Alternative credit and its asset classes A guide to understanding the complex universe of private debt assets First edition, May 2017 For professionals Important disclosure: The opinions expressed and conclusions reached by the authors in this publication are their own and do not represent an official position. The publication has been prepared solely for the purpose of information and knowledge-sharing. Neither NN Investment Partners B.V., NN Investment Partners Holdings N.V. nor any other company or unit belonging to NN Group make no guarantee, warranty or representation, express or implied, to the accuracy, correctness or completeness thereof. Readers should obtain professional advice before making any decision or taking any action that may affect their finances or business or tax position. This publication and its elements may contain information obtained from third parties, including ratings from credit rating agencies. Reproduction and distribution of (parts of) this publication, logos, and third party content in any form is prohibited, except with the prior written permission of NN Investment Partners B.V. or NN Investment Partners Holdings N.V. or the third party concerned. © 2017 NN Investment Partners is part of NN Group N.V. NN Group N.V. is a publicly traded corporation, and it and its subsidiaries are currently using trademarks including the “NN” name and associated trademarks of NN Group under license. All rights reserved. Alternative credit and its asset classes A guide to understanding the complex universe of private debt assets Table of contents Preface ...............................................................................................................................................................6 1. Introduction .................................................................................................................... 8 2. The history and rise of alternative credit .....................................................................11 2.1. The shift towards the capital market ......................................................................................... 11 3. Asset categories: categorisation can be multi-dimensional .....................................13 4. Key stakeholders in the financial ecosystem .............................................................19 4.1. Asset managers: managing loans with diversified perspectives ................................... 20 4.2. Fintech: the digital transformation in the financial sector ................................................22 5. The role of banks.......................................................................................................... 29 6. Key reasons to invest in alternative credit ................................................................ 32 6.1. Pick-up in return, better downside protection .......................................................................32 6.2. Diversification and low correlation to other asset classes ...............................................34 6.3. Defensive asset class in volatile environment and natural inflation hedge ...............34 6.4. Ability to apply ESG ..........................................................................................................................34 6.5 Matching liabilities ............................................................................................................................34 6.6. How can alternative credit improve risk-adjusted returns and enhance income? .... 35 6.7. Formats for investing in alternative credit .............................................................................. 39 7. The approach to alternative credit investments ....................................................... 42 7.1. The triangle approach to alternative credit ............................................................................44 7.2. Cash flow pattern of the loan ...................................................................................................... 46 7.3. Tenor and flexibility .......................................................................................................................... 48 7.4. Expected return of the loan .......................................................................................................... 50 7.5. Expected loss of the loan .............................................................................................................. 53 7.6. Expected loss (EL): risk-adjusted return ................................................................................. 60 7.7. Management costs .......................................................................................................................... 64 7.8. Net return after management fee .............................................................................................. 66 7.9. Capital and other charges related to investments ............................................................. 66 7.10. Liquidity, volatility and portfolio diversification .................................................................... 68 7.11. Complexity: the intellectual and sourcing premium in private debt ..............................73 Guidebook: Alternative credit and its asset classes 4 8. How to incorporate alternative credit in the matching portfolio ..............................77 8.1. What is liability-driven investing? ...............................................................................................78 8.2. What does a liquid matching portfolio look like? ..................................................................79 8.3. Specific characteristics of alternative credit and the impact on LDI strategies .... 80 8.4. Illiquidity ................................................................................................................................................ 81 8.5. Expected and unexpected repayment..................................................................................... 83 8.6. Valuation of private debt ............................................................................................................... 84 8.7. What private debt asset classes are suitable for a matching portfolio? .................... 84 8.8. The impact of private debt on risk-adjusted net returns .................................................. 86 9. Key sub-asset classes in alternative credit ............................................................... 88 9.1. Government-Guaranteed Loans ................................................................................................ 89 9.2. Infrastructure Debt .......................................................................................................................... 94 9.3. Leveraged Loans .............................................................................................................................103 9.4. European Residential Mortgages ..............................................................................................107 9.5. European Commercial Mortgages .............................................................................................114 9.6. Private Placements ..........................................................................................................................118 9.7. Direct Lending ..................................................................................................................................122 10. Conclusion ...................................................................................................................126 Authors ..........................................................................................................................................................127 Acknowledgements ..................................................................................................................................129 Appendix 1. Key legal documents in private debt .........................................................................130 Glossary of terms ........................................................................................................................................131 List of figures ...............................................................................................................................................134 List of tables ................................................................................................................................................136 Bibliography .................................................................................................................................................137 Guidebook: Alternative credit and its asset classes 5 Preface Alternative credit offers investors a variety of opportunities for earning income and provides them with the benefits of portfolio diversification. It is an emerging asset class that was formerly dominated by the banking sector. Clearly, navigating and comparing the benefits of individual products remains challenging. The purpose of this guide is to enable investors to adopt a structured approach to the benefits and risks of the individual sub-asset classes by providing a framework for comparing most of the key features. This book is the result of the combined efforts of the Alternative Credit and Integrated Client Solutions teams at NN Investment Partners. It does not contain any investment advice, nor does it make recommendations on the suitability of any