Read this article to understand:
- How the current macro environment is reflected in private market illiquidity premia across debt asset classes
- Drivers of debt activity and demand over the past 12 months
- Opportunities available across private debt asset classes
At the start of 2024, our portfolio managers and private markets research team flagged some of the pricing opportunities that had emerged in the private debt universe as a legacy of an uncomfortable period of high inflation, high borrowing costs and slower growth (see Rents, rates and the refinancing gap).1
Since that point, there’s been a general uptick in deal activity as central banks have started cutting interest rates alongside continued optimism that a “soft landing” will be achieved. Here in our latest deep dive, we highlight what the implications are for private debt illiquidity premia, as well as where we are seeing opportunities.
Using illiquidity premia to assess relative value
In private debt markets, illiquidity premia (“ILP”) are a key factor in assessing relative value between private sectors as well as versus public debt. For investors who can provide long-term patient capital, these premia represent the potential to harvest additional returns from investing in private debt, while also enabling investors with a “multi-sector” or opportunistic approach to take advantage of relative-value opportunities between private debt sectors and pricing dislocations versus public markets.
Our dataset and approach to measuring illiquidity premia
Our dataset encompasses over 2,000 private debt transactions over a 27-year period. It covers sterling and euro investment-grade (IG) deals only, covering mostly internal transactions but also external transactions where we were able to obtain pricing data.
The illiquidity premia output captures the spread premium over the most relevant reference public debt index (ICE BofAML index data) at the point of transaction, represented as dots in Figure 1. The illiquidity premium represents an additional spread (which is not always positive) over public debt markets to compensate for increased illiquidity and/or complexity risk. Figure 1 also includes the discrete calendar-year average illiquidity premium, which equally weights the underlying transaction data.
The key risk warning of this output is that the calculated illiquidity premia are rating-band (not rating-notch) matched and are also not duration/maturity matched to the relevant reference public debt index. Therefore, the illiquidity premia shown are indicative.
Figure 1 shows that since 2022 average illiquidity premia have improved across all private debt sectors. The key driver of this has been a backdrop of tightening public debt spreads (around 85 basis points since the middle of 2022) while private debt spreads have held relatively firmer.2 Tightening public credit spreads reflect market optimism of a “soft landing” outcome with the Bank of England, European Central Bank and US Federal Reserve all now starting to cut base interest rates.
In 2024, private debt illiquidity premia started high, but have trended back towards long-term average levels. A key factor here has been less restrictive bank lending resulting in increased competition for assets.
Figure 1: Illiquidity premia in private debt to Q3 2024 (basis points)
Past performance is not a reliable indicator of future returns
For illustrative purposes only. The value of an investment can go down as well as up and there is no guarantee that the forecasted return will be achieved.
Note: The illiquidity premia are calculated based on Aviva Investors’ proprietary deal information. There are various methodologies that can be employed to calculate the illiquidity premium. Please note that the illiquidity premia shown are measured against broad relevant public debt reference data, are rating band (not notch) matched and are not duration/maturity matched.
Source: Aviva Investors and ICE BofA Sterling and Euro Investment Grade Corporate indices. Data as of September 30, 2024.
A key takeaway we draw from this data is that illiquidity premia are not static and vary through the market cycle. Secondly, illiquidity premia across the various private debt sectors do not move in tandem, reflecting different dynamics through market cycles.
Private debt spread dynamics
An important driver of pricing dynamics is the “stickiness” of private debt sector spreads versus public debt.
- Real estate debt spreads tend to be the most “sticky” resulting in illiquidity premia that have historically been correlated to the real estate cycle. Real estate debt illiquidity premia tend to compress when real estate capital values decline, and then typically recover as real estate valuations rise.
- Infrastructure debt spreads tend to be moderately sticky, and re-price more gradually to public debt markets.
- Private corporate debt spreads tend to be the least sticky and re-price the fastest to public debt markets. Given this dynamic, illiquidity premia tend to remain in a narrower range over the long term. Also, some of the highest illiquidity premia have occurred during periods of higher market volatility, especially when there is less capital available from more traditional lending sources.
Figure 2 sets out these spread dynamics in more detail. The implication is that when investing in private debt, a multi-asset approach can be beneficial and allow investors to take advantage of relative value pricing opportunities between sectors.
Figure 2: Pricing dynamics across private debt sectors
Past performance is not a reliable indicator of future returns
Note: ILP = Illiquidity Premia.
Source: Aviva Investors, 2024.
Across private debt sectors, we are typically seeing more attractive illiquidity premia for euro private debt sectors with, however, higher “all-in” yields for sterling private debt sectors given the differential in sterling and euro risk-free rates.
We believe illiquidity premia in thematically resilient sectors such as living and industrials should continue to show resilience in 2024
For real estate debt, we believe illiquidity premia in thematically resilient sectors such as living and industrials should continue to show resilience in 2024. We continue to exercise caution regarding non-prime assets, particularly in the office sector.
A key risk to illiquidity premia in the short term would be worse-than-expected gross domestic product (GDP) growth or an unexpected spike in inflation. In these scenarios, it is likely credit risk would sharply reprice, with private debt spreads typically lagging public markets.
Infrastructure debt
Activity remained focused on energy and digital infrastructure
Despite the usual relatively quiet summer period, Q3 2024 infrastructure debt activity across Europe showed around a 30 per cent increase on Q2 2024 with total debt volume at £35 billion.3
UK sector activity remained strongly influenced by fibre broadband
The major contributor to this was Italy, which made up nearly one‑third of this activity due to the acquisition financing of the Telecom Italia fixed network by KKR. UK volume was down, just below £4 billion for the quarter. UK sector activity remained strongly influenced by fibre broadband, which accounted for around half of the 20 deals closed in the quarter.
The largest deals related to the refinancing of the Phoenix Gas Networks in Northern Ireland post the acquisition by CK Infrastructure Holdings, the HoldCo refinancing of Manchester Airport, and the refinancing of the Zayo Europe fibre network, which is a US/European entity.
Pricing in the market started to tighten with the potential for a lot of deal flow in Q4 2024 as issuers try and get ahead of the US election and potential further macroeconomic volatility.
Real estate debt
Activity levels and sentiment improve; margins tighten
During Q3 2024, we saw a continued improvement in both activity level and sentiment from Q2 2024. Notwithstanding the usual summer lull, we saw an uptick in financing enquiries not just for refinancing but also to fund acquisitions.
Sentiment amongst lenders has improved and there is strong appetite from a wide range of banks and other lenders
In many ways this reflects the wider increase in transaction volumes across the market, although refinancing activity remains an important factor. Sentiment amongst lenders has improved and there is strong appetite from a wide range of banks and other lenders.
During the quarter, we saw a return of larger transactions, with several deals of £150 million or more completing or coming to market. There was also a return of appetite for a wider range of underlying asset types, with strong competition seen in shopping centre, regional office and open storage sectors. In conjunction with this significant uptick in appetite, we saw margins across the market tighten.
Private corporate debt
Downward pressure on corporate spreads
In the private corporate debt space, we continue to see downward pressure on both corporate spreads and issuance volumes. Issuers are hesitant to lock-in heightened long-dated all-in yields and are instead opting for bank-style short-dated floating rate financing structures.
Sub-IG corporate spreads remain wide, reflecting a heightened risk of default
Most new issuances focused on refinancings. Sub-IG corporate spreads remain wide, reflecting heightened a risk of default.
As long-term rates start to stabilise, we expect to see more issuances relating to capital expenditure. However, it is too early to say if the activity will result in spreads widening as there is increased competition from insurers that comply with matching adjustment rules for long-dated issuances.
Structured finance
Opportunities in emerging markets and fund financing
Emerging market borrowers, particularly in Africa, are coming under budgetary pressures due to the higher interest-rate environment. As a result, we are seeing increased issuance levels with export credit agencies and multilateral covers. The borrowers are now starting to use matching-adjustment eligible structures to invite interest from the insurance sector and diversify funding sources.
The credit spreads in securitised market have bounced back and are at all-time lows
Credit spreads in the securitised market, particularly highly-rated tranches of Collateralised Loan Obligations, have bounced back and are at all-time lows. We see better relative value in mezzanine tranches where spreads have not compressed much.
Fund financing as an asset class is offering a significant illiquidity premium. M&A activity is subdued, and funds are using fund-level leverage to delay asset sales. As a result, the importance of fund finance as a liquidity management tool is increasing.
