GSAM Insurance Investment Strategy: Capturing Illiquidity Premium

Transcription

1 GSAM Insurance Asset Management January 215 GSAM Insurance Investment Strategy: Capturing Illiquidity Premium Executive Summary In today s low yield and uncertain interest rate environment, an efficient way for insurers to enhance portfolio returns may be through investing in less liquid assets. Insurers seeking to enhance portfolio returns can employ strategies such as migrating down the credit spectrum, taking on more interest rate risk or allocating, in part, to less liquid assets. In an environment where credit assets appear increasingly expensive and credit standards have weakened in liquid markets, insurers may be cautious of increasing credit risk. Increasing duration can be challenging when the path of interest rates remains highly uncertain as normalization draws closer, and can be particularly difficult for insurers focused on asset-liability matching. Allocating to less liquid or illiquid assets can provide an incremental return and enables insurers to capitalize on a longer-term structural advantage to provide liquidity where patient capital is increasingly scarce. Post the financial crisis, insurers focused on strengthening balance sheets and restoring capital positions. As a result, the industry has amassed high levels of cash, short-term instruments and liquid fixed income. Some insurers may be holding more liquidity than needed. Insurers with long duration and predictable liabilities or insurers with large surplus positions should consider selling liquidity by allocating to assets that can offer an illiquidity premium. The nature of insurance liabilities and insurers buy and hold orientation means that accepting a lower level of secondary liquidity can add incremental yield without significantly increasing portfolio risk. For insurers seeking illiquidity premium in investment grade credit, emerging market corporates offer a spread premium relative to comparable developed market corporates. Insurers comfortable with below investment grade credit should consider allocations to middle market loans, which offer an illiquidity premium relative to large market loans. Insurers seeking equity risk premium for either long duration liabilities or surplus capital can earn an illiquidity premium by supplying long-term patient capital to private equity assets. This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

2 Defining and Measuring Market Liquidity There are various forms of liquidity including central bank monetary policy, balance sheet liquidity, funding liquidity and market liquidity. This paper will focus on market liquidity which is the ease of trading and ability to transact in the market without materially affecting a security s price. Market liquidity provides asset holders the flexibility to sell when needed. Privately traded assets are less liquid than publicly traded assets, non-government bonds tend to be less liquid than government bonds, and alternatives tend to be less liquid than traditional assets. In the corporate bond market, illiquidity can be observed through bid/ask spreads which represent the difference between the highest price at which a buyer is willing to purchase a security and the lowest price at which a seller is willing to sell a security. Turnover, or trading volume as a percentage of the average amount of debt outstanding, can be used as a proxy for liquidity. A high level of turnover is associated with greater market depth and an improved ability to transact with minimal impact. The importance of liquidity is most apparent during market shocks when even highly liquid assets are difficult to trade. During the Financial Crisis, liquid assets such as high yield bonds and large market syndicated loans turned illiquid. The flight to quality created large liquidity differences and drove spreads materially wider. Markets that had been quoted in basis points were quoted in points. Lower Levels of Liquidity Due to Regulatory Change Amidst this easy monetary environment there are structural changes taking place that are having a long-term impact on liquidity. In an environment of unprecedented global monetary stimulus, markets are ostensibly flooded with liquidity. Accommodative monetary policies have reduced market volatility and risk premium, resulting in exceptionally low interest rates. However, amidst this easy monetary environment there are structural changes taking place that are having a long-term impact on liquidity. Bank regulators are focused on strengthening global capital and liquidity under the Basel III framework. As a result, banks face higher capital requirements particularly for riskier assets (Exhibit 1). Basel III also introduced the Liquidity Coverage Ratio (LCR), which ensures banks hold sufficient high-quality liquid assets to cover net cash outflows over 3 days, and the Net Stable Funding Ratio (NSFR), which requires funding in excess of a one year stress period. The diminished role of banks and market makers as liquidity providers is increasingly evident, as banks once supplied more than half of total credit extended to US corporates and real estate but now comprise only 2% of lending to the US corporate and real estate markets. 1 Further, US banks are facing greater restrictions on proprietary trading and tighter risk limits under the Dodd-Frank Volcker rules. This has led to diminished capacity for dealers to hold inventory and warehouse risk which reduces the availability of liquidity. There has been more than a 9% decline in net dealer holdings of corporate bonds since the pre-crisis peak (Exhibit 2), making it increasingly difficult for market participants to find liquidity. US investment grade corporate turnover has declined since TRACE data became available in 25. A European corporate bond issue now trades on average once per day compared to nearly five times per day just over a decade ago. 2 Recent market volatility in October 214 has highlighted the impact of lower levels of liquidity as capital and risk constraints exacerbated market movement. 1 US Federal Reserve and AllianceBernstein. December RBS Macro Credit Research, The Revolver, July Goldman Sachs Asset Management

3 Exhibit 1: Capital Charges Under Basel II and Basel III 16 Basel III Basel II 15% 15% 14 Capital Charge (%) % 4% 5% 4% 5% 4% 1% 6% 1% 8% 8% 8% Sov AAA Sov BBB Senior Banks A Corp A SME Loan Corp BBB HY Corp BB HY Corp B Source: Bank for International Settlements (BIS), RBS Research and Strategy. As of July 214. Exhibit 2: Primary Dealer Net Positions in Corporate Credit 35 Illiquidity premium is observable in credit assets such as emerging market corporates and middle market loans as these assets offer excess spread over more liquid, comparable assets. Dealer Net Positions ($ in Billions) Source: Federal Reserve Bank of New York. Net position defined as the difference in market value of primary dealers outright long and outright short holdings, reported weekly. As of December 214. Measuring Illiquidity Premium Measuring an illiquidity premium is challenging as it is difficult to isolate, not easily observable, and varies over time. Illiquidity premium can be approximated by comparing assets of similar quality and measuring the excess spread over the more liquid benchmark assets. The spread between on-the-run and off-the-run Treasury notes, which are assets with the same credit quality, has been used to empirically show the existence of an illiquidity premium. These spreads are currently at historic lows (Exhibit 3), indicating that off-the-run US Treasuries do not currently offer a meaningful illiquidity premium. When investing in less liquid assets, investors should evaluate whether they believe the asset class offers adequate compensation for lower levels of liquidity. In the current market environment, illiquidity premium is observable in credit assets such as emerging market corporates and middle market loans as these assets offer excess spread over more liquid, comparable assets. Goldman Sachs Asset Management 3

4 Exhibit 3: On-the-Run vs. Off-the-Run 1 Year Treasury Spread Spread (bps) Source: Federal Reserve, Thomson Reuters Datastream, RBS Research and Strategy. As of November 214. Framework for Insurance Company Liquidity Some insurers may be in a position to enhance returns by selling liquidity. To the extent that an insurer has liabilities with highly predictable cash flows, an insurer can back these liabilities with less liquid assets as the need to liquidate assets to support liability demands is limited. The process for identifying the liquidity profile of an insurer s liabilities varies by insurer, as each has a unique product mix, unique product distribution, and unique views on the development of future liability cash flows. To measure and understand its liquidity needs, an insurer should begin with a base-case projection of expected liability cash flow needs and expected asset cash flows (principal and interest) over time. A stylized example of such a projection is summarized by Exhibit 4. The shortfall of stylized asset cash flows relative to liability cash flows in years 3 and 7 is due to concentrated liability cash flows, such as GIC maturities. Exhibit 4: Illustrative 1-Year Base-Case Cash Flow Projections Asset Cash Flows (P&L) Baseline Liability Cash Flows ($) Source: GSAM estimates. For illustrative purposes only Years 4 Goldman Sachs Asset Management

5 An insurer should develop tail liability cash flow projections where the difference between tail liability cash flows and expected asset cash flows represents the amount of liquid assets that should be available in the event that the tail scenario is realized. Exhibit 5 uses VaR-95 as a tail measure, but each insurer should use a risk measure consistent with the insurer s own risk framework. To be conservative, the insurer can set its current liquidity requirement equal to the maximum liquidity requirement over the projected time period. In the illustrative example below (Exhibit 5), this occurs in year 3. The projected period (1 years in this case) should be approximately as long as the portfolio s average life as liquidity needs beyond this timeframe can be funded by asset maturities. Exhibit 5: Tail Liability Liquidity Requirement VaR-95 Liquidity Requirement Maximum Liquidity Requirement Liquidity Requirement ($) Source: GSAM estimates. For illustrative purposes only. Year Finally, Exhibit 6 provides a snapshot of the illustrative insurer s liquidity balance sheet at year. The exhibit compares current liquid assets versus the maximum liquidity requirement over the projected period. In this case, the maximum projected liquidity requirement is less than the current liquid assets held, thus creating excess liquidity. This excess liquidity represents the amount of illiquid assets that may safely be added to the portfolio to enhance returns. Exhibit 6: Balance Sheet Liquidity Excess Liquidity Liquid Assets Held Maximum Liquidity Requirement Liquid Assets Liquidity Requirement and Excess Liquidity Source: GSAM estimates. For illustrative purposes only. Goldman Sachs Asset Management 5

6 Illiquidity Premium in Credit Markets Credit assets that offer an illiquidity premium include emerging market corporate debt and middle market senior secured loans. Emerging market corporates are less liquid due to market size, fewer market participants, lower transparency and issuance concentration. Middle market loans are less liquid primarily due to loan size, more limited and private information, and supply/demand fundamentals. The emerging market economies are a major engine of global growth and comprise more than 5% of global GDP. Despite their macroeconomic significance, insurance companies hold modest levels of EMD. Emerging Market Debt Until the early 199s emerging market debt (EMD) consisted primarily of government bonds denominated in US dollars. The EMD universe has grown rapidly as many emerging market countries have implemented fundamental reforms that have enabled their economies to become major contributors to global growth. Over the last decade, many emerging market governments have implemented disciplined fiscal and monetary policies that have improved credit quality and have fostered a supportive business environment. Improving credit fundamentals in emerging market countries has reduced sovereign borrowing in the external debt market (primarily US dollar and euro-denominated) and has facilitated growth of the local debt market (local currencydenominated). The investment case for EMD has centered on strong growth prospects as well as favourable demographic trends and relatively low debt burdens. While GDP growth prospects for the emerging market region have slowed, emerging market growth rates remain well above developed market growth (Exhibit 7). The emerging market economies are a major engine of global growth and comprise more than 5% of global GDP. 3 Despite their macroeconomic significance, most institutional investors, including insurance companies, hold modest levels of EMD as a percentage of their fixed income portfolios. Exhibit 7: Real GDP Growth of Developed and Emerging Economies 1 Developed Economies Emerging Economies Real GDP Annual Growth Change (%) % 1.8% Source: IMF. Data through year-end 214. See IMF Data Mapper for the list of countries included in Developed and Emerging Economies. Local currency sovereign debt, or debt denominated in the currency of the issuing country, is the largest segment of EMD, representing more than half of the investable universe (Exhibit 8). This market is the most liquid within the EMD space, as countries that can borrow in their own currency are usually farthest along the development curve and have larger, deeper fixed income markets. Improving sovereign credit quality, along with migration of the sovereign market from an external market to a predominantly local currency market, has enabled local corporates to increasingly access external financing. The external corporate market is the fastest growing market within EMD with $1.6 trillion outstanding. 3 IMF. As of October 214. GDP shares are based on the purchasing-power-parity valuation of economies GDP. 6 Goldman Sachs Asset Management

7 Exhibit 8: Market Size of Emerging Market Debt Market Size ($ in Billions) % of Total EM Local Sovereigns 337 1,439 2,922 5,926 6,289 53% EM Local Corporates ,9 2,546 3,194 27% EM External Corporates ,378 1,619 14% EM External Sovereigns % Total 999 3,49 5,63 1,592 11,852 1% Source: J.P. Morgan and BIS. As of October 214. External Emerging Market Corporate Debt External emerging market corporates offer higher yields than developed market counterparts yet have maintained strong fundamentals. The JPM CEMBI Broad index has a market value of $81 billion (Exhibit 9) and represents the investable universe of emerging market US dollar denominated corporates that have a minimum size of $3 million. The JPM CEMBI Broad Diversified index is the most widely used index as it limits country weights, providing exposure to 49 countries (Exhibit 1) and over 55 issuers. 4 The index provides diversification as there is little issuer overlap with developed market benchmarks. Financials are the largest sector in the index comprising approximately 33% of the benchmark (Exhibit 11). Commodities are also well represented with oil and gas names comprising 14% of the index and metal and mining comprising another 6%. Many of these natural resource companies are export driven industry leaders that derive significant revenue from countries outside of their domestic market. Exhibit 9: Market Value of J.P. Morgan Emerging Market Debt Indices Market Value ($ in Trillions) EM USD Sovereign Debt $1.7 EM USD Corporate Debt EM Local Sovereign Debt $.8 $ Source: GSAM, J.P. Morgan. As of November 214. EM USD Sovereign Debt is J.P. Morgan EMBI Global Index, EM USD Corporate Debt is J.P. Morgan CEMBI Broad Index, EM Local Sovereign Debt is J.P. Morgan GBI-EM Broad Index. Exhibit 1: CEMBI Broad Diversified Regional Breakdown Exhibit 11: CEMBI Broad Diversified Sector Breakdown Asia 39% Africa 6% Middle East 15% Latin America 28% Europe 12% Source: J.P. Morgan, Bloomberg. As of December J.P. Morgan. As of January 215. Sector Breakdown (%) % Financial 14%14% 1% 7% 6% 5% 4% 4% 1% 1% 1% TMT Oil & Gas Utilities Consumer Metals & Mining Industrial Real Estate Diversified Pulp & Paper Infrastructure Transport Goldman Sachs Asset Management 7

8 While EM investment grade corporates have performed well, spreads between developed market and EM corporates remain relatively wide. EM investment grade corporates offer a spread premium of approximately 1 bps relative to US investment grade corporates and approximately 15 bps relative to European investment grade corporates (Exhibit 12 and 13). Exhibit 12: Investment Grade Corporate Spread Comparison 35 US IG Corporates EM IG Corporates Europe IG Corporates Spread (bps) bps 138 bps 95 bps Source: BofA Merrill Lynch Global Research, Bloomberg. Spread data is spread to worst. As of December 31, 214. US IG Corporate is BofA Merrill Lynch US Corporate Index, EM IG Corporate is J.P. Morgan CEMBI Broad Diversified High Grade Index, and Europe IG Corporate is BofA Merrill Lynch Euro Corporate Index. Exhibit 13: EM and US Investment Grade Corporate Spread Differential Spread Differential (bps) 13 EM vs US IG Corporates Average bps 86 bps Source: BofA Merrill Lynch Global Research, Bloomberg. Spread data is spread to worst. As of December 31, 214. US IG Corporate is BofA Merrill Lynch US Corporate Index and EM IG Corporate is J.P. Morgan CEMBI Broad Diversified High Grade Index. 8 Goldman Sachs Asset Management

9 Historically, the EM corporate spread premium over developed market corporates could be attributed to differences in credit risk, but EM corporates have evolved into a predominantly investment grade asset class. In the early stage of the EM corporate debt market, the spread premium over developed market corporates could be attributed to differences in credit risk, but EM corporates have evolved from a speculative grade asset class to a predominantly investment grade asset class. Investment grade issuers now comprise 71% of outstanding external EM corporate bonds (Exhibit 14). EM investment grade corporates have demonstrated stronger fundamentals through the recent credit cycle compared to their US investment grade counterparts. EM investment grade corporates have employed lower levels of leverage, with an average leverage multiple of 1.1x versus 1.4x for US investment grade bonds from 26 to 213 (Exhibit 15). Default risk is comparable with an average annual default rate of.11% for EM investment grade corporates compared to.14% for US investment grade corporates over the same time period. 5 EM investment grade corporates are shorter duration compared to US corporates and subsequently bear less interest rate risk (Exhibit 16). Exhibit 14: Outstanding EM Corporate Bonds by Rating Rating Breakdown (%) Investment Grade High Yield and Not Rated 61% 52% 47% 43% 38% 36% 35% 35% 33% 32% 31% 32% 29% 3% 29% 39% 48% 53% 57% 62% 64% 65% 65% 67% 68% 69% 68% 71% 7% 71% Source: J.P. Morgan. As of November 214. Exhibit 15: EM vs. US Investment Grade Corporate Net Leverage 1.6 EM IG Leverage US IG Leverage Net Debt / LTM EBITDA (x) x 1.26x Source: BofA Merrill Lynch Global Research. Data through December 31, 213. Net Debt defined as a company s debt net of cash and cash equivalents. 5 S&P Ratings Direct Goldman Sachs Asset Management 9

10 Exhibit 16: Duration and Spread Comparison Spread (bps) Duration (years) Spread Duration (years) EM IG Corporates EM IG Sovereigns US IG Corporates Europe IG Corporates Source: J.P. Morgan and Bloomberg. As of December 31, 214. EM IG Corporate is J.P. Morgan CEMBI Broad Diversified High Grade Index, EM IG Sovereign is J.P. Morgan EMBI Global Diversified Investment Grade Index, US IG Corporate is BofA Merrill Lynch US Corporate Index, and Europe IG Corporate is BofA Merrill Lynch Euro Corporate Index. Spread data is spread to worst. EM Corporate Debt Liquidity Despite strong credit fundamentals, investor perception of political risk and lower levels of liquidity contribute to greater volatility and wider spreads for EM corporates. Political risk remains a significant driver of volatility as evidenced by recent tension between Russia and the Ukraine. While EM corporate liquidity has improved as the asset class and investor base grows, EM corporates are less liquid due in part, to a smaller more concentrated market. EMD has fewer secondary market liquidity providers relative to developed market debt which is evident in wider quoted bid-ask spreads. In 214, the average bid-ask spread for emerging market investment grade corporates was 8 bps wider than US investment grade corporates and 7 bps wider than European investment grade corporates (Exhibit 17). Exhibit 17: Secondary Market 1-Month Trailing Average Bid-Ask Spreads 22 US IG Corporates Europe IG Corporates EM IG Corporates 2 Spread (bps) bps 9 bps bps May-11 Sep-11 Jan-12 May-12 Sept-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Source: BofA Merrill Lynch Global Research, Bloomberg. As of September 3, Goldman Sachs Asset Management

11 Trading volume as a percentage of face value is often high for EM investment grade corporates but volumes peak when large new issues come to market and drops significantly thereafter. Trading volume spiked when Petrobras announced the largest EM corporate new issuance in May 213, but volume dropped significantly after (Exhibit 18). EM corporate trading volume comprises a significantly smaller percentage of overall EMD trading volume (19%) relative to the sovereign market (Exhibit 19). Exhibit 18: EM Investment Grade Corporate Turnover and Relevant New Issues 6 55 Petrobras, Pemex and Vale Issuances Petrobras Issuance; Largest EM corporate debt sale on record Turnover (%) America Movil Issuance Apr-1 Oct-1 Apr-11 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Source: BofA Merrill Lynch Global Research, Bloomberg. As of September 3, 214. Trace Volume represents 12 of LatAm s largest issuers. Exhibit 19: EMD Relative Trading Volume 1 EM Sovereigns and Local Instruments EM Corporates Other % Trading Volume (%) % % 214 Source: J.P. Morgan. As of June 214. Other includes loans, Brady bonds, options, and warrants. Goldman Sachs Asset Management 11

12 Impact of Fed Tapering and Current Market Environment It is likely that volatility in EMD will increase as central banks withdraw liquidity. As market volatility increases, illiquidity premium is likely to increase. The impact of investor perception of EMD liquidity was evident during the Taper Tantrum in summer 213. The Fed s indication that it may begin tapering its bond buying program sooner than anticipated triggered an EMD selloff (Exhibit 2). This demonstrated the impact of central bank driven liquidity on inflows into the emerging markets. The market feared that a reduction of US Fed liquidity would reduce the flow of capital into emerging economies as low developed market interest rates have served to direct flows into the emerging market region. However, after the summer sell off, investors grew comfortable with potentially lower levels of liquidity and began to re-enter the market as they focused on strong fundamentals and attractive spread levels. EM corporates recovered their value by February 214. Exhibit 2: EM Investment Grade Corporate Spread during the Taper Tantrum Spread (bps) EM IG Corporate Spread US 1 Year Treasury Yield Yield (bps) Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug Source: BofA Merrill Lynch Global Research, BofA Merrill Lynch Bond Indices, US Department of the Treasury. Represents data from March 213 through August 213. Given the impact of central bank driven liquidity on emerging market inflows, it is likely that volatility in EMD will increase as central banks withdraw liquidity. As market volatility increases, illiquidity premium is likely to increase. Investors, such as insurance companies, that can withstand short-term volatility and have a longer-term investment horizon stand to benefit from the illiquidity premium offered by EM corporates (Exhibit 21). Exhibit 21: EM vs. US Corporate Return Comparison 8 7 EM Corporates US Corporates Annualized Return (%) % 5.1% 6.8% 6.5% 6.3% 5.5% 1 3 Year 5 Year 1 Year Source: Bloomberg. As of December 31, 214. EM Corporate is the J.P. Morgan CEMBI Broad Diversified Index and US Corporate is the Barclays US Aggregate Corporate Index. 12 Goldman Sachs Asset Management

13 Role of EMD in an Insurance Portfolio Given that insurers are typically buy and hold investors, trading a lower level of secondary liquidity for a spread premium can add incremental yield to the investment portfolio. Insurers EMD allocations are evolving from a tactical allocation to a long-term strategic allocation. While insurance holdings of EMD have increased, they remain small relative to the total investment portfolio (Exhibit 22). Given that insurers are typically buy and hold investors, trading a lower level of secondary liquidity for a spread premium can add incremental yield to the investment portfolio. US insurers typically hold investment grade bonds at amortized cost and should therefore be able to withstand moderate price volatility in the asset class. Dollar denominated emerging market corporates circumvent the need for currency hedging and can be used to match against US dollar liabilities. Exhibit 22: US Life Insurer EMD Allocations as a Percentage of Total Invested Assets Allocations (%) EMD Sovereigns EMD Corporates 1.1% 1.1% 1.% 1.% 1.2% 1.3% 1.4% 1.5%.5.7%.7%.6%.6%.6%.7%.7%.7% Source: SNL Financial. Data through year-end 213. Middle Market Senior Secured Loans Middle market senior secured loans (middle market loans) offer investors the potential opportunity to capture a spread premium relative to large market syndicated bank loans (large market loans) due, in part, to lower levels of liquidity. The search for yield combined with uncertainty around the path of interest rates has led to record inflows into large market loans which offer higher yields relative to investment grade fixed income as well as interest rate protection through floating rates. Demand for large market loans has driven spread compression across all credit ratings (Exhibit 23). Investor appetite for issuance has fueled a resurgence of covenant-lite deals over the last few years, contributing to an easing of underwriting standards in the large market loan space. Large market loans are fairly liquid as they can trade frequently and pricing is transparent. Exhibit 23: Large Market Loan Average Spread-to-Maturity by Credit Rating L+4 BB-/Ba3 B+/B1 B/B2 B-/B3 CCC+/Caa1 L+35 L+3 Spread (bps) L+25 L+2 L+15 L+1 L+5 L Source: S&P LCD and S&P/LSTA Leveraged Loan Index. Reflects 15 largest names in each category. As of September 214. Goldman Sachs Asset Management 13

14 Middle market loans, in contrast to large market loans, have experienced less spread compression. The middle market is defined as companies with less than $5 million in EBITDA. Lending involves a concentrated and aligned debtor community that directly structures loans with borrowers. Middle market loans have maturities ranging from three to seven years but the average life of the loan is often shorter due to refinancing. The smaller size and private ownership of these companies makes it difficult for banks to trade the debt which results in lower liquidity, and subsequently buyers tend to hold the assets to maturity. As the vast majority of these assets are private and unrated they also have more limited price transparency. Middle Market Loan Fundamentals Although middle market loans are less liquid, they are often higher quality and offer better structural protection relative to large market loans. Although middle market loans are less liquid, they are often higher quality and offer better structural protection relative to large market loans. A simple capital structure with fewer stakeholders enables faster resolution of credit issues as they arise, typically resulting in lower defaults and higher recovery rates. Over the last ten years, the middle market, on average, has demonstrated an 82% recovery rate compared to 8% and 48% for large market loans and high yield, respectively (Exhibit 24). In contrast to middle market loans, large market loans have many participants and more complex capital structures which can make resolution more difficult to achieve. Exhibit 24: Middle Market Loan Fundamental Comparison to Large Market Loans and High Yield Bonds Middle Market Loans Large Market Loans High Yield Bonds Company Size (EBITDA) Less than $5mm More than $5mm More than $5mm Average New Issue Yield % 5.3% 5.71% Total Leverage 7 5.3x 5.8x 6.2x % Cov-Lite 8 32% 72% 1% Defaults 9 1.9% 2.4% 3.9% Loss Given Defaults 1 18% 2% 52% Loss Rate 11.34%.48% 2.3% 14 Goldman Sachs Asset Management 6 Represents average new issue yields for the twelve months ending September 3, 214. Based on middle market and large corporate loan indices per S&P LCD and based on Bank of America/Merrill Lynch Global High-Yield Strategy Index (HA). 7 Based on middle market, high-yield, and large market LBO transactions per S&P LCD for Q3 214 YTD. 8 Covenant-light percentage represents percentage of volume as of September Average LTM default rates (by count) per S&P LCD from September 24 to September Middle markets loss given default data per GS estimates. Large market losses from S&P based on $-weighted ultimate recoveries for all loans from 1987 to Loss rate calculated by multiplying LTM default rates (by count) and loss given default rates cited above. For illustrative purposes only. This information discusses general market activity, industry or sector trends, or other broad based economic, market or political conditions and should not be construed as research or investment advice. There is no guarantee these objectives will be met. Past performance does not guarantee future results, which may vary. Please see additional disclosures.

15 Middle market loans typically employ less leverage than large market loans, and while leverage ratios in the middle market have increased, they remain below those in the large market. The average leverage multiple for middle market loans from 29 to 214 is 4.4x, compared to an average multiple of 5.1x for large market loans (Exhibit 25). Fewer capital providers is resulting in higher yields and more disciplined underwriting in the middle market. While covenant-lite deal volume has picked up in the middle market, representing 32% of deal volume in 214, it is still well below the large market at 72% (Exhibit 26). Covenantlite loans are defined by less stringent incurrence covenants, which require financial ratio tests if the issuer takes certain actions, such as issuing additional debt, paying a dividend or making an acquisition. Middle market loans typically have strong maintenance covenants which require borrowers to maintain debt and cash flow metrics. Exhibit 25: Middle Market vs. Large Market Loan Leverage Comparison 8 Large Market LBO Loans Middle Market LBO Loans Debt / EBITDA (x) x 3.8x 4.8x 4.2x 5.3x 5.4x 4.7x 4.7x 6.2x 5.6x 4.9x 4.5x 4.x 3.3x 4.7x 4.2x 5.2x 4.3x 5.3x 4.5x 5.4x 4.8x 5.8x 5.3x Source: S&P LCD. As of September 214. Exhibit 26: Middle Market vs. Large Market Loan Covenant-Lite Exposure Cov-Lite as a Percentage of New Issue Loan Volume (%) Middle Market Large Market 72% 63% 37% 33% 32% 28% 1% 1% 1% 1% 9% 1% 2% 3% 4% 5% 4% 1% Source: S&P LCD. As of September 214. Goldman Sachs Asset Management 15

16 Supply/Demand Fundamentals The spread premium in middle market loans can in part be attributed to supply/demand fundamentals in the market. Middle market companies have not had the same access to financing as large market companies. This limited supply of capital is reflective of a structural change in the middle market. Prior to the credit crisis, mid-size companies were served by national and regional banks, specialty finance companies, CLOs, and hedge funds. Post-crisis, these funding sources have returned to the large market but not to the middle market. The spread premium in middle market loans can in part be attributed to supply/demand fundamentals. Middle market companies have not had the same access to financing as large market companies. The banking industry experienced significant consolidation, and commercial banks are now facing more stringent regulatory capital requirements under Basel III and other recently adopted regulations. Capital charges for risk assets such as middle market loans have significantly increased. Banks have largely retreated from the middle market and now comprise 1% of total leveraged lending while non-bank investors comprise 9% (Exhibit 27). Middle market companies are generally deemed too small for the high yield market, and the shadow banking sector, including hedge funds and CLOs, remains focused on larger and more liquid bank loans. Exhibit 27: Primary Market for Leveraged Loans: Bank vs. Non-Bank Primary Market Share (%) Banks & Sec. Firms Non-Banks % 1% 214 Source: S&P LCD. As of September 214. Non- banks include institutional investors and finance companies. Exhibit 28: Middle Market Loans Outstanding as a Percentage of All Leveraged Loans % Loans Outstanding (%) % 5.2% 5.7% 4.9%5.% 5.2% 4.8% 5.5% 5.2% 3.7% 3.1% 3.4% 2.3% 2.8% 2.2% 1.2%.7% Source: S&P LCD. As of September Goldman Sachs Asset Management

17 Middle market loan supply remains muted, as outstanding loans comprise less than 1% of total outstanding leverage loan volume (Exhibit 28) and 2% of total leverage loan new issuance volume in 214 (Exhibit 29). Middle market M&A deal activity has not yet resumed to pre-crisis levels (Exhibit 3), but as deal volume increases from its current anemic levels, demand for financing will likely increase. Further, demand for refinancing is also likely to increase as more middle market loans reach maturity (Exhibit 31). Exhibit 29: Middle Market vs. Large Market Loan New Issue Volumes Volume ($ in Billions) Large Market Volume Middle Market Volume as Percentage of Total Middle Market Volume as a Percentage of Total New Issue Volume (%) Source: S&P LCD. As of September 214. Exhibit 3: Private Equity Sponsored Middle Market M&A Deals 25 Number of Deals Source: S&P LCD. As of September 214. Exhibit 31: Middle Market vs. Large Market Loan Maturities Cumulative Loan Maturities as a Percentage of Total Loans Outstanding Middle Market 12% 215 <1% Large Market 19% Source: S&P LCD Leveraged Loan Index maturity breakdown as of October % 26% % Goldman Sachs Asset Management 17

18 Illiquidity Premium in Middle Market Loans The illiquidity premium in middle market loans is evident when they are compared to large market loans of similar credit quality. A less efficient and less liquid market for middle market loans has resulted in higher spreads in comparison to large market loans. Over the last five years, middle market B rated loans have offered on average 13 bps of additional spread over large market B rated loans (Exhibit 32). Middle market loans also offer LIBOR floors similar to large market loans. Over the last five years, middle market B rated loans have offered on average 13 bps of additional spread over large market B rated loans. Exhibit 32: Middle Market vs. Large Market Single B Loans Average Discounted Spread Spread (bps) L+3,5 Middle Market Large Market L+3, L+2,5 L+2, L+1,5 L+1, 656 bps L+5 L+ 529 bps Source: S&P LCD Leveraged Loan Index maturity breakdown as of October 214. Middle Market Lending and Insurance Portfolios Insurance companies with appetite for credit assets with lower liquidity have an opportunity to become capital providers where banks are increasingly leaving a void. The cash flows from middle market loans can be used to back intermediate-dated liabilities such as Single Premium Differed Annuities (SPDAs) that do not require a high degree of current liquidity, though insurers would need to manage the duration mismatch due to the floating rate nature of the loans. Loans can be capital efficient for insurers (Exhibit 33) when rated and held directly on balance sheet as opposed to in a fund vehicle. Exhibit 33: US Statutory Accounting and Risk Based Capital Life Corporate Credit NAIC Rating Accounting Treatment After-Tax RBC A or Above NAIC 1 Amortized Cost.3% BBB NAIC 2 Amortized Cost 1.% BB NAIC 3 Amortized Cost 3.4% B NAIC 4 Amortized Cost 7.4% CCC NAIC 5 Amortized Cost 17.% Unrated NAIC 6 Lower Cost/Market 19.5% Source: S&P, NAIC. As of year-end Goldman Sachs Asset Management

19 Private Equity Insurers can capture illiquidity premium by allocating to smaller, less efficient credit markets or they can increase allocations to assets that are inherently less liquid such as private equity. Private equity refers to equity that is bought and sold in a privately negotiated transaction, is not registered, does not trade frequently and is not listed on an exchange. These investments require a long-term commitment from investors, sometimes 1-12 years, which by definition makes the investment illiquid. Private equity also has limited accessibility and requires investors to fund capital calls. A long lock-up on capital is crucial for private equity managers to generate returns, and investors willingness to accept this lock-up reflects an expectation to receive higher returns. A long lock-up on capital is crucial for private equity managers to generate returns, and investors willingness to accept this lock-up reflects an expectation to receive higher returns. Private equity investments provide exposure to concentrated idiosyncratic risk and return (Exhibit 34). For example, venture strategies enable investors to access niche sources of return and capitalize on investment themes that can be difficult to access through the public markets as these companies are often in an early stage of the business cycle. Leveraged buyout managers focus on implementing value creation strategies such as operational and strategic improvement, aided by the use of leverage. These managers acquire a controlling interest in established companies with the intention of helping the company grow organically or through a buy and build strategy. A buy and build strategy entails acquiring a company of significant size, and adding smaller companies to the initial acquisition in order to create a larger industry player. The strategic plan may include cost restructuring measures, the disposal of non-core assets, or the sale of unprofitable divisions. Exhibit 34: Private Equity Strategies Venture Capital Growth Buyout Invests in young, early stage companies that are often cash flow negative Invests in profitable and growing companies with limited or no free cash flow Helps finance purchase of established companies Distressed Debt/ Special Situation Buys corporate bonds or equity at steep discount of companies that filed or expect to file for bankruptcy Focuses on high growth and innovative sectors/ companies (e.g. telecom and healthcare) Aids company s growth by improving operations, entering new markets, and facilitating acquisitions Builds value by improving profitability as well as acquiring and consolidating businesses Returns typically uncorrelated to economic growth Goldman Sachs Asset Management 19

20 Private Equity Sources of Return Measuring and comparing private equity returns is challenging. Until realization, private equity valuations have an element of subjectivity as they rely on appraisal-based valuations given there is no public exchange. Manager selection is one of the most crucial aspects of private equity investing. This includes understanding the strategy, process, competitive advantage, organizational structure and evaluating the performance record. Manager selection is one of the most crucial aspects of private equity investing, and is often more qualitative than quantitative. The selection process includes understanding the manager s investment strategy, process of the fund, competitive advantage, organizational structure and evaluating the performance record. Top quartile managers are often successful because of a proven investment philosophy, a unique skill set, or a repeatable investment process, which can result in consistent performance. Top performing private equity managers may be in a position to negotiate better deal terms in exchange for access to strong management skills which can help them deliver consistent returns. Private equity manager return dispersion is significantly wider than that of public equity or fixed income managers (Exhibit 35). Exhibit 35: Private Equity vs. Public Equity and Fixed Income Return Dispersion Returns (%) U.S. Fixed Income Upper Quartile Median Bottom Quartile Large Cap Small Cap Int'l Equity All Private Equity Mezzanine Buyout Growth Equity Distressed Venture Real Estate Secondaries Source: Private asset data: Thomson Reuters (public data); Morningstar Principia (public data). As of June 3, 214. Note: Private equity fund returns are compared with 4-year annualized average returns of public funds, realized over a period starting one year after the private equity fund vintage year. This lag and time-averaging is done in order to take into account the private equity investment period and long time-horizon over which private returns are realized. Private equity data is for funds raised between 199 and 213, with returns as of June 3, 214. The data for public fund returns are over the years 199 through 213 and are chosen by matching the MorningStar category to the market designations listed in the chart (i.e. they are not necessarily benchmarked to an index which covers the respective market). 2 Goldman Sachs Asset Management

21 The investment horizon and illiquid nature allows successful private equity managers to implement longterm operational and strategic improvements aimed at delivering sustainable growth and improving earnings. The investment horizon and illiquid nature of the asset class allows successful private equity managers to implement long-term operational and strategic improvements aimed at delivering sustainable growth and improving earnings. The ability to successfully implement these strategies can lead to the outperformance of private equity-backed companies over comparable public market companies. In contrast, public companies that are subject to frequent evaluation by investors can find it difficult to implement longer-term strategies that may impact shorter-term profitability. Daily price volatility, analyst estimates, and shareholder lawsuits result in public companies having a shorter-term focus. Role of Capital Markets and M&A in PE Liquidity Private equity returns often move in tandem with broad credit and equity cycles. Liquidity in private equity is typically found through a public exit such as an initial public offering (IPO) or through a strategic sale. Private equity is highly correlated to public equities given its reliance on the public equity market for realizations. Healthy equity capital markets are important for driving realizations either on a comparable basis for M&A activity or for a public exit valuation via an IPO. When public market conditions are more challenging, strategic sales are more prevalent relative to IPOs. Leveraged buyout cycles are tied to credit markets, as a lower cost of financing can result in higher returns. Periods of lower market liquidity are likely to coincide with periods when private equity managers find it difficult to finance their investments, which can result in lower valuations with attractive entry points but lower exit multiples. If private equity managers cannot access financing or have difficulty refinancing, they may be forced to liquidate or sell at lower valuations. Improving market conditions have benefited portfolio companies that were negatively impacted by the crisis but have since regained value and have found profitable exits. This highlights the benefit of a long-term investment horizon as private equity managers are able to hold companies and reposition during cyclical downturns to materialize a successful exit. Goldman Sachs Asset Management 21

22 Private Equity in an Insurance Portfolio Private equity allows insurers to capitalize on a structural advantage to provide liquidity where individuals, banks, and other institutional investors are less willing or able. Alternative assets such as private equity can play an important role in an insurer s surplus portfolio and/or to fund the tail of long-dated liabilities, particularly in an environment with low current bond yields. Insurance companies can benefit from diversifying traditional fixed income risk and should seek equity risk premium to match, in part, against the tail of long-term liabilities or surplus capital. Insurance companies can benefit from diversifying traditional fixed income risk and should seek equity risk premium to match, in part, against the tail of long-term liabilities or surplus capital. Life insurers have relatively small equity allocations (Exhibit 36) and generally have the capacity to take more equity risk. High equity investment capital charges under US Risk Based Capital (RBC) guidelines deter investments as the post-tax capital charge for private equity investments is 19.5%. However, if we assume a US life insurer holds the industry average equity allocation of 3.3%, adding incremental equity exposure can result in a lower risk based capital charge due to a co-variance adjustment in the life RBC formula for diversifying investment risk (Exhibit 37). Exhibit 36: US Life Insurer Private Equity Allocations as a Percentage of Total Invested Assets Allocations (%) % 1.6% 1.6% 1.6% 1.7% 1.8% 1.9% 1.9% Source: SNL Financial. Data through year-end 213. Exhibit 37: US Life NAIC RBC: Effective Capital Charge Post-Diversification Effective Capital Charge (%) Equity Capital Charge Pre Diversification Equity Capital Charge Post Diversification Additional Investment (% of Portfolio) Source: SNL and GSAM calculations. As of year-end Goldman Sachs Asset Management

23 Conclusion Insurance companies have an opportunity to earn an illiquidity premium in a market environment where liquidity is increasingly scarce and where the compensation for interest rate and credit risk is limited. Healthy balance sheets with strong capital positions along with longer duration, predictable liabilities provide some insurers the flexibility to sell liquidity by allocating to assets that offer incremental returns over more liquid assets. Depending upon the risk tolerance, there are various asset classes that can offer compensation for taking liquidity risk. Investment grade emerging market corporates offer excess spread over comparable developed market corporates. Middle market loans enable insurers to take advantage of a dislocation in the supply of capital to earn a premium over larger, more liquid loans. In exchange for long-term patient capital, private equity provides equity risk premium, diversification from fixed income risk, and excess return over liquid assets. Contributors Farzana Morbi Vice President, Insurance Investment Strategist Stephen Smith Vice President, Insurance Strategist Nina Onsager Analyst, Insurance Investment Strategist Goldman Sachs Asset Management 23

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