The evasive 'liquidity advantage'
In the realm of private debt investments, a significant trend has emerged in the European investment-grade market. Empirical data indicates that the illiquidity premium, a crucial factor adjusting returns to account for the additional risks associated with illiquid private debt, plays a pivotal role in pricing models.
Recent research has developed enhanced benchmarks for private debt, explicitly incorporating illiquidity premiums alongside underwriting risks associated with private loans. These premiums serve to adjust returns relative to more liquid fixed income instruments, reflecting the additional compensation investors require for illiquid private debt exposure.
While the exact magnitude of the illiquidity premium in European investment-grade private debt is less explicitly quantified, studies on private loan benchmarks suggest that the premium is significant enough to warrant adjusted pricing compared to public debt. The illiquidity premium compensates investors for the difficulty in trading private debt and the associated underwriting complexities.
The established empirical literature on liquidity premiums in fixed income markets provides a broader context. Related work explores liquidity premiums in sovereign bonds and corporate bonds, showing that spreads between liquid instruments (like US Treasuries) and less liquid corporate bonds partly reflect liquidity premia embedded in pricing. However, this is outside the direct scope of European investment-grade private debt.
Notably, no recent comprehensive empirical study specifically focusing on the European investment-grade segment of private debt has been presented. Yet, the framework of pricing private debt with illiquidity and underwriting risk premiums is an accepted standard in industry models and academic research.
Aviva Investors, a key player in the private debt market, has originated £35.1bn of private debt deals over the past 10 years. Their private markets team has been publishing a chart to systematically quantify the investment-grade private debt illiquidity premium on a deal-by-deal basis. For a given set of credit metrics, investors can get better terms in private debt than in comparable bonds.
The simplified illiquidity premium attached to these deals has averaged 59-72 basis points, depending on the sector. The team compared the spread of these private debt deals to the spread of a public bond index, matching the currency, sector, and broad rating band. The increasing demand has taken the illiquidity premium back to long-term averages of 50-75 basis points, but investors do not expect it to be a constant static number.
Spreads in the European investment-grade private debt market have compressed over the last couple of years, primarily due to increased competition in the market, including from banks that have loosened their lending standards. Companies seeking to borrow less than several hundred million dollars have multiple options, including banks, insurers, and asset managers.
The chart published by Aviva Investors' private markets team does not account for rating-notch matching, maturity, or whether the deals are fixed or floating rate, which may result in some inconsistent numbers. However, it offers valuable insights into the current state and trends of the European investment-grade private debt market.
In conclusion, empirical benchmarks for private debt consistently incorporate an illiquidity premium in pricing models, with investment-grade European private debt reflecting such premiums that account for restricted market liquidity and underwriting risks. Quantitative estimates vary by method and market conditions but are acknowledged as material components of private debt returns.
- In the private debt market, Aviva Investors has developed a method to systematically quantify the illiquidity premium associated with investment-grade private debt deals.
- The illiquidity premium, a crucial factor that adjusts returns to account for the risks associated with illiquid private debt, plays a pivotal role in pricing models for real estate, finance, and business investments.
- Recent research has shown that the premium is significant enough in European investment-grade private debt to warrant adjusted pricing compared to public debt, such as fixed income instruments.
- Spreads in the European investment-grade private debt market have compressed over the last couple of years, mainly due to increased competition in the markets, including from banks, insurers, and asset managers, offering various options for companies seeking to borrow.
