Turning Illiquidity into an Asset
The persistently low interest rate environment has resulted in a broad hunt for yield, and while conventional wisdom holds that higher yields equal higher risk, not all risk is created equally. Private lending typically yields above traded credit instruments because of the illiquidity of the underlying loan, not because asset-based lenders face materially higher issuer, interest rate or market risk. And importantly, prudent borrower selection and transaction structuring can address these issues, thus turning the illiquidity found in private debt into an asset, not a disadvantage.
Structural Changes Impacting Liquidity
Growing structural changes from financial services consolidation, increased capital requirements, and stricter regulatory oversight on investment banks have significantly altered the normal market-making activities of many traditional fixed-income market participants. The result is that there has been a significant reduction in the liquidity profile for most U.S. debt markets since the financial crisis. Investors should be alert to the fact that in a crisis situation, the liquidity normally available for many fixed income instruments just may not materialize.
If investors embrace the notion that traded market liquidity may be illusionary, then the advantages of asset-backed lending become clear. When properly constructed, with deep collateral coverage, disciplined due diligence and other risk mitigation techniques developed by Old Hill, the illiquidity inherent in asset-based lending can provide a yield premium without the typical increase in risk associated with higher-yielding alternatives. In our world, illiquidity is to be embraced, not shunned.