The benefits and challenges of distressed debt investing for insurers
The main advantages to be gained from distressed debt investing include capital efficiency, risk and return diversification and high cash income, says Eddy Verbiest, former Assets & Liabilities Manager at Fidea.
Sara Benwellposted on Monday, April 12, 2021
Insurance Investor: What are the range of advantages and challenges to investing in distressed debt and special situations as an insurer and what are the possible solutions?
Eddy: Firstly, it has excellent capital efficiency, this is the case for private debt funds in general but going up in the risk range to distressed debt it becomes even more so.
Typically, you have net return around 12-15% and typically for a distressed debt fund you have a capital cost of something like 25% in spread cost, 2-3% equity cost and 25% if everything is in dollars as currency cost, but currency diversifies away nearly completely so that in all you have about 7% currency cost left.
This gives you a capital efficiency if you take all diversification into account of around 60%: 20% capital cost including diversification with liabilities for 12% net return, so 60% capital efficiency which is way above what you normally set as limit when going to alternatives.
“It has excellent capital efficiency”
Besides the capital efficiency it is an asset with excellent return with gross returns of 15%-20%.
There is also excellent risk and income diversification in the sense that high yield and distressed debt tends to be counter-cyclical which means that if you have market stresses, these provide opportunities because spreads tend to widen more than subsequent losses would warrant.
This means that in principle it is a very good risk diversifier as risk is somewhat misperceived by the market.
With any individual situation the risk is of course high but in the portfolio context, spreading investments and looking for the best opportunities, it is more counter-cyclical and therefore offers good diversification.
“Besides the capital efficiency it is an asset with excellent return with gross returns of 15%-20%”
You also typically have high income of 8% to 6% of cash income which is always very nice.
It is a very efficient way for insurers to harvest the illiquidity premium because insurers always have liquidity to sell.
Also, the economic context is still quite good as with Covid there is a lot of uncertainty which could lead to opportunities.
Banks are still deleveraging, there is still a low interest rate environment, there are more covenant light deals around, and high leverage. All this is the seed for opportunities in the distressed space.
“Once you are set-up to account and treat fiscally one fund, you are also set up for these kind of illiquid funds”
There are a lot of advantages but of course there are challenges. On the accounting and fiscal side, if you have no investment in any fund yet, then you have to set-up to invest in these funds.
In my experience and certainly in Belgium, there is no different fiscal or accounting treatment for illiquid funds like debt funds from any other fund with legal personality.
So, once you are set-up to account and treat fiscally one fund, you are also set up for these kind of illiquid funds.
“The thing that is mostly lacking for these illiquid funds is an estimate of the fair market value”
The main issue that there could be more to do with fund management. It is absolutely necessary that when you have capital calls and distributions that there are very clear indications by the fund manager on what is cost, income, redemption and fees.
Once you know exactly what you are paying for and receiving then the accounting department will have no problem with it as all is then very clear.
The thing that is mostly lacking for these illiquid funds is an estimate of the fair market value because Solvency II and accounting need it.
Fair value appraisal means that you need to make an estimate of the market value that because it is illiquid is rather irrelevant for the fund manager and for the market but regulations and accounting will still need this.
“It is crucial that the fund clearly separates cost redemption from income, fees, and that it provides a fair market value estimate”
In my experience, if the fund manager makes an estimate and they are audited, the audit of the insurer and the regulator will have no problem in accepting these estimates.
When you have to do it yourself, let’s say when you get the annual report of the fund or when you have a lot of information but not an estimate of the market value, it is always cumbersome.
In principle, you do need a fair value estimate on a regular basis. We did a monthly closing so had a preference for monthly but if it is a quarterly or semi-annual estimate it will do.
It is crucial that the fund clearly separates cost redemption from income, fees, and that it provides a fair market value estimate.
“Another factor that could be challenging for first time investors in these funds is the level of fees”
Of course, the estimate needs only to be a best effort estimate, not intended for actual trading.
Another factor that could be challenging for first time investors in these funds is the level of fees, typically 1.5% or more and a 20% performance fee over 6%-8% which could deter some investors from investing.
Given the returns and the kind of expertise and work that is needed in order to identify these opportunities these fees shouldn’t really be a problem.
The real challenge is more about providing room in your risk appetite to go into alternatives and to have illiquid investments.
This is part one of a series. In part two, Eddy Verbiest, former Assets & Liabilities Manager at Fidea explores how to establish currency hedging tools and deal with the accounting and reporting challenges in distressed investing. Click here to read part two.