Furthermore, those three institutions had relatively narrow criteria for bilateral lending and invariably some form of security was required either by way of a fixed charge over specific property assets or a floating charge over financial assets. That position has now changed materially with a number of new entrants into the sterling private placement market most notably Canada Life, BAE, Rothesay, PIC and Barings along with a number of other pension funds, insurers and asset managers.
What has brought about this change?
THE PRIVATE PLACEMENT MARKET TODAY
There are several factors that have led to a substantial expansion in the size of the sterling private placement market and the number of institutions active in the market as follows:
LACK OF LIQUIDITY IN PUBLIC MARKET
Prior to the 2007/08 financial crisis all major bond banks ran sizeable market making operations in listed bonds. This was very useful for institutional investors which were able to buy and sell, often material positions, in particular bond issues with the banks taking the risk of finding other buyers and sellers of those positions in due course. However, following the financial crisis many banks suffered large losses on the write down of their long bond positions as credit spreads increased substantially to reflect the greater credit risks. As importantly, regulators stepped in to force banks to allocate many times the amount of capital that banks had allocated to their trading operations prior to the crash. Consequently, it became considerably more expensive for banks to hold long bond positions and over the last 10 years many banks have now effectively become little more than brokers, taking bond positions only when they know they have a buyer lined up to purchase the position.
IT BECAME CONSIDERABLY MORE EXPENSIVE FOR BANKS TO HOLD LONG BOND POSITIONS
The effect of this for investors was significant. While there was genuine liquidity for listed bonds, investors were prepared to buy bonds on tighter credit spreads by anything up to 50bps compared to private unlisted and therefore non-tradeable bonds. The general rule of thumb for the major institutional investors was that for a private placement i.e. with no listing and no liquidity, they would require a premium of between 20-30bps in credit spread compared to a listed liquid bond for the same issuer. However, with the withdrawal of bank trading positions, the advantage for an investor of a listed and therefore “liquid” security has considerably reduced. This has meant that several investors now see little difference between a listed and a privately placed, unlisted bond and therefore the premia for unlisted bonds have in many cases been eroded putting private placements on a par with listed bonds – but of course, there will still be pressure from institutional lenders for an illiquidity premium. This is all the more relevant for several life and pension funds which often buy long dated securities with every intention of holding them until maturity. So the illusion of liquidity has in many cases removed the cost advantage of listed bonds.
VARIABLE NEW ISSUE VOLUMES IN THE PUBLIC MARKET
As the graph below demonstrates, aggregate levels of corporate new bond issuance have been highly variable from approximately £2bn in 2007 hitting a peak of around £16bn in 2009 and 2014, declining to around £11bn in 2015 and 2016 although 2017 volumes are likely to be over £15bn.
In the absence of adequate new supply to satisfy demand, several institutional investors have sought private placements as an alternative way of investing in fixed income assets. Not surprisingly, investors have found that in many cases they can tailor the asset to suit their specific requirements in terms of maturity, structure and covenants. In many cases borrowers are flexible regarding the exact maturity of a new financing and will be happy so long as the maturity is long dated. But most institutions will have specific maturity sweet spots and will often be willing to offer more competitive terms for a maturity that plugs a gap in their maturity profile.
Furthermore, other terms including covenants can be negotiated to suit the institutions’ requirements. Once an institution has established a lending relationship with a borrower it is not uncommon that just like a bilateral banking relationship, the borrower will turn first to its existing lender as and when new debt finance is required. Such a borrower/lender relationship, with loyalty and commitment from both parties, is clearly more difficult to establish through publicly listed bonds.
INCREASED DEMAND FOR SPREAD PRODUCT
In a low interest rate environment, credit product (i.e. bonds or other debt instruments that pay a credit spread above either Libor or Gilts) becomes more valuable and therefore more sought after by investors. A simple example to illustrate the point is as follows: When the 10-year Gilt was yielding 2%, a corporate bond with a credit spread of 2 % would double an investor’s return to 4%. With a 10-year Gilt yield of 1%, the same bond issued by the same borrower at a credit spread of 2% would triple the investor’s return for the same credit risk. Hence with interest rates at historically all-time lows, bond investors have been hunting for yield and that has resulted in increased demand for debt instruments paying a credit spread.
At the same time, low interest rates and the availability of medium to very long-term debt have enticed many corporates, housing associations, universities, investment trusts, schools, charities, livery companies and a wide range of other organisations to borrow to fund a variety of projects. In many cases these borrowers had internal resources and liquid investments that could have been used to finance their requirements and projects, but debt has been and remains so cheap on both a comparative and a historical basis that they have chosen to use debt rather cash resources or other investments. Indeed, several Oxbridge colleges have made use of their effective AA equivalent credit ratings to raise debt with maturities of up to 50 years at coupons of anywhere between 2.25 – 2.75% with one Cambridge college raising long dated debt at a coupon of 1.99%. In many cases the proceeds of the financing have been used for building and other capital projects. But several colleges have simply borrowed cheap term debt and invested the proceeds in property and financial assets yielding anywhere between 4-7% thereby simply leveraging their credit quality to expand their investment portfolios and enhance returns.
CONSOLIDATION IN THE INSTITUTIONAL INVESTOR MARKET
One significant and continuing trend among the institutional investor market is consolidation. Within the last two years, Aviva has acquired Friends Life, Legal & General has acquired Aerion (National Grid’s pension fund manager) and most recently Standard Life has merged with Aberdeen Asset Management. The significant implications of this consolidation are twofold. Firstly, the number of traditional UK institutional investors continues to decline leaving borrowers with a reduced number of potential providers of medium/long term debt. But secondly, the institutions that remain have the capacity to lend larger amounts than before. Five years ago, few UK investors could lend in a single medium/long dated debt financing more than £50m. However, there are now several private placement investors who have little interest in transactions of less than £50m and can, for the right transaction lend up to £250m.
NEW ENTRANTS IN TO THE PRIVATE MARKET
While the traditional UK institutional investor base has contracted, there have been several new entrants into the private placement market. In the pension fund sector, the two best known entrants are Pension Insurance Corporation and Rothesay Life. Both these investors have a strong interest in debt private placement financings.
Outside the UK the large US insurance companies continue to be very active in the UK private placement market. The two largest insurance companies, MetLife and Pricoa have had significant London offices for many years. More recently they have been joined by New York Life and Barings (the brand name for the merged Mass Mutual and Babson Capital businesses).
The private placement market in the UK has continued to grow and now provides a deep pool of debt finance for a wide spectrum of borrowers for amounts from £10m to £250m in sterling, US dollars and Euros with maturities from 5 to 50 years. Given the historically all-time low interest rates it is hardly surprising that many borrowers have locked into long term fixed coupon or inflation-linked financing.
Many other borrowers are either preparing to follow suit or are watching developments with great interest especially now that there is a growing expectation that interest rates are beginning to push higher and the Bull market we have seen in bond markets over the last 25 years is coming to an end.