Bankers Lose Interest How Do You Profit?

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1 Aon Hewitt Retirement and Investment Bankers Lose Interest How Do You Profit? Risk. Reinsurance. Human Resources.

2 Bankers lose interest how do you profit? More stringent regulations are forcing banks to lend less but there are many economically viable projects looking for other providers of the debt financing they need. This is creating attractive investment opportunities for those who can step in where banks are exiting. With such opportunities, investors need to lock up their money for some time but this is expected to be rewarded in the form of higher returns or less risk. The range of opportunities is wide, from lending to property and infrastructure projects through to providing finance to companies which are too small to issue bonds. Introduction Stricter regulation of the financial sector is creating long term change in financial markets. Aon Hewitt has conducted significant research into the implications of these changes for our clients and they are far reaching. Banks are making less long term loans, which will create medium term investment opportunities for new lenders to step in and profit. Background In the early noughties, banks lent more and more to borrowers see chart below. Total lending by banks, indexed 100=1999 Europe United Kingdom United States New regulations create structural changes Governments and regulators globally have introduced rules to make the financial system more robust and stable, including Basel III and the Dodd Frank Act. The new regulations mean that banks need to hold more capital relative to the amount of loans granted, so that they can withstand borrowers not being able to repay. This means that banks are not renewing loans when they mature, or they are selling loans. The regulations particularly penalise higher risk and longer term loans, making these permanently less attractive to banks. Unique opportunities for long term investors There are some projects and investments that need loan finance to operate and expand. Banks may view many of these as viable from an economic perspective but not from a regulatory perspective. Many banks have been reducing the amount they lend, and tend to avoid long term or riskier loans, although loans of all maturities and quality are affected. Therefore, some borrowers will become financially distressed and will quickly need to find replacement loan finance or new loan finance even if they are not economically distressed Source: BIS Year However, they also did not hold enough reserves to cover potential losses from borrowers not being able to repay loans. When the Global Financial Crisis took hold, governments around the world needed to support banks, and banks reduced the amount of money they lent. Having conducted significant research into the regulations and investigated the state of the banking sector as a whole, we expect banks to continue to lend less over the next five years. Borrowers that need new loans will have to accept punitive terms. Lenders can demand higher interest rates on the loans, or better security so that more money can be recovered in the event of the borrower not being able to repay the loan. In other words, new lenders can expect higher returns or lower risk, or a combination of both. Fantastic! Aon Hewit Bankers lose interest how do you profit? 2

3 The main drawback is that these kinds of loans cannot typically be sold quickly or at low cost. Such assets require investors to lock up their money and are called illiquid. There are few long term investors such as pension schemes and insurance companies that can step in and profit from providing illiquid loans. Long term lending is a very good fit for the ten year timescale in which many pension schemes aim to reach full funding. Structure of investments Some banks will be forced to sell loans or not refinance certain loans at short notice. The process is likely to be disorderly and hence provide opportunities for investors that can move quickly. Therefore, investment managers who look to provide loan financing often need immediate access to money and so private equity structures are appropriate. Here, investors commit monies to a fund, and then the manager can take up to five years to draw this down and build up a portfolio which then lasts for 5-10 years in total. Investors are typically locked into the fund until it matures. Expected returns on the loan opportunities The table below outlines the debt opportunities and the returns we expect. Some funds invest in lower risk senior debt whereas others include investments in higher risk debt, so we have provided a range of returns. The loans below are illiquid except US sub-investment grade debt and UK investment grade corporate bonds, which we have shown as liquid comparators. Fund Type UK property debt European middle-market direct lending Infrastructure debt US subinvestment grade debt UK investment grade corporate bonds Typical fund life 7 8 years 5 8 years 10+ years Liquid Liquid Expected 10 year annualised returns for overall asset class 4 6.5% 5 7% % 4 5% 3 4% Source: Aon Hewitt as at 30 September Typically, the riskier the loan, the higher the expected return so it is difficult to compare returns for different loans with different levels of risk. European middle-market direct lending and the higher risk parts of UK property debt are more comparable with high yield debt in terms of risk level. We expect them to return around 2% p.a. more, a healthy compensation for the illiquidity they carry. This is a direct result of changing financial regulations which aim to penalise longer term and riskier loans by banks. Opportunities and their characteristics Property Debt Property companies have historically raised money partly from banks as loans, and partly from investors as equity. Basel III penalises higher risk property loans. There is approximately 116bn of loans maturing between 2014 and 2016 in the UK alone. We expect that there will be a refinancing investment opportunity worth approximately 70bn for investors such as pension schemes to exploit, in addition to debt in respect of new property transactions. The key attraction is that loans are secured on the underlying properties. The interest on the loan is paid out of the rent from tenants. If the property company cannot pay the interest on the loan, the underlying properties may be sold to repay the loan. The loans often attract arrangement fees. Some are structured so that the lender benefits if the underlying properties rise in value, which is particularly attractive when there is the potential for redevelopments/refurbishments. Aon Hewit Bankers lose interest how do you profit? 3

4 European mid-market direct lending Many companies used to borrow money from banks. As banks have scaled back lending, larger companies have increasingly issued debt (tradable IOUs, often called corporate bonds) directly onto capital markets. However, this is not possible for small to mid-sized companies who are looking to replace loans from banks they need direct loans from new lenders. There is a mismatch; companies prefer stable long term finance, whilst regulations penalise banks who make long term and riskier loans. We expect that there will be good opportunities in Europe, where the UK, France and Germany comprise over 80% of the market. Infrastructure Debt Banks are still lending to infrastructure projects, but they prefer shorter term loans. Overall, there is a significant weight of capital targeted at better quality infrastructure debt. There are some opportunities for alternative lenders in either higher risk or long term loans, where the banks are less active in the current market. We are actively monitoring the market for opportunities. However, we have a cautious view at present, due to low yields across the market. Opportunistic Credit Funds These funds aim to invest in a variety of areas created by banks reducing lending and opportunities created by new regulations. Such funds operate in many areas of the credit markets and in special situations using complex techniques that have historically been used by hedge funds. They lend to property companies, industrial companies, infrastructure projects and transportation companies, as well as making mortgage loans and some higher risk loans. Some focus on buying complex financial instruments from banks which are penalised under regulations. Investors typically avoid complex financial instruments as it takes expertise to properly analyse and understand them, so they offer higher returns. Such funds buy very illiquid assets and there is generally limited scope to make material changes to the asset allocation once the funds are invested. However, they provide diversification across many borrowers in different sectors, which is a key attraction. They can deploy money where they see best value at the point of investment. Unlike dedicated single asset class funds such as direct lending, they do not involve taking a strong macro view. Value-add and opportunistic property funds The other investments in this paper relate to lending, but value/add opportunistic property relates to investment in higher risk property; this opportunity has arisen due to a lack of bank lending and hence investment, following too much borrowing in the noughties. Many property funds set up in borrowed significant amounts of money, and subsequently suffered from property value declines due to weaker investor sentiment, falling rental income and weak rental demand. Across Europe, owners of such property structures with expiring loans have been forced to sell them to opportunistic property funds. These funds can restructure the holdings and sell them on. Over recent years, there has been a lack of new development projects and capital expenditure on existing assets and the valuation gap between prime (high quality) and secondary (lower quality) property is currently very wide (see below chart). Prime and secondary valuation yields, % Prime Secondary Current 425 bps 7 6 Average 260 bps 5 4 Low 115 bps Year Source: CBRE There are opportunities to invest in property assets which have been under-managed and require capital expenditure and/or significant lease re-positioning. This will increase annual rent to attractive levels and hence the property value. There are opportunities in distressed assets, more complex ownership structures, property debt, and speculative developments. We are positive on such funds, and expect returns of 10-15% p.a., but with a relatively high risk profile. We are positive on such funds, and expect them to return 10 12% p.a. Aon Hewit Bankers lose interest how do you profit? 4

5 What do we look for in fund managers? Fund managers need to be able to find good borrowers who need finance, so deal sourcing is key. Investors need to be sure that their fund manager will carry out thorough due diligence on underlying borrowers to achieve attractive returns. Managers need to be able to assess the risk of lenders not being able to repay loans; and, in the event of non-repayment, the manager needs to consider the likely value of the borrower s assets which can be sold to recover losses on the loan. We therefore prefer fund managers with experience, and enough skilled staff to source deals and assess them properly. As such, we have a limited number of buy rated funds in each area. Practical drawbacks As we stated earlier, private equity structures are used for the illiquid investments outlined in this paper. This has three practical drawbacks. Fees may be charged on the entire amount committed to a fund, even if no underlying investments have been made. Additionally, there is often a performance related fee of 10-20% on returns in excess of a certain level. Committing money to a fund with a term of 5-10 years means that an investor is making a call on the financial environment in a particular asset class, and therefore needs to do their research on the area. For debt funds that focus on one area, such as direct lending, a key risk is lack of opportunities at any given point in time. Funds with the flexibility to lend to different types of borrowers can overcome this drawback. Opportunistic credit funds have this flexibility. Investors need to rely on the fund manager to adopt a disciplined approach not to invest money into sub-optimal investments with either higher risks or lower expected returns. It is arguably in the manager s interests to draw down committed monies to earn higher fees. Investors need to take care with manager selection. We believe that the expected returns net of all fees in many areas will compensate investors for locking up their money, complexity, financial market risk, and manager risk. Prepare now to invest later Fund managers open new funds, raise capital to target amounts, and then they are closed to investors. You need to be able to act quickly to assess and access funds, so think now about what area you might target over the next year. For our fully delegated clients, we already invest in some of these opportunities, and we are actively considering other areas. Meet the expert Doug Steevans Principal Portfolio Manager Aon Hewitt Doug joined in 2004 and works as a Principal Portfolio Manager in Aon Hewitt s Delegated Consulting Services team. He is based in the UK. Doug is the lead portfolio manager for 20 client portfolios, a return-seeking bond portfolio and a cost controlled multi-asset growth portfolio. Doug is an active member of the Idea Development Forum and works on bringing new investment ideas to clients. About Aon Hewitt Aon Hewitt empowers organisations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organisational and personal performance and growth, navigate risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is a global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit: aonhewitt.com Follow Aon on Twitter: twitter.com/aon_plc Sign up for News Alerts: Aon Hewit Bankers lose interest how do you profit? 5

6 About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 66,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people solutions and through industry-leading global resources and technical expertise. Aon has been named repeatedly as the world s best broker, best insurance intermediary, best reinsurance intermediary, best captives manager, and best employee benefits consulting firm by multiple industry sources. Visit aon.com for more information on Aon and aon. com/manchesterunited to learn about Aon s global partnership with Manchester United. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated. This document is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by any third party. This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinion or assumption in this document is not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance or compliance with legal, regulatory, administrative or accounting procedures or regulations and accordingly we make no warranty and accept no responsibility for consequences arising from relying on this document. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: Registered Office: The Aon Centre The Leadenhall Building 122 Leadenhall Street London EC3V 4AN Copyright 2015 Aon plc aon.com Risk. Reinsurance. Human Resources.