As a large lender in private markets, Aviva Investors has access to a pool of proprietary data they use to analyse market trends and enhance investment decision making. The data shows that during economic downturns or periods of market stress, illiquidity premia tend to be squeezed as private debt markets reprice at a slower rate than public market equivalents. This observation has held firm through the most recent interest-rate hiking cycle and sharp tightening in financial conditions.
We can see the impact on illiquidity premia over the last 17 years across all asset classes, although the extent depends on the sector and nature of individual transactions (see Figure 1). Recently, illiquidity premia in real estate debt have been squeezed in line with the real estate cycle (shown in green), and refinancings are seeing steadier flow than new deal activity. In contrast, premia have increased in infrastructure debt over the past year (blue), with deal flow remaining steady and non-discretionary projects proceeding as planned.
Further deal activity is expected in the coming months, as the realisation of a higher-for-longer interest-rate environment sets in. Given the macro headwinds, lenders will likely remain cautious, paying close attention to debt terms and fundamentals.
A key takeaway from our proprietary model is that illiquidity premia are not static variables but have elements of cyclicality. This is important from an origination standpoint and can help establish a view as to the direction illiquidity premia will take.
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- Real estate debt spreads tend to be the most “sticky”, resulting in illiquidity premia that have historically been most correlated to the real estate cycle. Real estate debt illiquidity premia tend to compress (and can turn negative) when real estate capital values decline, and then typically recover as real estate valuations rise.
- Private corporate debt spreads tend to be the least sticky and re-price the fastest to public credit spreads. Given this, illiquidity premia tend to remain in a narrower range over the long term. Some of the highest illiquidity premia have tended to occur during periods of higher market volatility and/or lower capital availability from more traditional lending sources.
- Infrastructure debt spreads tend to be moderately sticky, and re-price more gradually to public markets. Illiquidity premia tend to be highest during periods of economic recovery.
Looking forward, we expect real estate debt illiquidity premia to recover over 2024 and into 2025, alongside a recovery in real estate valuations. In our view, opportunities are currently most attractive in thematically resilient sectors such as living and industrials. Additionally, we see selective opportunities in whole loans.
We also believe private corporate debt and infrastructure debt should continue to generate attractive illiquidity premia in the coming months given the restrictive lending environment from more traditional sources of capital. A key risk to illiquidity premia in the short term would be a worse-than-expected recession, resulting in a sharp repricing of credit risk, with private market spreads lagging public markets.
Our methodology
For our illiquidity premia analysis, we track every deal undertaken across our real assets franchise and, from there, identify the appropriate public market benchmarks for each sector.
It is this delta between our private transactions and the commensurate public proxy which each dot in Figure 1 indicates.
It also means the data and trends created are based purely on observations from our proprietary dataset. More importantly, it enables cross-sector illiquidity premia to be compared directly. From here, we use local regression techniques based on the data points in the sample to smooth the data points into the trend shown on the chart.
Infrastructure debt
Higher for longer is beginning to drive further activity
Q3 infrastructure markets remained relatively stable. Deal flow has been steady throughout the year with more activity in euro than sterling markets as demand from lenders remains strong, despite the macroeconomic challenges.
As we reach the end of the hiking cycle, the realisation of a likely higher-for-longer scenario is beginning to drive further activity. Equity valuations are now reacting to the macroeconomic environment, after proving sticky earlier in the year. There remains an absence of discretionary financing and M&A activity, with only a few refinancings driven by the expectation that short-term rate changes are unlikely. Borrowers have remained active, partially due to the non-discretionary financing requirements inherent for infrastructure.
While the pathway to net zero remains a major focus for investors, particularly in energy and digital infrastructure, renewable energy deals are not yet coming to market in the volumes needed. However, more opportunities are expected to emerge over the coming years as investment increases in carbon capture, nuclear power and renewables.
Elsewhere, the UK fibre sector is seeing increased challenges as a result of reduced bank lending. Meanwhile, deal flow is expected to increase for the transport sector, as investors seek to reduce the level of equity built up during COVID-19.
Real estate debt
Bifurcation between prime and non-prime stock
Commercial real estate debt activity has remained slow in the second half of this year, continuing the trend from the first half as decision makers grappled with the higher inflation, higher rates world. Volumes remain low given that finance costs are often non-accretive. However, the expectation is that there will be an increased sense of urgency as investors come to terms with a higher-for-longer rate environment.
Lenders remain cautious, paying close attention to leverage, debt service levels and sustainability. Markets are not closed; borrowing terms are being adjusted and leverage is being reduced, while there is also less appetite for single big-ticket transactions.
We have seen significant valuation repricing in some sectors. A bifurcation can be seen between prime and non-prime stock, particularly in offices. Prime stock is experiencing strong letting activity, whilst non-prime has experienced significant valuation declines. Lenders are negative around offices generally, so any large refinancings could prove challenging.
In industrials, the underlying income performance and occupier demand suggest a resilient outlook in certain locations. Other areas we have strong conviction in are those with resilient underlying tenant and investor demand, for example parts of the living sector, such as build-to-rent and student accommodation, and life sciences. Retail has generated mild interest amongst investors as the sector has seen a marginally improved outlook.
Structured finance
Unwinding of central bank funding could generate opportunities in guaranteed loans
Structured finance opportunities in emerging markets featuring credit guarantees by sovereigns are seeing increased activity. These opportunities are becoming prevalent as the need for essential infrastructure remains, but credit spreads have widened for emerging-market economies.
Opportunities continue to be driven by the unwinding of central bank COVID-19 funding programmes. As a result, a number of collateral swap portfolios have returned to the market. Given the rise in rates, we expect banks to move to an originate-to-distribute model as opposed to loans remaining on balance sheet. This will also give access to low-risk, low-return opportunities, such as in the guaranteed loan market, thanks to the positive illiquidity premium.
This could be an entry point for flexible capital to take advantage of higher spreads, which in many cases reflect the higher cost of funding of market participants as opposed to increased risk. Elsewhere, asset-backed securities (ABS) which are not matching adjustment-eligible have seen spreads widen. In addition, increased opportunities are being seen for rarer matching adjustment-eligible ABS securities, as ABS issuers seek alternative sources of financing.
Note: The illiquidity premia calculated is based on our proprietary deal information. There are various methodologies that can be employed to calculate the illiquidity premium; the data in this report is illustrated against gilts.
