Private asset classes such as real estate and private equity have been gaining demand for many years now. But over the past few years private debt funds have also seen increasing investor interest, particularly among life insurers seeking an asset class that they understand but which yields a decent return in a generally low interest rate environment.
The asset class is very broad, comprising everything from securitisations of mortgages or credit card payments all the way to portfolios of mid-market corporate loans and distressed debts. And opportunities in this space continue to grow, courtesy of banks in Europe and the US seeking to offload loans that have become onerous under shifting capital rules.
Yet for all this interest, there are some concerns over whether the appeal of such private debt investments is waning, courtesy of rising prices and fears over an eventual economic downturn. Additionally, the ongoing appetite of asset owners for private debt has allowed an ever-broadening array of creditors to tap this market, raising fears that the quality of borrowers is falling.
Worrying signs for the world's credit markets include a 20% drop in appetite for syndicated loan lending in the US in 2019, along with falling appetite for leveraged loans, with investors pulling money from loan funds. Meanwhile there has been a rise in corporate credit defaults in China – although that is offering opportunities for distressed debt funds.
Given this environment, AsianInvestor canvassed views from four experts on the appeal of private debt with investors over the coming year, and which parts of the private debt space offer the most opportunity.
Daniel Blamont, head of investment strategy
Phoenix Group (a UK life insurer)
We still anticipate significant demand for private assets generally, especially from the life insurance sector, for a couple of reasons. First, we suspect that private asset allocations are still below targets for a number of insurers. And consultants expect to see £20 billion ($26.3 billion) to £30 billion in pension liabilities transferred to insurers this year (in the form of bulk purchase annuities).
Due to high demand, 2019 saw a compression of spreads and illiquidity premiums in UK private debt versus public debt. In some cases the strength of covenants weakened, although this was more prevalent for lower-rated debt, to which life insurers allocate less.
This could reverse in 2020 if we see an increased supply of debt. If the uncertainty around Brexit lifts and (to a lesser extent) trade tensions ease, there are pent-up investment needs in the UK that could be financed by debt. This could favour infrastructure and commercial real estate debt in particular, where recent supply has particularly been affected by Brexit.
The base case macroeconomic scenario from most economists suggests modest growth and central bank support. As such, the main worry is not about a downturn in 2020. Instead we would advocate a diversified portfolio and maintaining underwriting discipline – for example, being selective on BBB/BBB- and avoiding cov-lite – to be more resilient to any future downside surprises.
Brian Dillard, managing director and head of Asia Pacific credit
Private debt as an asset class has benefited from the sustained period of low interest rates and we expect that allocations will continue to increase as investors focus on the illiquidity premium in their intensifying ‘yearn for yield'.
However, as the market continues to heat up, investors are moving further along the risk/return spectrum and we are keeping a close eye on a number of evolving trends, such as the loosening of covenants and inclusion of aggressive add-backs.
Despite global macro headwinds, we see great opportunities for private credit investing worldwide in 2020, but the way we think about private debt is shifting. We are being more selective in our investments and we believe the key to success going forward is to be a ‘solutions provider’ that can offer flexible options depending on the needs of the borrower – whether it’s a first-lien, unitranche, or a second-lien solution, or the ability to write a larger or smaller check.
We’re particularly attracted to the asset-based or specialty finance space. We see some compelling risk-adjusted returns in geographies like Asia Pacific, the US and Europe and we’re spending time looking at mortgages, auto loans and even hard assets like the aviation leasing space.
Vincent Mortier, group deputy chief investment officer
Private debt has for sure gained interest with institutional investors because they lack alternatives, while it is also a fact that it is an illiquid long-term asset class, so it suffers less mark to market concerns, which can be interesting for long-term investors.
To be sure, question marks are being posed as to the quality of some new credits which are being issued and their long term suitability. So you need to be sure you are paid for lack of liquidity that you accept. The spread of quoted debt to non-quoted debt yields must be acceptable. This variation depends on the credit but you for sure need to have [about] 1.5 to 2 percentage points difference.
However, we see that some private debt is converging with quoted debt and so you can question if its acceptable to give up liquidity for five years to 10 years; it’s a big commitment and so you should be paid for it. This is an issue because there is so much credit in negative territory that people are becoming desperate to find some yield. Despite this, you should always look risk versus reward.
We are seeing more and more questionable debts coming out this year such as leveraged loans or SMEs (small and medium enterprises) private debt that has poor credibility or poor performance. Given that, it's important to choose both the right asset class and manager. It's also why you need to be very strict on your [credit analysis] processes and to understand each company or have people that can do it for you. Given where we are in the credit cycle it's easy to make mistakes, and that's why active management is particularly important.
Overall, I would say that investment grade-equivalent debts are so far fine and can perform even for the long-term, but when it comes to leveraged loans and high yield areas you need to be even more questioning than before. To do your job properly you need to go line by line, name by name and to become comfortable with each name, sector and risk.
Simon Coxeter, director of strategic research
Private debt will probably play a growing role in capital markets given the evolution in commercial bank lending since the global financial crisis. Viewed through the lens of a robust due diligence framework, private debt offers select opportunities for attractive risk-adjusted returns.
However, with more widespread reliance on fund-level leverage to enhance returns, we’re not convinced that investors are fully aware of the risks involved.
Managers use leverage to enhance returns because yields are low. While this works well during a benign credit environment when defaults are low, it can become dangerous if underlying investments don’t perform as expected.
Leverage is a valuable tool for some experienced managers, but we need to see a long-standing track record of using leverage effectively, with prudent deal structuring and fundamental underwriting skills across many investments. We also believe that managers should define, disclose and limit uses of subscription lines (which are short-term loans).
Investors should dig deeper into the complexities of subscription lines and fund-level leverage.
Joe Marsh contributed to this article.