The financial crisis drained the coffers of the banking industry, and has led to a great deal of additional regulation in the financial sector. That in turn has led many banks and other financial institutions to change their borrowing policies and reduce their exposure to higher-risk loans.

A recent report from global professional services firm Towers Watson highlights that the increased regulation of the financial sector has resulted in a diminished bank lending capacity, and by the same token,  created a new opportunity for institutional investors to step in and provide capital in the illiquid credit markets.

In the report, TW’s Gregg Disdale and Chris Redmond emphasize the potential of the global illiquid credit markets: “The available opportunity set is changing rapidly as strict regulation of the financial sector has led to a loss of bank lending capacity, and as such created an opportunity for institutional investors to step in and provide capital in illiquid credit. Institutional investor appetite for illiquid credit has grown since the global financial crisis, attracted by the higher return potential versus traditional credit and the opportunity created by reduced bank lending capacity. However…we believe there is significantly greater scope for investors to consider illiquid credit as a meaningful part of both low-risk and return-seeking portfolios, indeed we view this as an excellent opportunity for clients with a tolerance for illiquidity and a desire to improve overall portfolio efficiency.”

Defining illiquid credit

Illiquid Credit Markets

Illiquid credit (a form of private debt) is a part of the broader alternative credit space, and refers to non-traditional asset classes with a limited ability to sell prior to maturity. The illiquidity risk premium is a big part of the overall investment performance, and investors may have to pass up other investment opportunities and secure other liquidity sources.

Illiquid Credit Markets

In Figure 2, the illiquid credit opportunities are grouped based on their risk/return characteristics, with the headings describing the roles illiquid credit can play in a portfolio. At one end of the spectrum, infrastructure debt is a viable alternative to traditional investment grade credit, and can provide a low-risk, long-term cash-flow stream for the liability-matching program of a pension fund or insurance firm. On the other end of the range, there are opportunities like distressed debt, which seek a return at least equal to that of equities, and thus could compete for capital with private equity.

Three reasons to consider illiquid credit

  1. First, tailwinds for the illiquid credit markets remain compelling — The heavy regulatory burden is forcing banks to divest some assets and business lines, or partner with alternative providers of capital to maintain profitable business lines while complying with new Tier 1 capital requirements. Consider the large opportunity from European bank asset sales, for example, with PwC projecting €100 billion in activity in 2015 (compared to €80 billion in 2014). Institutional investors are likely to acquire some of these assets that provide high levels of cash-flow and lower sensitivity to the credit cycle.
  2. Illiquid credit also offers access to often poorly utilized return sources (illiquidity, skill and complexity premia) and an improvement in the diversity of the portfolio.
  3. Finally, illiquid credit allows for the diversification of sources of credit risk (a key consideration at this point in the economic cycle). TW suggests looking at middle market direct lending and European real estate debt as two potential areas for credit risk diversification.