Asian asset owners' hunt for yield is causing them to increasingly tip toe into the vast but opaque asset class of private debt.
The term private debt is essentially a catchall to describe various forms of debt financing that are not traded on a daily basis. These types of investment have grown as traditional bank lenders have reduced lending to high yield or middle market corporate borrowers. Their withdrawal was a consequence of global regulations, most notably Basel III bank capital requirements.
That’s offered an entry point for alternative lenders, especially asset owners with long time horizons and capital to spare. Over the past decade global investors have become increasingly willing to dive in.
Global fund assets under management in private debt have increased threefold in 10 years, from $150 billion in 2006 to $595 billion in 2016, according to data provider Preqin.
Asia Pacific investors are increasingly playing a part too. Institutions including Korea’s Public Officials Benefit Association (Poba), the Hong Kong Jockey Club, the New Zealand Superannuation Fund and Australia’s Cbus have introduced private debt into their portfolios or increased allocations this year. More will do so in the years to come.
In Asia, pension funds and insurance companies are major investors, according to Yang Mei-ni, head of private markets services at Mercer. “Together, they account for roughly 50% of investors, and the remaining half consists of foundations, endowment, family office and sovereign investors,” she told AsianInvestor.
Their interest is understandable: private debt is by its nature not a liquid asset class, with many of the assets within it having to be held until maturity. And, while it is viewed as relatively safe (indeed, many loans have a higher seniority than bonds issued by the same borrowers), that can be a concern for investors with shorter time horizons.
But, for asset owners seeking to ensure a set level of return, private debt instruments can offer some compelling—and more importantly predictable—levels of return. That looks likely to drive more funding into this enormous fringe market.
Of particular appeal
When assessing private debt, institutional investors first need to understand it.
“A common way to think about private debt is [as constituting] non-broadly syndicated transactions that are more between a small group of lenders and the end capital user,” Chris Redmond, global head of credit at Willis Towers Watson, based in London, told AsianInvestor. “[The loans] tend to be direct with a corporate or through a private equity sponsor with a small number of lenders, or in some instances just the one lender.”
In addition, some private debt is comprised of leveraged loans or bank loans are broadly syndicated to other investors, which sometimes trade the debt with each other, offering some liquidity. Collateralised loan obligations are also lumped into the asset class, and specialist fund managers exist that are willing to buy and sell such securitisations.
Preqin’s latest survey on the private debt sector, conducted in the second half of 2017, reveals that certain private debt strategies are gaining particular attention.
The majority (62%) of investors felt direct lending presented the best opportunities, as the fund type and underlying strategies have increasingly become mainstream components of investor portfolios. Forty percent of respondents liked the look of mezzanine funds, while 32% and 20%, respectively, looked favourably on distressed debt and special situations funds.
For their first taste of private debt, asset owners typically allocate to areas like middle market corporate debt lending. For a growing continent of asset owners, including pension funds and insurance companies, it also includes refinancing and buyout activities in private equity, commercial real estate lending, syndicated loans and securitised products linked to aircraft and shipping leases.
In return for giving up liquidity, investors into private debt can enjoy decent levels of annual return.
Senior private debt strategies typically deliver a 200 to 300 basis point additional return over traditional fixed income for being in the illiquid part of the market. For asset owners pursuing higher returning, more subordinated and non-performing opportunities, the private debt market can typically add high single-figure percentage point returns.
The allocations tend to be funded from allocations from equity portfolios, and larger Asian asset owners have often created teams in both fixed income and equity alternatives, to analyse the opportunities in each.
“Our European exposures anticipate a higher IRR (internal rate of return) around 8%,” Linda Cunningham, head of debt investment at Australian superannuation fund Cbus told AsianInvestor. “But clearly within alternative debt we’ve got a mix of higher and lower return seeking investments, which combined help to meet our objectives.”
Cbus has about 5% of its A$42 billion portfolio invested into European senior secured private debt. In Australia, it also has exposure to private debt in the form of bank loans.
“That’s essentially the market; it’s not really subordinated,” said Cunningham. “It fits within what we call our alternative debt sector, which targets 2% above cash net of fees on a rolling three-year basis, so it’s not an overly aggressive sector. It’s very much focused at the senior end.” She estimated Cbus’s total exposure to private debt to be about 7% of its assets under management (AUM).
Investors are attracted by the fact the funds pay out quickly, despite their illiquid structures. They also appreciate the fact most private debt issues are floating-rate, as it offers some insulation against a rise in interest rates. The combination can make private debt appealing versus other alternative asset classes.
“Private debt funds can generate a fast distribution of income compared to private equity funds,” said Jang Dong-Hun, chief investment officer at South Korea’s Poba. “We really do not like to go through the J-curve effect (where a period of negative returns is followed by a gradual recovery over an extended period), so private debt is a way to overcome this effect.”
Korean institutions beyond Poba have embraced private debt investing with gusto in the last two years.
Other asset owners putting money into private debt funds over the past two years have included the Korean Credit Teachers Union, Korean Teachers Pension Fund, Government Employees Pension Service (GEPS), Police Mutual Aid Association and Korea Post. And in 2017 GEPS, Poba and Korea Construction Workers’ Mutual Aid Association all made further commitments.
Chris Redmond, global head of credit and diversifying strategies at Willis Towers Watson, estimates the median percentage allocation within the average global asset owner portfolio is in the 3% to 5% range. The average is lower than the median figure because, Redmond observed, “there are still some investors who are at zero and have no interest in building knowledge and exposure, while some investors are at high single figures.”
Three years ago, Poba stood among the former, when Jang joined. It needed reliable annual investment returns to help stock up for its retirees, but the obvious fixed income asset classes—US treasuries and Korean treasuries—offered very low carry yields. “Private debt funds were one of the key investments I had to work with,” said Jang.
The pension fund has allocated about W240 billion ($210 million) into private debt, especially via direct lending and senior tranches, and has earmarked $610 million in total into the asset class.
The interest rates remaining stubbornly low in the European Union and Japan, and only inching upwards in the US, more funds are likely to join Poba and its Korean peers in the search for the yield opportunities that private debt can provide.
This is the first in a two-part series on the appeal of private debt with Asian asset owners, adapted from a feature in AsianInvestor's December 2016/January 2017 magazine. Look out for the second part soon.