PGIM Alts Forum: Opportunities in Liquid Strategies
PGIM brought together a host of experts across a handful of asset classes for our first installment of the PGIM Alts Forum.
Institutional investors have increasingly allocated to illiquid private assets for the potential diversification and private asset premium benefits. Institutional private asset opportunities are broadly available, but one of the most daunting challenges for CIOs is how to best construct a portfolio with a combination of illiquid, private assets and liquid, public assets.
In Part 2 of PGIM’s Alts Forum, we brought together a panel of investment experts to discuss the opportunities and risks surrounding a range of private credit strategies, including direct lending, real estate debt and sustainable power mezzanine debt. Here are just a few highlights of our webinar:
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>> Welcome. Good afternoon, good morning and good evening to everybody. And welcome to the second in our series of PGIM Alts forums, looking today at less liquid strategies. We have a group of good institutional investors, a good group of institutional investors joining us today from continental Europe, the Nordics, the UK, North America and the Middle East. So you're all very welcome. I think the next hour or so will be very interesting. PGIM, as you may know, is one of the world's largest alternative investment managers. Today, we're going to look at opportunities and ideas from two of our affiliate firms. I'll be hosting a panel a little later with Matt Harvey and Deb Henzi from PGIM Private Capital, PGIM's 100 billion private capital affiliate, and Andrew Radkovitch, from PGIM Real Estate, the second largest real estate investment manager in the world with some 182 billion in assets under management, around half of which is in credit strategies. We're also delighted to have Dr. Bruce Phelps, the head of PGIM's investment advisory solutions group, who's going to discuss some of the research his group have done into private assets and their place in an institutional portfolio. The format of the main panel will be an overview and outline of their strategies from each of our panelists, followed by questions of around 30 minutes. We also having as we did at our first event an artistic contribution from the Juilliard School and the Lincoln Center for Performing Arts -- a bit more of that later. There's been a lot of commentary recently about how private market alternatives and liquid alternatives may be inexorably moving together. I have some views on that, which you may have read if you saw my article in Hedge Wig last week. But here at PGIM, it's our view that there are significant differences between the two categories and that we intend to keep our current emphasis on separating both liquid and illiquid oils on future conferences. So we'll be covering liquid alternatives at our next event. So to start, I'd like to turn it over to Jenny Staley, who's going to introduce Dr. Bruce Phelps.
>> Thank you, Steven. Dr. Bruce Phelps is head of our institutional advisory and solutions group known as IAS. IAS, our data driven, asset allocation and portfolio construction research group. They conducted a number of research projects. And examples include building and maintaining a desired exposure to private markets and balancing performance and liquidity. Today, Bruce will provide a short presentation on a fair comparison framework between private and liquid assets. Bruce, over to you.
>> Good morning. Good afternoon, everyone. And thank you, Jenny. Probably the most challenging task for a CIO or asset allocator is how to construct a portfolio with illiquid private alt assets and liquid public assets. Many of you get many presentations on particular alternative investments. But at the end of the day, you have to sit down and decide how are you going to combine them in a portfolio. And that's a subject that my group has been working on for the past several years. I would like to spend the next few minutes describing to you some of the work that we have done and how it might be of use to you. So for a CIO, the CIO has to answer two key questions. The first is how to assess the relative risks and expected returns of alt in a manner that's consistent with other alt investments and with public investments. And secondly, the CIO needs to determine how to form the optimal allocation between illiquid assets and liquid assets so that the portfolio achieves the expected return target and also satisfies any liquidity requirements that the portfolio has. So in the first subject, measuring relative risk and returns, this is quite problematic. In fact, we got started on this project to construct a fair comparison framework from an investor who wanted to invest in private credit. But notice that the returns from private credit seemed quite inferior to buyout funds. And the question within the organization is why should we make any allocation to private credit? So the task to us was to how can we show the relative risk and return characteristics of these assets. And what you see in this graph is what is typically presented to a CIO. These are historical cumulative quarterly IRR returns from various private assets and public assets. And you see at the top, over the past 15 years, buyout funds have done particularly well. Mezzanine credit in the black line has done less well. And then you have the S&P 500 and public, let's say, investment grade corporate bonds. But this is very misleading. As you know, the published alt returns are not necessarily replicable. You can't invest in the entire market as you can in public markets. Calculated returns for alt aren't comparable to public returns because it's a GP who has control over when your money is invested and when it's not invested. And when it's not invested, you have to invest elsewhere. And finally, there's no accounting for the relative risk of these different markets. So we came up with a fair comparison framework. It's not a straightforward exercise, but I want to give you the intuition behind it. We can't rely on short term returns because the nav is very uncertain in the early years of investment. And measuring risk is difficult because return to correlated. So what we do is we form portfolios. And we look at the horizon value, the horizon wealth value of the portfolio. And we construct these portfolios in a way that mimics how an investor would construct portfolios. You invest in a few funds every vintage year. Your cash is -- uncalled cash is invested in some public asset. And what we do is we track what is the horizon value of your wealth at the end of your holding period. And to show that, at the top, we have two investments. The one in pink are buyout funds, and the one in black are mezzanine credit funds. And as we move from left to right at the top, that's years that's passing. And what we're showing is the distribution of horizon wealth at the end of that particular year. So at the end of the horizon, at the end of, let's say, this 12-year period, we have a distribution of horizon wealth from these various investment strategies, buyout funds and mezzanine credit. And we take that last year distribution, we flip it on its side. And so you can see it in the middle there. Again, we have the buyout horizon wealth distribution at the top in pink. And we have the mezzanine credit below that in black. And you see what the distribution of horizon wealth is from these two different investment strategies. And from that horizon wealth distribution, we can actually compute the expected return and the volatility. So this is how we can sort of circumvent some of the short-term problems of measuring performance for all investments make it more comparable to public market investments. And we can generate an expected return and risk measure that's comparable across different assets. And this should be very intuitive to investors in alt -- illiquid alt investments. After all, why should you care so much about short-term returns? Your money is really at work for that period. It's unlike a public investment. So you looking at horizon wealth is a very natural way of thinking about alt investments. The next slide shows you what the performance characteristics can be. So over at the left is the traditional way, showing return divided by risk, so a relative risk adjusted return. On the left, we show the distribution of risk adjusted returns for various alt and public market investments. And as you can see, mezzanine investment looks very good. It has very good return, but also very low volatility. And that's the blue bar in the center of that left-hand. distribution. Over to the left, far left in black is our buyout funds next to it. And then further to the left is the S&P 500. Now when we move to the fair comparison framework, which is the next set of bars, you see that you get a much more realistic picture. Your mezzanine credit still looks very good relative to buyout, but the return differential isn't as strong, because we've now properly accounted for measuring expected return and risk. As we move to the right, we make further adjustments. The third set of bars to the right is showing you the returns when we calculate the risk adjusted performance on an equal risk basis. So we bring everything to the same level of risk as buyout funds. And then farther to the right, we incorporate fees and alpha, which are already included in alt investments but aren't included in public investments. The next slide shows you one other adjustment that we've made. When we've talked -- spoken to investors about the fair comparison framework, they raised the objection that they have skill in picking their general partners. And so they've been investing in alt investments for some years. And so they want to incorporate their fun selection, their GP selection skill in their investments. And so that's what we do in this diagram as well. We allow the LP to have some skill in picking good performing GPS. And we see that that also adjusts the relative performance of alt versus public markets. One nice feature of alternative investments is that they actually perform very well during volatility events, as we experienced with the events in March of this year. I think for those of you who have been investing in alt, you found that their performance was much more stable than it was in the public markets. And this is another study that we've done on showing the relative performance of alts versus publics during stressful market periods. And then finally, to close, we bring this all together with an asset allocation and the last slide that shows the top down asset allocation, which is how much you decide to invest in publics versus alt. The bottom up asset private market investment, that includes your commitment strategy of investing in alternative investments. We incorporate your cash flow obligations from your portfolio, and we arrive at the right-hand side that shows the efficient frontier of your investment strategies where instead of volatility risk, we show liquidity risk on the horizontal axis and the expected return on the vertical axis. So that's how we bring alt together with public market investment to help the CIO construct portfolios to meet their expected return and liquidity obligations. So with that, I'll turn it back to Steven.
>> Thank you, Bruce. That's always been a problem since I was a consultant some 20 years ago was having a fair comparison between illiquid investments in your portfolio and coming up with a strategic asset allocation that recognizes the true risks within investments. If you want to learn more about the work of IAS, please look at PGIM's website and the IAS page, or you could send us an email. The pandemic has had different impacts on different sectors. Anyone who requires an audience has been badly affected. While we have continued to work from home in the financial sector, theaters and concert halls have been dark and their performance largely condemned to playing alone or acting online. PGIM has had a long link with the Lincoln Center for Performing Arts and the Juilliard School, which is a performing arts school, quite famous, that is attached to the Lincoln Center. I mentioned at the first PGIM Alts that one famous graduate of Juilliard was Alan Greenspan, the former chairman of the Federal Reserve. I'm not sure that many people believed me. And I was going to show you a picture of him playing his clarinet when he was with the Woody Herman band, but unfortunately, I can't do that for copyright reasons. But nonetheless, if you type Greenspan and clarinet into Google, you will find a picture of him. Our next guest, Ellie Troy, is not only an incredible emerging musical talent from Juilliard, she is also studying economics at Columbia University in a unique dual program. So who knows? She could end up at the Fed as well. But you may think not when you hear her playing. She's going to play a short piece now from Bach while we prepare for the main event, our panel. She will also rejoin us at the end to play out with a longer duet. Over to you, Ellie.
>> Hi. My name is Ellie Troy. It's my pleasure to be a part of the PGIM Alts forum. I hope you enjoy my performance.
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>> Oh, that was wonderful. Thank you, Ellie, very much. I think we'll be hearing more from Ellie, not just at the end of our session either. Now it gives me great pleasure to introduce our speakers on the investment panel to look at the changing with the private credit. Matthew Harvey, who is a partner and head of direct lending at PGIM Private Capital, Andrew Radkovitch, who is global head of private debt strategy and investor solutions at PGIM Real Estate, and Deborah Henzi, who's a partner of sustainable power and energy, again, at PGIM. Private Capital. There's been increased interest in private credit in recent years, as investors have looked for yield in a low rate world and traditional lenders have been replaced by institutional investors and their managers. It's a complex world, representing the spectrum of risk and return from senior secured to quasi-equity mezzanine. Matt, I think we'll start with you. And I wonder if you could give us an overview of the private credit landscape and some of the developments that you've been seeing and how you approach specifically direct lending.
>> Thank you, Steven. Very happy to do so. Good afternoon. Good morning, everyone. It's hard to follow such a talented rendition as we just saw, but in any event, we'll talk about corporate direct lending, which we also view to be a very riveting asset class discussion these days. When people think about this market, it's really a market that's grown in prevalence considerably over the last 10 years and originally was born out of the global financial crisis and in 2008 to 2010 timeframe. Banks began to go risk off, issuers were looking for sources of leverage lending capital, and the private debt nonbank market was there to provide that capital. And you can see in this graph on the left-hand side how across various private credit strategies, capital was formed with institutional investors and ultimately has been supplied to the market. The market principally exists to finance traditionally leveraged buyout financing for sponsor related transactions. But it also extends to other forms of event driven and risk transaction. So it's not principally leveraged buyout financing market, although that's certainly where the heritage of the market lies and where much of the asset class formation has existed to finance. What you can see over this period is the trend of significant formation in the asset class has continued to pace over the last five years. Even during COVID, the fundraising process was relatively resilient with nearly 120 billion raised in private debt. You can see over this time, core direct lending has been the biggest single recipient of capital. And I'll come back to where that exists within the broader private credit spectrum. But equally opportunistic strategies such as distressed mezzanine and other forms of private credit have attracted capital as well. One of the narratives that we often hear given this this degree of capital formation and activity is has the supply demand dynamic shifted in favor of equity issues? And will that result in deteriorating returns for investors of private credit? It's important to keep that question in context. And when you consider the supply side of what produces these transactions to finance and if you consider a proxy for that private equity dry powder, you can see on the right-hand side even more fundraising has occurred in the private equity markets. And that's resulted in roughly a five times multiplier of private equity dry powder versus global private debt dry powder, considering the average private equity transaction attracts at least $1 debt for every dollar of equity capital and also considering there's a very large market of nonchanging control risk transactions, often referred to as the non-sponsored direct lending market. We think the use case for private credit and direct lending actually remains quite robust, despite these trends and the growing prevalence of the asset class. If you look here, one of the questions we also get quite often is direct lending has a bit of ambiguity in terms of how we define this as an asset class. I'll focus on corporate direct lending, where we sit within the PGIM private capital business. If you look at the graph here, this really illustrates the spread of leveraged finance available to issuers. On the right-hand side, you have larger issuers that are really capital markets issuers and tapping broadly syndicated loans in the upper right-hand quadrant and then high-yield bonds in the lower right-hand quadrant. These are issuers on average with EBITDA earnings north of $50 million. They're going to the market with a credit rating from an agency. And they're running a broadly syndicated process to raise capital for many institutional investors. Direct lending really starts when you go into the left two quadrants on this graph. And it can be described into three different strategies. One is core direct lending. This is most comparable to broadly syndicated loans, except very simply focused on middle market issuers. In our definition, 10 to 50 million of EBITDA on average. These are senior secured loans often extended at roughly up to 50% loan to enterprise value of a company and typically come with a 2 to 300 basis point premium over broadly syndicated loans. That's in part driven by the liquidity. It's in part driven by small size of company premium. And it's in part driven by, very importantly, terms. Direct lending, managers and loans come with maintenance financial covenants, whereas the broader market and broadly syndicated loans typically are covenant light. Other forms of direct lending -- you could refer to them as court plus, which is the bottom half, unitron and second lien, where you're getting 9, 10, 11% returns in exchange for deeper financial risk in the issuer. And then finally, on the left-hand side, what we refer to as opportunistic direct lending strategies that either come with very small size of companies, principally the SME market, as its broadly referred to, or other true opportunistic strategies with respect to mezzanine debt, distressed and special situations. So in our view, again, the prevalence of the direct lending market remains quite robust. The use case for this type of financing is still in demand by issuers. And many of the common attributes which have attracted capital to the market in terms of spread premium over broadly syndicated loans, a lower beta return as in part as a function of illiquidity in better terms. And high quarterly cash distribution remains intact for the asset class. And with that, Steven, turn it back to you.
>> Thanks very much, Matt. We'll ask some questions later. And if anyone has any questions for Matt or any other of our panelists, please type them into the box on the right of your screen. I'm now going to turn to Andrew Radkovitch. Real estate debt is perhaps a strategy that historically has been seen as somehow part of real estate. But I think what you're going to tell us about, Andrew, is how perhaps it's more part of the whole private credit spectrum. So I'll hand over to you now for your speech. Thanks.
>> Thanks, Steven. Thanks, Matt. And it's a great pleasure to be invited on to this Alts forum. And really, over the next few minutes, I'll try and describe how real estate debt increasingly has been fitting into the private credit universe. And Steven is absolutely right, I guess, as real estate gets introduced to institutional investors really after the last financial crisis. And it's fair to say that it's doing some catching up to other alternative assets. However, on this graph is shown the sheer scale of the market. On the left-hand side, here, we show the annual origination hitting $1 trillion a year ago, evenly split about half of that in the US and half outside the US. So on an annualized basis, a very deep and liquid market of opportunity. But as we look at that opportunity and really look at the opportunity for alternative capital and alternative lenders, the graph on the right really sort of breaks that story out a bit more and makes it a bit clearer. What we show here is that the total outstanding real estate debt of about 6 trillion globally between regions. However, in the US, a clear and marked difference between the rest of the world where in the US, approximately half of that is held by banks and the other half through a range of insurance company balance sheets, private debt funds and the securitization market. And that's a market that's really evolved quite rapidly over the last 10 years to provide those different sources of capital, whereas this, we look outside the US into particularly UK and Europe. The banks significantly over 90% of that holding. And this is where the opportunity is starting and really sort of building up momentum to the extent that bank regulatory change has had an ever increasing impact on the ability of banks to lend into real estate debt, mainly through bank regulations of initially Basel 2, then Basel three and now Basel 4. And we see different opportunities across the US and Europe, but collectively a growing opportunity. When we talk about real estate debt, it is quite broad. And really, what I want to do here is in our own minds classify where it all fits. Very simply put, we talk about it in three different strategies, really driven by not just the return side, but actually where these different types of real estate debt investments fit in core players. So when we look at core debt slightly differently, we're really looking at investment grade quality debt, very high quality real estate, very transparent, long-term underlying income, granular diversification and really there to produce an investment grade alternative, investment with secure income. Those returns over a cycle will be at that end of 2 to 4%, but really looking at those spreads, 150 to 250 spreads, and on average between 50 and 75 basis points above an equivalent corporate bond, public corporate bonds. Then we move into core plus, which is still sort of an income driven strategies. This is where we start entering the private credit space. Clearly, the returns are going up. However, there is still security. There is still underlying income, or income from the underlying real estate fully covers the coupons payable. But here, we start getting a bit more creative with the underlying loan investment. We have home loans, which is the equivalent of [inaudible] and corporate debt. We're going to add senior debt but slightly higher up the capital stack. But we're beginning to enter more junior and subordinated position of structured notes within senior debt and subordinated debt and also writing senior loans with conservative level. Because the collateral covers there, because the underlying income is there, these are very, very predictable returns, and in effect can generate those higher income returns with very clear levels of collateral income. And finally, high-yield debt, which is really where alternative credit and real estate was born 10 years ago. And this is a mixture of whole loans, mezzanine, sometimes embedded equity, really secured against real estate, but also carries a level of active management and value creation. These are total return strategies that really still get at least 75% of their return through underlying coupon fees and income. But these also feature an element of capital participation. So overall, these are strategies that are throughout cycles can deliver anything between 8 to 12% net on that total return basis. So I'll finish there really and hopefully given you an insight both to the scale and the different types of strategies available within real estate. Now I'll hand it back to Steven.
>> Thank you. Thank you, Andrew. Very interesting. And I know we have a few questions for you coming up shortly. But before then, I want to turn to Deb. Sustainable Energy is one of the fastest growing areas in the energy sector. And if you saw the Economist magazine this week, you'll see it quoted a study by Princeton University that estimates that if America is to move towards President Biden's net zero carbon emissions target by 2050, there will be a requirement to invest some $2.5 trillion over the next decade mostly in wind and solar projects. So I'm pleased to say that PGIM is actively involved in the sustainable power sector. Deborah, perhaps you could tell us more about the sector and the risks and possible returns from a credit perspective and how you're planning to deploy the capital you have at your disposal.
>> Sure, thing, Steven. I'd be happy to. Thank you. Thank you, everyone, for having us here. The first place to start is to just define our mandate, because sustainable power means different things to different folks. The program that we're -- we've recently launched is a mezz and passive equity platform that seeks to invest in projects, portfolios and companies that develop, own or operate renewable generation, energy storage or transmission infrastructure in the US and Canada. Our program was set up to take advantage of strong sector fundamentals, including the ongoing transformation of the installed generation fleet here in North America away from aging coal toward clean gas fired and renewables, robust growth and renewables, as Steven was just alluding to, driven by supportive regulation, declining costs, and favorable public sentiment. Continued consolidation will also be a driver in terms of the fundamental picture in the sector in the US as a sector matures. Our program also seeks to respond to increasing investor focus on ESG, which has been an increasingly large and dominant focus of many different constituents in the market for many different reasons, as well as to leverage our established origination platform and the direct deal sourcing network that we've developed at PGIM over the last 25 to 30 years, building a -- what's now a $12 billion power depth platform. Turning to our strategy and the schematic more specifically, this schematic seeks to show that risk return in the power sector is a function of three variables -- the stage of development of the project or the portfolio and the commodity -- degree of commodity risk exposure, which is depicted on the x axis here and as well as the position in the cap structure, which is depicted on the y axis. Now if you -- taking a step back and looking at the schematic, you see a little bit of a counter intuitive phenomenon happening, where you can see that mezz returns and slightly riskier contexts to the left of the graph can be greater than the common equity returns in the more conservative place on the right-hand side of the graph, where cash flows are more predictable. And that bears reflecting somewhat because I think we've seen a lot of increasing fund accumulation in the sector in the last couple of years with credit strategies and the safer equity strategies targeting this similar return range, eight to 12, seven to 11, gross type returns. What I've laid out here kind of is a way to explain that phenomenon. Within this context, though, we've identified three areas for capital deployment, all of which are probably could be defined as different flavors of opportunistic. The first area is the darkest gold shaded block, which is monetizing the equity and operating assets and portfolios, whether via acquisitions or recaps, using mezzanine structures to more finely parse, risk and return around the underlying project cash flows. The thesis here is that offtake agreements are shortening, which increases the proportion of asset values, subject to investors views of commodity prices after contract expires. This phenomenon kind of creates a cost of capital arb that can be monetized with mezz structures. The second area, and is the next lightest kind of shaded box, are shorter term bridge facilities set up to finance projects and late stage development and construction. The thesis here is that risk declines and cash needs rise as the project advances through the development cycle. However, this progression isn't linear. The existence of must have items like certain permits or certain interconnection agreements or otherwise has historically created a step-like function delta and return requirements between projects in development and operations. This also creates a cost of capital arm that can be monetized by parsing more carefully through the risks around the very late stage development last mile kind of development, when binary risks have been mitigated, as well as construction to structure a mezz product. The third key area that we've highlighted for deployment is development platform financing to provide growth capital for smaller developers. The thesis here is that development equity is quite expensive and can involve giving up control of the asset in addition to upside. So the thesis here is that if we can anchor a mezz deal with recurring revenue streams, whether development fees from asset sales, asset management fees are back in promotes, we can minimize the size or defer the timing of an equity raise and craft a mezzanine instrument that isn't as subject to volatile outcomes as otherwise. So Steven, to wrap up and comment a little bit more specifically on your opening comment, Biden's policies to the extent enacted will certainly, you know, supercharge the efforts that are already underway. However, existing policies and economic forces will, by themselves, result in the replacement of two-thirds of the installed capacity base in the US by around 2030 or so and 100% replacement of the capacity base by 2050. This will cause wind and solar as a percentage of total generation to rise from the current 10 to 15% today to around 30% by 2030 and 55 to 60% by 2050. And just to get to those goals, the -- many of the major consultancies are forecasting total capital requirements and the $1.3 trillion range by 2050 or roughly 40 to $45 billion a year. So exciting times, indeed.
>> Thanks, Deb. Really fascinating and so interesting to hear about that, which is an area that I think we're going to increasingly hear more about. And now we're going to have questions.
>> So the first question we have is in a world where the market has bifurcated into COVID affected and COVID unaffected, where are we in the credit cycle? So pre-COVID, it was fairly clear we were late cycle. In your view, has that change? Or do we continue to face the risk of a changing cycle in addition to the risks COVID has introduced? I think all of you can probably share your thoughts on that. Matt, I suppose, if you could go first.
>> I'm very happy to, Jenny. And it's a very good question and a common question we obviously face every day as we execute our investment policy in corporate direct lending. I would characterize it as the following. I think, pre-pandemic, no question, the economic expansion was on a multi-year uninterrupted period, which would have resulted in the longest economic expansion certainly since at least World War II, in the US anyway. I think with the significant monetary easing and fiscal stimulus that's come through on both sides of the Atlantic, our view is that most companies in the core economy has been -- has been reset to extend that cycle for probably at least a couple of years. The more salient question as we consider our business and bearing in mind we're investing in illiquid loans where the transaction flow is sort of manufactured, so to speak, on a primary basis, we're motivating transfers of capital to create investment. And where we view the real question to be in the short-term and evaluating that is exactly that. Does COVID impacted sectors? How quickly will they come back into a recovery path, which, of course, depends on vaccination curve return of normal sort of traffic and flow to society, et cetera? And so generally, from our perspective, it's best and conservative at least as a lender to be in one of the more risk off sectors, one of the more COVID resilient sectors from a capital deployment perspective and not attempt to time that recovery path, bearing in mind the overall economic conditions are still favorable, considering the massive stimulus and both on the monetary and fiscal side that we've seen.
>> Great. Thank you. Andrew, what are your thoughts?
>> Yeah, I'll pick up exactly that clearly, this COVID world, we're seeing the impacts of a huge levels of liquidity pumped into the system. But interestingly, just before this call, that's exactly the same topic was covered with one of our large institutional European investors. And really, the answer is in two parts with respect to real estate debt. The first part is one with real estate, our underlying assets. Another keyword to take out, in our opinion, is very much an acceleration of already structural trends, the most dramatic being in terms of consumer spending going from physical retail shopping centers to being bifurcated between logistics assets and shopping centers. So essentially, we've already seen the structural growth in demand for logistics and industrial property at the expense of secondary and tertiary retail property. And that's something that almost has been really pushed forward by the pandemic, but it is happening already. Flipside of that, looking at investor demand and occupational demand, it continues those sectors such as logistics. And in fact, residential, granular income, income driven strategies are gaining weight with institutional investors. And those are the assets that are performing better. And so, you know, I think pre and post COVID, for the real estate side, was a lot of acceleration structural trends. Interesting in real estate, then, and probably why it's such a late starter in the overall market is, again, the regulatory impact that has been increasingly coming in over the last 10 years and increasingly in Europe over the last three, four years. Again, the pandemic really shone a spotlight of what the banks can and can't do with their balance sheets. So they're very, very much looking at their existing books, which do contain more unfavored sectors, which is combination of looking forward at new lending that's going to be restricted because of those books, as well as regulatory changes further restricting their lending. There is a -- there is a contraction of liquidity from the banking sector post-COVID. But ultimately, neither of those two came as a surprise. And actually, it accelerated what we thought was probably going to happen over the next three to five years.
>> Thank you. Deb, do you have anything to add?
>> I can be brief. Jenny, the impacts in the renewable sector were muted and short-lived, if anything, driving a delay in some of the bills' pace, not postponement, though, and certainly not cancellations.
>> Thank you.
>> Deb, a question for me. Looking at your sector and this enormous growth that you've spoken of, going forward, where's that capital going to come from? How much of it is going to be from investors, institutional investors, individuals versus governments do you expect?
>> It'll all be, I think, predominantly, Stephen, private market or bank market, not so much government spends in our sector, we don't think. Tax equity tends to form 35 to 65% of the total capital of a new project with debt -- bank debt, generally representing another 30% and equity, the balance. So in that context, mezz is a bit of an opportunistic and nitchy kind of play, you know, looking to, again, look for these cap structure optimization plays or cost of capital arms that I described earlier.
>> Understood. Thank you.
>> I've got -- I had a few more questions submitted for you, Deb. But for now I'm going to pivot to Andrew. And this is pre-submitted. And it says in real estate, where do you see the highest relative value in the capital stack?
>> Great question. And one that has changed, I think, pre and post COVID. It is in two parts because we look at relative to what. I think I start -- if I start with more on the cost side, real estate debt offers quite a deep market, perfectly investment grade private credit. We've sort of sit separately, I guess, to the rest of the private markets. And that one is still one given the constraints on liquidity of the banking sector, one that does offer an interesting premium like for like over quarter equivalent rated corporate bonds. And we see that still developing further due to capacity reasons. And there's also an argument that although it is illiquid, tracked record over many decades show the actual default and loss rates at that level of core real estate that performs incredibly well against like for like corporate. So I'll leave that there, because that's very much in the investment grade space. I think, certainly relative value, bringing in risk and volatility against the return certainly is being seen very strongly in the higher yielding space. And really, the reasons for that is the fact that where we now need to go into the capital stack, on the last dollar risk, i.e. on the top level of leverage has reduced slightly not dramatically to achieve the same level of return, say 12% of the transaction. I'd say now the other attachment point, i.e. where you attach the senior in the mezzanine has probably doubled. So whereas normal position in a real estate capital stack is between 60 and 75, 80% to get a 12% return on a transitional property, now what we're seeing is you still get a 12%, but you're starting at 30, 40% in a stack. So double the amount of exposure, lower risk on a blended basis, but the same return. Different regions, that's in Europe in that range I showed, 8 to 12% also, we're currently probably towards the 12% of the return, whereas pre-COVID is more towards the 8%. And in the US, again, probably that core plus of the high yielding space. Again, not needing to get as high in capital stack to generate the same levels of return. Hopefully, that covers that question.
>> Great. Thank you.
>> Matt, a question for you that's come through and maybe Deb as well. How do you advise investors to integrate sustainability risks into investment risk management and oversight governance?
>> Really good question, Steven. And obviously, a common theme that we have in in the asset class. I think, from my perspective, when considering direct lending, of course, you have to consider a manager that has a holistic view top down to monitoring, evaluating, and managing ESG risks. We are not active owners of assets as lenders. And so our ability to influence an ESG outcome is built in portfolio construction on the front end. Possibly over time, there could be developments in the derivative market similar to green bonds, et cetera. You see in the syndicated markets that hasn't principally happened yet. And so from our perspective, it's really about thoughtful portfolio construction that in a way is ESG friendly, but in another way, more fundamentally, is investor outcome friendly. We're invested in sectors and with companies that are very responsible in undertaking these sorts of obligations. And then I think what you have to look for, of course, is managers that have, as I said, a top-down approach to monitoring -- have a top down approach to senior firm level oversight and commitment in terms of how they're thinking about ESG risks and have the ability in the technology in house to report on the developments in their portfolio and the ability to over time manage and sort of reallocate portfolio away from perhaps bad actors with respect to sort of ESG as a theme.
>> Thank you. And Deb, I'm kind of assuming that it's a given that your strategy is ESG compliant. But maybe there are -- you do need to think about sustainability risk even in the sustainability market.
>> You know, I think that we do, and I'd echo Matt's comments in that regard, Steven, with the obvious overlay of the mandate itself being very specifically focused at renewables and sustainability.
>> Actually, Steven, I know -- sorry to interrupt. But I think -- can I just make a quick comment on the ESG from that side because --
>> Yes, of course, you could.
>> -- [inaudible] quite a lot of passion. And I want our real estate debt view to come across as greenwashing. And I'll try and give a few examples. Clearly, real estate impacts on it quite a lot, particularly from our debt side, where we're driving developments, or driving refurbishments or driving change in property. We do make a lot of ESG selection at the front end. But we are true believers in the fact that this is another structural trend. So by funding low sorts of projects that are ESG positive, then those will result in a lower risk at the backend. But just to give examples, you know, environmental is obvious for real estate. And that is the big box that you tic. But if you take, for example, funding logistics, we're going funding modern logistics that needs to be powered positive. It's no longer good being carbon neutral whether it's through solar, whether that's through generate or using certain building construction techniques to generate that power, all the way across to another example at the other end, where we look at social. You know, we're big funders of purpose-built student accommodation. We've really backed those operators. But they just focus on providing flats but focus on the operational side. For example, most recently big issues around mental wellness and the wellbeing of students. So although we're debt, you know, our capital has a power to actually support certain operators and borrowers over [inaudible].
>> Great. Thank you. Jenny, do you have a question for the panel from --
>> I think all of you can help address it. So obviously, with the uncertain economic outlook, and also last year, what sort of levels of defaults did you see, if you saw any? And what do you expect going forward?
>> I'm happy to start in the corporate side. I would say that the best way to answer that question is to compare it to what the corporate direct lending market experienced during the GFC. By and large, defaults were meaningfully less than we saw, certainly at the peak of the GFC. I think if folks had portfolio that was over indexed to consumer facing sector, certainly, they had a higher experience of default. And I think the remedy of those defaults will be a little bit longer in duration. But for the most part, folks with properly diversified portfolios toward business services, manufacturing, industrial versus consumer generally saw a lower incidence of default, and those issuers in default, a shorter period of time and default. So unbalanced from our perspective. We've actually been pleased to the upside about the resiliency of the portfolio and corporate direct lending as an asset class, which has been, again, in part assisted by stimulus and in part assisted by, for the most part, responsible equity owners of these companies also being there to provide capital and ensure balance sheets are continually serviced properly.
>> Probably from real estate debt side, both are driven in two ways. Clearly, the collection of rents and that properties payer interest. But as with the value side, on the bet side, given where interest rates are, we've often got on the senior debt side debt service of one and a half, two times. So two things happen. One, lot less volatility on interest payments, except for sectors such as hospitality and retail. Thankfully, we've got restrictive exposure there. But what actually happened that surprised on the upside was how quickly rent collection. And we measured that we have reports monthly -- actually recovered. So actually, you had very few cash flow defaults. And those [inaudible] hospitality exposures were supported by very strong borrowers who continue to pay their interest. So probably, our typical PGIM deep dives were an awful lot more conservative than actual have turned out to be, but actually, they still supported, you know, a certain strength and significant downside protection and share position in the statement of cash flow cover coming from the underlying diverse revenue streams.
>> Great, thank you. Deb, I know that, you know, the strategy that is new for you. But can you give any sort of feedback from just energy in general?
>> Yeah, sure. Power and utilities is a very defensive sectors, as the listeners, I'm sure, know, with very inelastic demand. The utility side of things is really quite, you know, resilient to shocks like this. Because demand tends to only soften within a very narrow bandwidth. Where we saw any weakness or the most weakness was probably on the commercial, industrial solar side, because the commercial industrial customers were uncertain about the futures of their business. But again, it's a phenomenon that we had seen weakness in the second, third, quarter in terms of CNI customers signing up new contracts. But we didn't see large scale defaults or tremendous distress in the performance of existing assets.
>> Great. Thank you.
>> Thanks, Deb. I had a quick question for you, Andrew. I was intrigued by that chart that you've showed that demonstrated that the origination is much more diversified, if you like, in the United States. But in Europe and Asia, it's all banks. How quickly or if ever do you see the other markets moving in that direction?
>> That's fabulous. I mean, [inaudible] securitization market, the new directors and the EU has effectively killed the securitization market for European investors and issuers. So we do not see agency of securitization being a significant part in Europe or, in fact, Asia. So therefore, as the banks have to diversify, they can't keep on lending that proportion. It's mainly going to come from a breadth of alternative capital through private credit funds. You know, where we see securitization, like take a large loan against portfolios where they'd be put into the capital markets in the US. We'll probably do the same but directly with investors, circumnavigating investment banks and [inaudible] agency. So it'll be similar types of institutional capital but accessing through privately rather than through public CNBS bonds or agency bonds. Quite different.
>> Thank you. Jenny, do we have time for one final question? And do you have a final question to ask? If not, I'll wind up the form -- the former part of the form.
>> I guess we could -- Deb, maybe I could ask you a final question. So the returns that you mentioned earlier, you know, they're quite strong. So what are the risks around these investments and the cash flows around them?
>> Yeah. The big risk factors are stage of development and your degree of exposure to commodity exposure to commodity prices after contracts expire at high leverage if you're in a mezzanine context. So those are the three big drivers. And where you kind of land on that return spectrum is a function of one or multiple of those three, typically.
>> Thank you.
>> Thanks very much. Well, that more or less brings us to the end of the formal part of proceedings this afternoon. Ellie Troy is going to play again for you, this time, a piece of Brahms. It's from one of Brahms's piano concertos. And she's accompanied by one of her colleagues from Juilliard on the piano for that. That will last for about another 20 minutes. So thank you to all of our speakers for joining us. Thank you to all of you for joining us today. I hope you found that interesting. If you want to learn any more, please email us or have a look on the PGIM Alts website. Thanks again. Goodbye.
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