Institutional investors are increasingly turning to illiquid assets and active management strategies to combat macro-economic trends, anticipated market volatility and divergent monetary policy, according to a new survey by BlackRock.

BlackRock polled 174 of its largest institutional clients, which together represent more than $6.6 trillion in assets (public pension funds (25%), corporate pension funds (34%), official institutions (1%), insurers (25%), investment managers (6%), endowments and foundations (7%), and others (4%)), about their asset allocation plans following the recent market volatility. The survey found that investors are increasingly embracing illiquid assets, including private credit and real assets, as a way to meet their long-dated liabilities, rather than the traditional assets classes of stock and bonds.

It seems that the recent market volatility is driving a repricing of assets globally, allocations to equities appear to be decreasing while institutions are anticipating modest reductions to their fixed income portfolios. What’s more, when asked how they plan to manage their equity exposures, 25% of respondents to BlackRock’s survey said they planned on increasing their allocations to active managers. In comparison, only 16% of the sample was looking to increase index-based allocations. The largest increase in interest for institutional investors is long-dated illiquid strategies. Over half of the respondents indicated an increased allocation to private credit, followed closely by real assets (+49%), real estate (47%), and private equity (39%). Broadly speaking, the respondents to BlackRock’s survey expressed demand for the return premia offered by illiquid assets.

Demand for illiquid assets in increasing

“Over the past 12 to 18 months we’ve seen the majority of the new fund launches we’re working on are focused on the credit space. Whether it’s direct lending or buying distressed companies,” said Michael Minces founder of Blue River Partners, one of the US’s largest compliance firms, in a telephone interview earlier this week.  He continued:

“There’s a lot of demand for working capital and debt especially as equity markets get more distributed. Particularly in the oil & gas space. You’re seeing alternative asset managers or fund managers setting up vehicles to earn returns in return for providing debt financing.“

According to Minces, who is based in Texas, around 80% of the new fund launches handled by Blue River are in the energy space. These new funds, most of which have a credit focus, are seeking to profit by buying distressed loans from the banks, the CMBS market and direct lending:

“Fund managers have a lot more flexibility with what they can do with the loans and how they can creatively work them out. They can extend the duration and adjust the limits of the credit facility to provide flexibility. They can do a lot more than a bank can because they’re not subject to the same regulations as a bank.”

And the banks are all too happy to shift these illiquid, distressed loans off their balance sheets.

Banks face a tough decision

Since the beginning of 2016, almost all of the large US banks have warned that their provisions for credit losses stemming from the oil patch will increase this year. In January Bank of America said that $8.3 billion of its $21 billion in energy exposure was in the “high risk” activities of exploration and production and oilfield services. Around a third of the bank’s “high risk” debt is classified as problematic but energy debt as a percentage of the bank’s overall loan book is only 2.4%. Morgan Stanley has the highest exposure of the large US banks to oil & gas debt as a percentage of its total loan book. Loans to the energy sector amounted to 5% of the group’s total loan volume during Q4 2015. Source CNBC.

But it’s at the regional level where the pain will really be felt. Energy-focused regional bank BOK Financial Corp, which primarily operates in Oklahoma and Texas, warned two weeks ago that credit losses for the fourth quarter will amount to $22.5 million, nearly four times the midpoint of the $3.5 million to $8.5 million forecast earlier.

However, with many of these oil & gas loans now distressed, banks face a dilemma: cut energy clients’ borrowing ability and risk sending them over the edge, or continue to accommodate them in order to prevent defaults. On the other hand, according to Michael Minces fund mangers have more options:

“A lot of the oil a& gas loans are collateralized with good equipment. A lot of the real estate loans are also collateralized. In those areas managers have the ability to hand pick the loans. We’re seeing more and more funds setting up right now with a credit focus and a big reason for that is the fact that banks are having a harder and harder time conducting lending due to the constraints introduced by Dodd-Frank. I think as these loans get more and more distressed they’re creating plenty of opportunities for these managers who can come in and work something out so they can turn a profit. These funds have more options available to them.”

Moreover, unlike the banks fund mangers have a longer term outlook and aren’t afraid to take ownership of a company’s assets if the bet doesn’t work out. Blue River Partners is seeing a lot of private equity funds coming in to buy these loans with a ten to twelve-year investment horizon, “they’re setting up new vehicles to deploy this capital. A lot of capital is yet to be deployed, but yet we’re still seeing new funds come to the market. I think over the long term they’re assuming that commodity prices will return to more reasonable levels, and they can work these loans out at a profit. Or take the securitized assets on default,” said Minces.

Baupost, Seth Klarman’s hedge fund, is just one of the funds that’s stepping in to fill the void left in the credit space by banks. Alongside Baupost’s fourth-quarter and full-year letter to investors, Jim Mooney, the head of Baupost’s public investments group revealed that the fund is now accumulating distressed debt at extremely attractive prices:

“While the opportunity in credit is not yet a torrent, in the last three months, we have begun to accumulate the bonds of several companies in the energy complex as well as in other areas, including some non-energy commodities businesses. We even had a chance to play an anchor role in a refinancing transaction for an energy company after it became obvious that the deal would price more than 500 basis points wider than the underwriters had anticipated. In that case, we expect to earn a low-teens return on secured paper that we believe is covered by more than two times in our downside case and even more robustly in a near-term liquidation. In the fourth quarter, we added just over 2% of partnership assets in distressed/stressed credit to the portfolio.”

As we have previously reported, Baupost already has some big investments in distressed debt, including Lehman Brothers and Arby’s.