Private debt eyes up real estate finance
Nicolas Campiche, chief executive officer of Pictet Alternative Advisors, reveals why real estate debt may be a bright spot of alternative credit amid an uncertain market in 2017.
Amid concerns about illiquidity in some parts of the market, strategies focused on distressed debt and real estate lending could hold some opportunities.
After a record fundraising year in 2015, when almost $100bn was raised across private debt strategies, 2016 actually witnessed a slowdown, estimated to at approximately $74bn, according to data provider Preqin.
Mezzanine funds attracted the most money closely followed by direct lending and distressed strategies. That said, the highest number of vehicles in the market remain direct lending funds, highlighting the continued theme of scarcity of lending capital and disintermediation due to a flood of new regulations setting ever-stricter leverage and capital retention limits for traditional lenders (banks and insurance companies).
We have witnessed many of the same stories at the most liquid end of the distressed space, with positions originating in the global financial crisis dominating the opportunity set (Icelandic banks, Lehman Brothers, Greece sovereign debt...).
Economic growth remains slow, and we are likely late in the business cycle. Additionally, a record amount of the leveraged credit markets are controlled by daily liquidity vehicles at a time when broker dealer inventories are at record lows and liquidity in these markets is extremely limited.
This could prove a dangerous combination if high yield and leveraged loan investors decide they want their capital back in concert, causing trading prices to dislocate meaningfully from the fundamental performance of their underlying issuers. In addition, US corporate leverage is particularly high when compared to the periods immediately preceding the previous two downward turns in the economic cycle.
Interestingly, leverage is not only concentrated in the energy sector – more than 40 per cent of bonds in almost every high yield sector exceeds 6x leverage. High yield debt issued by highly leveraged companies such as these has more than doubled since 2011.
Historically, distressed managers have shown strong performances in a rising rate environment, when defaults typically increase. We continue to favour managers who have an ability to move around asset classes (from debt to post re-org equities) with long-term experience, strong sourcing capability and global geographical reach.
The opportunity we continue to find particularly interesting today is real estate lending. Debt originations are not keeping pace with maturities as liquidity continues to be insufficient due to scarcity of lenders. Total volume of new issued debt remains below pre-crisis level despite high Commercial Real Estate transactions volume.
Thanks to a looming debt wall (around $1.4trn of commercial real estate debt is set to mature in 2016-19), the ingredients seem to be in place for real estate debt strategies to continue to be attractive into 2017. Shrinkage of debt also resulted in a global healthier equity/debt investment structure. The capital structure of a real estate investment offers debt providers an improved collateral cushion and higher yields (whole or subordinate loans) on an asset that has also had a fair value assessment.
We particularly like expert real estate lenders who can originate, arrange and sell loans on high-quality collateral. The appeal of this strategy stems from potentially regular income, rapid paybacks and capital appreciation associated with strong collateral. Prime opportunities are to be seen in mezzanine (the lowest, and therefore highest-risk debt tranches yield some of the highest coupons in the market, around 11 per cent today) and in senior debt tranches (typically secured by a senior lien on the underlying property, currently yielding coupons in the 6 per cent range).
Investors may benefit from a range of sources of return, including upfront fees, current coupons, payment-in-kind and equity