Written By: Jo Waldron
Jo Waldron of M&G Investments considers how investors can maximise the opportunities provided by private debt
As yields on public bonds have declined, owners of long-term capital have increasingly recognised the long-term potential for private debt to help them meet their investment goals. Investment in private debt and leveraged loans has flourished over recent years as pension funds and insurers have reallocated risk in search of additional returns. The push into private debt by pension funds is not new, but with many institutions indicating plans to further increase their allocations, this looks set to accelerate. How can investors make the most of opportunities in an evolving market?
Determining the right allocation for your investment objectives
Private debt, as a term, is often used interchangeably with “direct lending”, given the popularity of this investment strategy with many investors, but private debt is more than direct corporate lending. Private debt covers a range of different investment styles and sub asset classes – ranging from well-established areas such as private placements, infrastructure debt and commercial mortgage debt to newer, more niche or highly-specialised areas such as trade receivables, asset-based lending or specialty finance.
The private debt opportunities on offer today can help investors with varied financing needs access a diverse range of maturities, risk/return profiles and instruments – offering a variety of fixed, floating or inflation-linked cashflows. Investors with genuinely long-term liabilities can gain exposure to long-dated, contractual cashflows, while other investors may be looking to increase exposure to tangible assets based in the real economy. Investment managers have also developed flexible, innovative investment strategies to address the evolving needs of their clients, no matter what challenges they face along the way.
For pension funds, the relatively high coupons on offer can enable them to meet ongoing obligations and improve their funding levels, while benefiting from diversification from traditional asset classes through lower volatility and better downside protection. The breadth of the private debt investment universe means it can play a role in different parts of pension schemes’ portfolios, depending on the specific circumstances of the scheme, and trustees’ and sponsors’ tolerance for illiquidity. A scheme’s individual investment objectives, time horizon and constraints will help to determine the right portfolio balance and investment strategies needed to achieve its desired outcomes.
Understanding the risks and finding value in private debt
Investors are compensated for the relative illiquidity of private debt assets and limited secondary trading opportunities – with this extra yield over comparable public debt assets often referred to as an “illiquidity premium” – although factors such as the complexity or structure of the deal are often bigger contributors to excess pricing than illiquidity. To determine whether an investment provides adequate compensation, you have to also be able to assess the value being offered by similarly-rated public debt instruments – where these exist. Managers that are equally as active in public debt markets as they are in private debt markets may be better equipped to do this.
Those investing or considering raising their allocation to private debt to harness the illiquidity premium should nevertheless be mindful that it can vary over time and the private or illiquid nature of the asset does not guarantee that an investor will earn a premium. If investors have fixed allocations to specific subsets of the private debt markets that are witnessing particularly high levels of demand relative to the amount of supply, then these investors may end up seeing little or no premia. Investors therefore need to be disciplined in ensuring that they are always sufficiently rewarded for the illiquidity – either in terms of receiving higher returns, or through enhanced structural protections. A private debt investment opportunity should compensate for the risks being taken and compare favourably to the public and liquid alternative, and if this is not the case, then having the flexibility to invest elsewhere can be beneficial.
Market commentators tend to focus on the high levels of dry powder that have built up over recent years in certain pockets of the market, given worries about spread compression and looser documentary protection for investors. These levels of uninvested cash only become challenging if the pressure to deploy capital quickly leads managers to go after investments they would have normally decided to pass on – deals that lack the transparency to fully evaluate the creditworthiness of the borrower or issuer and/or come with high execution risk.
It is not easy to trade in and out of the asset class as there are limited secondary trading opportunities available once an investment has been made, unlike for leveraged loans where lenders have the option to exit an investment if they feel uncomfortable about the borrower’s ability to service the debt it owes, for instance. This is where having dedicated resources on hand for private and unlisted debt becomes very important – including a large credit team to perform the necessary credit analysis and due diligence on the borrower or issuer upfront and carry out post-investment monitoring, while being able to draw on the expertise of an in-house workout team to help to protect value in the unexpected event that things do not go to plan.
Selectivity and the importance of diversification
At this late stage of the cycle, there is greater importance on investment selection within and across asset classes, as well as the ability to manage credit risk in portfolios to minimise expected credit losses and ensure credit rating downgrades and defaults remain low. The key thing is not to be a forced buyer – either of weaker companies that might not fare well in a downturn or of strong companies with healthy cashflows whose documentation fails to protect the pre-eminent status of the senior (first lien) lender adequately.
Private debt opportunities are often senior secured (private placements are unsecured but rank alongside bank RCFs). This means that if an investment does not perform as expected, then the holders of these assets are first in line to be repaid, ahead of unsecured debt holders – affording more downside protection compared to other similarly-rated fixed income instruments. Structural protections such as covenants are also a common feature of most forms of private debt and serve to provide the investor with early warning signs of any deterioration of company earnings, income or liquidity. Covenants allow an investor the opportunity to intervene before a significant credit deterioration occurs.
Together with seniority and security, managers can also buffer in sufficient downside protection in an investment portfolio by investing in certain assets over others when it makes sense to do so. This could be ensuring assets are cheap relative to their fundamental value before investing to maximise risk-adjusted returns, while maintaining a high degree of selectivity over which assets make it into a portfolio. Diversification is also important to minimise concentration risk.
Taking the long view
Private debt is a broad and diverse asset class in its own right, but having the flexibility within a portfolio to consider income-generating opportunities from both public and private markets, on an asset-by-asset basis, can also help to achieve the required risk-adjusted returns and provide sufficient downside protection for investors. Private debt can provide pension schemes with assets that range between everything from long-dated investment grade opportunities to help fund cashflows, to higher-returning high yield opportunities that can help to reduce funding gaps over time.
For Investment Professionals only.
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