An allocation into a portfolio combining liquid and illiquid assets can provide the potential for higher risk-adjusted returns and further diversification.
By Gianluca Oricchio, Co-Head of Parallel Lending and Chief Data Scientist at Muzinich & Co.
Investment solutions that combine liquid and illiquid assets can provide investors with the potential for higher risk/adjusted returns, additional diversification in their portfolios and more choice and flexibility. Particularly at a time when global markets are bracing for a potential recession, inflation remains persistently high and credit markets face the risk of seeing rates moving up further in a «higher-for-longer» cycle.
A strategy that combines in one portfolio syndicated loans, traditional direct lending, with parallel lending can provide investors with an illiquidity premium available through the private markets allocation in a structure with a certain amount of liquidity through the syndicated loans allocation – a feature typically unavailable in traditional closed-ended funds.
Public Market Liquidity Provision
Floating rate instruments such as European syndicated loans benefit from a rising rate environment given their rate is reset every three months over a LIBOR floor. As a result, these instruments may offer a particularly compelling return during periods when rates rise.
Their elevated position in the capital structure increases repayment potential and helps with potential default concerns. In addition, European leveraged loans are actively traded, so an allocation provides the strategy with liquidity.
Private Market Illiquidity Premium
An allocation into private debt offers the potential for additional upside via the illiquidity premium and protection from mark-to-market volatility. We believe low-levered companies in the lower-middle market can provide a potentially higher risk-adjusted return.
This segment has been traditionally underserved as most players focus on the upper-middle market. The market opportunity for lenders who focus on the low-levered, lower-middle market is attractive and large, with 175'5961 companies within this segment, many of which are family and founder-owned, we believe an on-the-ground presence in each jurisdiction, local language skills and proprietary screening and monitoring tools are key in the origination and monitoring of each deal.
Diversification and Bank Lender Rights
Parallel lending is a model where an asset manager co-lends pari passu in conjunction with a bank to provide financing to European middle-market businesses. The bank maintains 100 percent of the ancillary and capital-light business but, by sharing the Term Loan risk with the asset manager, counterparty exposure is reduced, and the bank is able to invest the capital relief from asset sharing in new profitable business.
At the same time, the asset manager can utilize the bank’s distribution network and the high number of sourced transactions offering the ability to quickly build a highly diversified and granular portfolio. Meanwhile, they are only exposed to the most senior part of the capital structure which ensures the portfolio contains high-quality credits.
Increased Benefits
This segment of the market offers increased diversification benefits. The universe of eligible EU corporate credit opportunities suitable for parallel lending is significantly greater (6'138 billion euro) than that of the European high yield bond (452 billion euro)2 and syndicated loan markets (387 billion euro)2, combined.
While rates are currently rising, the incremental cost of debt does not increase the default risk for low-levered companies. It’s likely central banks will reach terminal rates sometime this year and, over time the rates environment will change.
Sticky Inflation in the EU
However, it is also true that the inflation in the EU is stickier compared to the US, in part due to the rigidity of the labor market. However, a strategy that has flexible investment guidelines can navigate multiple market cycles depending on the market environment.
1Amadeus BVD, April 2023. Criteria: Last available year, Eastern and Western European countries, Operating Revenue min = 25 million euro, maximum = 250 million euro. Updated annually.
2All data from ECB: Statistical Data Warehouse, April 2023, on Q4 2022 ECB data. Representing corporate bank loans originated by ECB-supervised banks. *As represented by ICE BofA European High Yield Constrained Index (HEC0) as of December 31st, 2021. **As represented by INSTITUTIONAL Western European Leverage Loan Index (CSLLETOT) as of December 31, 2021. For illustrative purposes only.
Gianluca Oricchio is Co-Head of Parallel Lending and Chief Data Scientist at Muzinich & Co. Prior to joining Muzinich, Gianluca has been Managing Director in several European Banking Groups and has developed SME Credit Rating Models and Early Warning Systems. He has been advisor of Moody’s Analytics. Gianluca is a PhD in International Accounting and Full Professor of Corporate Finance and Accounting. He graduated from La Sapienza University.
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