private-lending

2018/08/29

Summary

The promissory note loan (Schuldscheindarlehen, SSD) continues to be used increasingly by corporates as a financing instrument. Even outside the banking market, the instrument is gaining importance for investors via private lending. As a result, a classic form of investment used by insurance companies could possibly be on the brink of re-invention as an alternative asset class.


Update Magazine II/2018
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Capital investment by insurance companies – regulated for more diversification

From a historical viewpoint, insurance companies were very conservative investors, especially life insurers. They invested the money received from their policyholders mainly in longterm government bonds or local quasi-government issuers. Safety, liquidity and profitability were prioritised (Section 54 of the German Insurance Supervision Act [Versicherungsaufsichtsgesetz, VAG] [old version] Investment principles for restricted assets).

On the other hand, insurance companies have developed and re-defined themselves and their capital investments to cope with changes in the conditions in capital markets. In doing so, they have taken new and sometimes innovative paths to fulfill their product claim, i.e. to generate the guaranteed rate of return for their customers, the policyholders, and ideally a respectable surplus return.

This can be clearly followed in the development of the Regulation on the Investment of the Restricted Assets of Insurance Companies (Investment Regulation: Anlageverordnung, AnlV) in Germany in the context of the Insurance Supervision Act (VAG) and the supplementary circulars published by the Federal Insurance Supervisory Office (Bundesaufsichtsamt für das Versicherungswesen, BAV) and, since May 2002, by the Federal Financial Supervisory Authority (BaFin). The latter throw even more light on the changes in the general conditions for capital investments by insurance companies, as they are constantly revised, adapted or replaced.

Under the “former Solvency I” regime, there were “precisely” defined quantitative limits as to how much was permitted to be invested in specific asset classes to cover the guarantee assets. These limits were laid down in the Investment Regulation, and further specified in the relevant circulars and, in some areas, also extended.

The volatility of capital markets over the last two decades, and the low interest rate environment since the financial crisis, compelled insurance companies to broaden their range of investments in order to derive even more benefit from diversification. The trends in the capital markets, in particular the performance of derivatives and structured products, opened up many new investment opportunities. Insurance companies made use of these opportunities to service their liabilities, which are very long term in some cases, or to generate additional income.

In order to address these developments, Circular R 3/1999 (Information on investing in structured products) and Circular R 3/2000 (Information on preemption and use of derivative financial instruments) were implemented at that time. Due to the introduction of financial innovations such as asset-backed securities (ABS) and credit-linked notes (CLN), Circular R 1/2002 (Investments in asset-backed securities and credit-linked notes) was brought in. With the aim of offering insurance companies even more options for diversification, the Circular on hedge funds, R 7/2004, was introduced in 2004. In the course of time, other asset classes such as private equity were also adopted in the Investment Regulation, even if only under strict adherence to defined risk ratios. The requirements in the Investment Regulation were then specified in another Circular, with the latest version published last December (Circular R 11/2017, previously R 15/2005, R 4/2011).

The volatility of capital markets over the last two decades, and the low interest rate environment since the financial crisis, compelled insurance companies to broaden their range of investments in order to derive even more benefit from diversification.

Solvency II and the interest-rate differential at the reinvestment stage

With the introduction of Solvency II, all these requirements no longer apply. They make room for risk-based solvency rules for the capital resources of insurance companies, and qualitative requirements for the risk management of insurance firms in Europe. However, this “old Investment Regulation“ may still apply at many insurance companies in Germany, although in a slightly modified version, in their internal investment guidelines.

During this prolonged low-interest-rate environment, innovative ideas are more than ever in demand for investing new money, or reinvesting the capital from expiring securities that usually pay higher interest. For the purposes of the additional interest reserve in particular, many securities had to be sold to raise undisclosed reserves and, by doing so, to finance the additional interest reserve.

So where to place the money? In recent years, new buzzwords have frequently been thrown into the discussion: private debt, private placements, loans, infrastructure, etc. All of this could be regarded as a new “alternative” asset class. The objective of these asset classes in the current environment is, firstly, to diversify the investment and, at the same time, to generate additional returns.

However, these “alternatives“ often need to be introduced internally as a new asset class. Yet that is not all. Under the new Solvency II regime, they incur a “capital charge“, i.e. these forms of investment “cost“ equity capital. This is the first major hurdle for many alternative investments, as the capital requirements for the (in some cases unrated) investments are very high. In addition, it is also expected in Pillar 2 that a thorough in-house risk assessment (ORSA, Own Risk and Solvency Assessment) will be drawn up for the investments. This could present many insurers with an almost insoluble problem for these asset classes. In our opinion, this asset class generates a “complexity premium“ rather than an illiquidity premium. This is why these investments are outsourced to asset managers for the most part.

In principle, diversification into “alternative“ asset classes is to be welcomed, because they also offer the potential to generate higher returns in the current environment. Most of the investments in this context are highly illiquid. Nevertheless, this should not deter life insurers in particular from investing: due to their long-term investment horizon, they pursue a buyand- hold strategy for the most part.

In this article, we would like to look at an asset class that can be described as “alternative“: promissory note loans (SSD) and registered bonds (Namensschuldverschreibungen, NSV) from corporate issuers1. Why is this investment referred to as “alternative“? On the one hand, this asset class is unique to Germany, while on the other, most of the issuers in the past were federal states, cities and banks. In this article we intend to focus on promissory notes issued by corporates, which represent a logical extension to the range of promissory notes. This type of promissory note is not yet quite as common for some investors, partly because these notes are more timeconsuming to source and require very complex due diligence, especially in the case of unrated issuers, in addition to the company‘s own risk analysis that is necessary under Solvency II. If you look at the balance sheet of a German (life) insurer, the proportion of promissory note loans and registered bonds can in some cases be up to 50%, even though public-sector issuers and banks account for most of this.

So where to place the money? In recent years, new buzzwords have frequently been thrown into the discussion: private debt, private placements, loans, infrastructure, etc. All of this could be regarded as a new “alternative” asset class. The objective of these asset classes in the current environment is, firstly, to diversify the investment and, at the same time, to generate additional returns.

Historical development of the promissory note loan

The origins of the promissory note loan can be traced back to the last century, when life insurance companies provided various municipalities with capital not only through the purchase of municipal bonds, but also by granting them loans against the issue of a promissory note2. Since then, the promissory note loan has passed through several high points. The first such phase was in the Third Reich, when insurance companies were forced to buy new batches of Reich bonds from the Reich Ministry of Finance. Alternatively, however, they could also issue promissory note loans earmarked for a specific purpose to publicsector entities, up to a certain level.3

The second real boom was in the post-war period. Even shortly after the currency reform in 1948, large sums of money regularly flowed to insurance companies through premium payments. These funds had to be invested to earn interest over quite a long term. On the capital-seeking side stood utilities and (industrial) companies. At that time they were unable to fully cover their enormous need for capital through other capital market instruments, as the equity and bond markets were still being developed right into the 1950s.4 Subsequently, promissory note loans led a shadowy existence for very many years, until they experienced a renaissance at the beginning of the new century.

Market development

The volume of promissory note loans issued by corporates, EUR 3 billion as estimated at the beginning of 2000, reached a new all-time high of more than EUR 27 billion in 2017 (see chart). In the case of these securities, however, it must be taken into account that, in issues from companies with a term of more than 10 years, the registered bond format is added to promissory note loans issues. It is also important to note that the number of issues and the issue volume could in fact be higher. This is because the promissory note loan is also used as a “genuine“ private placement, and consequently no corresponding figures are published by the arranging banks.

In 2017, for example, several hundred million euros‘ worth of these private placements were arranged by us alone, without the involvement of a bank (direct lending) and put on the books of various insurance companies in the Group.

It is not possible to forecast reliably whether the trend will continue in this form. Factors such as increasing credit defaults or difficulties of current promissory note loan issuers or declining quality of the promissory note market may, on the one hand, discourage issuers from continuing to use promissory notes as a means of financing. On the other hand, investors could also become more cautious.

The granularity of the capital-raising companies is very high. For example, a wide range of issuers are among the more than 160 transactions in 2017, from DAX-listed companies through family-run small and medium-sized enterprises to special-purpose associations organised on public law lines.

A/ Trend in the issue volume of corporate promissory note loans since 2004

Trend in the issue volume of corporate promissory note loans since 2004

Diversification within the promissory note market

In the last calendar year, our own estimates suggest that approx. 65% of the issuers of this typically German financing instrument are from Germany. This was followed by issuers from Austria with around 15%, and from Switzerland with about 10%. The granularity of the capital-raising companies is very high. For example, a wide range of issuers are among the more than 160 transactions in 2017, from DAX-listed companies through family-run small and medium-sized enterprises to special-purpose associations organised on public law lines.

The investor base has also expanded in previous years: in addition to various investors from Germany (banks, insurance companies, pension funds, etc.), buyers are also increasingly coming from other countries, both near and far.

Issuer market

In recent years, we can refer to an issuer market for various reasons, where the price structuring and contract design have moved steadily in favour of the capital-seeking side. For example, the last few years have seen a strong narrowing of risk premiums (spreads), which is difficult to follow in some cases. Even if the high demand coupled with often significant oversubscriptions puts pressure on the price, thus confirming the arrangers‘ pricing, it is quite legitimate to question the pricing of individual transactions. For example, maturity-independent spreads (i.e. that the risk premium is identical for different maturities) do not adequately reflect the associated risks from the investor‘s perspective, because contrary to all probability and experience, it is assumed in this case that the credit risk is independent of the maturity. Likewise, the pricing should also take into account that, unlike a traded instrument, a promissory note loan should include a maturity-dependent illiquidity premium, because the investor cannot usually sell a subscribed promissory note loan tranche at short notice, in contrast with a bond.

In contract design, the strong position of companies seeking to raise capital is also shown. In the last few years, for example, financial ratios were agreed in the contract for only very few issuers, in which breach of these ratios could result in a margin step-up or cancellation by the buyer. While the trend in financial ratios is still transparent in some aspects, situations are increasingly arising that are not acceptable to promissory note loan investors in all conscience. It is not clear, for example, why investors should casually accept the following “disparities“ in contract design that have recently occurred more and more:

Structural subordination
This situation arises when, in addition to the issuers, other group companies (are permitted to) borrow funds, in a bad case even to an unlimited extent. The situation is even more investor-unfriendly if the issuers themselves have not set up any (major/realisable) assets.

“De facto” subordination
An escalation occurs when, within the raising of loans at the level of the issuer or other companies in the group, the funds raised can also be secured. The latter is possible if the negative pledge in the documentation refers only to the issuers. In this case, there is even a combination of a structural and de facto subordination (“double subordination”).

Asset disposal
The lack of a clause on the possible or unrestricted sale of assets may result in a major change in the basis on which the investment decision had been made. This may also lead to an “erosion” of the issuers.

However, there are certainly options acceptable to both sides that could lead to a reduction in investor risks of this nature. In these contract designs, for example, the position of the investors could be improved somewhat through joint liability of other companies, while at the same time restricting the transfer of assets to these companies and/or their borrowing. In practice, however, this is very rarely taken into account for arranged promissory note loans.

From the banking market to private lending partnerships?

Under these general conditions, the market for promissory note loan issuers is very attractive, regardless of their company size. On the one hand, large issuers with corresponding capital requirements can collect issue volumes of more than EUR 1 billion. On the other hand, smaller issuers can reach new investors or expand their funding base. It also helps issuers that the number of arranging banks has grown strongly, with the result that they are in competition with one another for the marketing of the issue. Accordingly, they want to get in a good position with the issuer in relation to the “selling power“ (placement with investors) and the risk premium, as well as the documentation.

The 2017 financial year has undoubtedly seen sufficiently interesting opportunities to invest in the promissory note loan market arranged by banks, even for investors with the highest quality standards. These options have nevertheless decreased significantly compared to previous years. Due to the trend described above, these investors were pushed more and more to enter the private placement business (in the form of direct lending). Large investors such as investment companies or asset managers with the necessary expertise and track record should also have opportunities in this respect to make this available to thirdparty investors who do not have the expertise or the capacity for a credit check. The aim would be to use these additional funds for even larger issues, which would not be possible on a stand-alone basis. This could also enable third-party investors to accommodate the options relating to equity capital offsetting under Solvency II, as currently discussed by the EIOPA. A particularly fascinating aspect is the extent to which the corporate promissory note loan, either rated or unrated, is categorised as a worthwhile asset class for insurance companies, and the extent to which it provides relief for capital adequacy requirements.

It should not be forgotten that the increased implementation of private placement as direct lending is a result of various discussions with (potential) issuers. As the maturity increases, the issuers appreciate aspects such as investor security (reliability, creditworthiness, reputation) and are also willing to reward these accordingly, through the price or documentation. Since the investment continues for many years or even decades, both parties also speak of a “partnership“ in this context. This may be extended during the business relationship by increasing the exposure, or it may be continued after repayment of the loan. As an arranging investor, it is always important to find a fair solution for all parties. This includes: a fair risk premium with appropriate issuer documentation for a reliable, highly creditworthy, strategically-oriented “buy-and-hold“ investor.


Teoman Kaplan Teoman Kaplan,
Actuary (DAV), is Director Insurance Group
Allianz Global Investors

Dietmar Schubert, Dietmar Schubert,
Deputy Head Portfolio Management European Corporate Loans and Senior Portfolio Manager DACH,
Allianz Global Investors



1) The promissory note loans issued by corporates are regulated in Section 2 Para. 1 No. 4 of the Regulation on the investment of guarantee assets by pension funds, death benefit funds and small insurance firms (Investment Regulation: Anlageverordnung, AnlV) in conjunction with the “Principles for the granting of business loans by insurance companies – promissory note loans”.

2) Cf. Hilben, H., Die Kapitalanlagen der deutschen Privatversicherungsgesellschaften und ihre Bedeutung für den deutschen Kapitalmarkt [The capital investments of German private insurance companies and their significance for the German capital market], Jena 1908, p. 109-112; Mueller, R., Anlage und Verwaltung der Kapitalien privater Versicherungsunternehmungen [Investment and management of the capital held by private insurance companies], Berlin 1914, p. 90-93.

3) Cf. Dr. Staehle, W., Die Schuldscheindarlehen [Promissory note loans], Betriebswirtschaftlicher Verlag Dr. Th. Gabler, Wiesbaden, 1965.

4) Cf. Zender/Grunow in Finanzinstrument Schuldschein [The promissory note as financial instrument], Springer Gabler Verlag, Wiesbaden 2018.

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The US economy remains strong, but tail risks are rising

2018/08/29

Summary

Tax reform has given the US economy a second wind and widened its divergence from the global economy, which has faltered amid fears of trade wars and emerging-market uncertainty. Sector rotation in US equities could make tech and consumer discretionary attractive; energy and industrials may also benefit.

Key takeaways

  • The Fed will continue on its normalisation path as we move later in the cycle, but we don’t foresee a recession in the next 12-18 months
  • Tail risks are emerging – including trade wars and geopolitical uncertainty – but US equities could still outperform global peers, albeit with higher volatility and some sector rotation
  • It’s too early to move completely away from the tech sector, which has still delivered strong year-to-date returns; in the overall markets, we believe mid to high single-digit returns are still feasible this year
  • Investment opportunities could also be found in energy and industrials, short-duration fixed income, Asia and alternatives