As banks continue to retreat from privately negotiated deals in the wake of the global financial crisis, some buy-side investors are now looking to move in.
The risks of investing in such illiquid markets can be high but the opportunity is too big to ignore, delegates at the AsianInvestor's 11th Asian Investment Summit heard last week.
“One of the favourite sayings inside Pimco is do what banks can't do – that is disintermediate the banks,” Scott Steele, head of the institutional business for California-headquartered Pimco in Asia excluding Japan, told the audience.
Before 2008, banks in both the US and Europe could deliver a return on equity of around 15%, he said. But that has now has fallen under 10% (or 8.6% in the first quarter, in the case of US banks), he said.
“That differential of profit is worth about $85 billion and €200 billion [in the US and Europe, respectively]. Somebody out there is going to earn that money,” said Steele, who was speaking on a panel on the attractiveness of alternative investments versus public markets.
New rules designed to make banks safer following the global financial crisis have restricted their ability to take advantage of market inefficiencies in more illiquid markets. Meanwhile, real money accounts are keen to invest in unlisted, illiquid instruments for a variety of reasons such as diversification or return enhancement.
Peter Ryan-Kane, who heads portfolio advisory at Willis Tower Watson, a global insurance broker and financial consultancy, cautioned against most buy-side investors leaping into new markets without carefully assessing the risks.
"If anyone thinks that asset managers are going to be the new banks then we should all be a bit worried," said Ryan-Kane, who traded Asian debt in the mid-1990s and recalled when liquidity dried up sharply.
He noted that the basic mindset of banks when putting money to work is different to other investors. Banks look to earn a premium on lending over and above their cost of capital while asset managers are trying to earn a yield beyond that on, say, government bonds. Regulators also do not require them to hold a capital cushion against such investments.
“I have yet to see an asset manager in the market talking about yield minus loss,” Ryan-Kane said.
The added complication is that banks’ retreat as middlemen in many markets due to tougher regulation, namely Dodd-Frank and Basel III rules that make holding inventory and financing positions more expensive, has meant that Asian markets have become more illiquid, potentially resulting in extreme price movements.
“What was liquid has become illiquid,” Ryan-Kane said.
The illiquidity premium, the compensation investors enjoy for putting their money in such stop-start markets, is the lowest it has been for about 15 years, according to research by Willis Tower Watson. On average, the firm regards the general level of available illiquidity risk premia on the assets it measures to be moving towards the lowest end of its fair value range.
Buy-side interest in these markets pre-dates the global financial crisis but if that interest is now growing it is happening at a time when the maths needed to make it work has become highly demanding.
Hideo Kondo, the asset management director of Tokyo-based DIC Pension Fund, a corporate pension fund that manages $1 billion of assets and targets a return of 3.5%, said he had been investing in unlisted instruments since 2004.
“We suppose a 60% probability to win in private markets so we need a double-digit return to protect our investment in private markets,” Kondo said at the conference.