As Asia’s asset owners increasingly delve into private debt, they have become increasingly interested in riskier mezzanine and subordinated debt tranches, in addition to the top of the capital structure.
These types of investment offer better returns—but they also increase the likelihood of something going wrong.
Korea's Public Officials Benefit Association (Poba) is one example of an institutional investor willing to take more risk into private debt investments. It invested $50 million into distressed debt in a new mandate in 2017 via specialist manager Alcentra, chief investment officer (CIO) Jang Don-hung told AsianInvestor.
“We felt the committed amount was not excessive for a first-time investment, and we needed to have a higher risk element in this area," he said.
In part, Asian investors take more risk because of their return expectations. “In Asia you are [often] assuming the local equity market is going to give you 6% to 8%. Thus, when going illiquid and offshore, there’s probably a greater requirement for return,” Chris Redmond, global head of credit at Willis Towers Watson, based in London, told AsianInvestor.
NZ Super CIO Matt Whineray offers a similar view. His sovereign wealth fund has to take an off-benchmark risk allocation to get into private debt. “From a risk perspective, that means we have a hurdle framework that requires a higher return for a more illiquid asset,” he said.
The fund currently has three private debt mandates with Canyon Partners (NZ$180 million) and Bain Capital Credit (NZ$90 million) and American Securities (NZ$33 million). They are primarily focused on distressed debt.
Funds need a degree of size and sophistication to minimise the risks of private debt allocations. “Without scale and appropriate resourcing, understanding the credit market and having people who have invested through cycles, I think it would be challenging,” said Linda Cunningham, head of debt investment at Australian superannuation fund Cbus. “You ... really want to know who’s lending your money, because when things are getting tough, either in the market or with the corporate, you want to know how they are going to be paid.”
The influx of money into private debt has also led spreads to compress.
“It’s quite competitive to find the right deal, the finance conditions are getting looser and we have started to have some concerns,” said Poba’s Jang.
Redmond says the biggest risk for investors lies in their losing sight of the economic factors affecting debt markets. This includes cyclical headwinds and the fact that mass quantitative easing has compressed debt yields.
“The current benign default environment is unlikely to persist over the medium term,” he noted.
Critically, budding investors need to remember that not all illiquid credit investments are created equal. “Value varies wildly across the myriad of different component asset classes,” warned Redmond.
Investors also need to be sure they won’t need the capital they deploy into this illiquid asset class for a few years.
Despite these challenges, private debt looks set to grow as an asset class. Some predict it could keep expanding for the next decade.
“The deepening and broadening of the private debt asset class is likely to represent an important driver of asset owner allocation growth,” said Redmond. He estimated that institutional investors could shift from an average portfolio exposure of 3% to 5% up towards 10% over the next five to 10 years.
Private debt is quickly shifting from being uncharted ground to a well-established field of asset investment.
This story is the second in a two-part focus on asset owner interest in private debt in Asia, and was adapted from a feature in AsianInvestor's December 2016/January 2017 magazine. Please click here to read the first part.