Every Chinese New Year, AsianInvestor makes 10 predictions about developments that will affect global financial markets and the portfolios of Asian investors, especially asset owners. Today we consider the appeal of private credit for asset owners looking for diversification and yield.

Which alternative asset class will climb most in asset owner portfolios?

Answer: Private credit

Institutional investors’ never-ending quest for strong, predictable returns is leading them to pump increasing sums into alternative assets.

SWF Institute survey published earlier this month revealed that the average asset allocation of global pension funds to alternative assets rose from 12% to 24% between 2008 and 2020. Korea Investment Corporation (KIC) is one of the many asset owners looking to do even more; in its case raise its alternatives exposure from 15.4% (at the end of 2020) to at least 25% by 2027.

Private equity will continue to dominate asset owner portfolios in terms of sheer volume and possibly returns, but when it comes to growing allocations, private credit will likely enjoy the biggest climb in the Year of the Ox. The asset class may not offer as much bang for buck as PE, but it can potentially lower portfolio volatility and offer more diversification. It is also typically a far smaller part of most asset  owners’ portfolios.

Alternatives data provider Preqin predicts that global assets under management in private debt will expand 11.4% annually, rising from $848 billion at the end of 2020 to $1.46 trillion at the end of 2025. That said, Preqin was even more bullish about the prospects for private equity, predicting it will rise 15.6% during the same period.

While the growth of the two asset classes may vary in the years to come, there are several reasons to be confident why the coming 12 months could favour asset owner interest into private credit in particular. 

First of all, opportunities in the private credit space are fast emerging, particularly in the US. Financial regulation makes it expensive for banks operating there to hold exposures to junk-rated companies, which forced many to let go of credit lines to businesses that  were downgraded amid the economic pain of Covid-19. This has created a dearth in middle-market lending, which provides an opportunity for investment.

Demand for bridge financing in US and Europe has also increased. According to an investment professional at a large US fund house, some of these short-term loan opportunities are offering yields of 600 to 800 basis points above Libor. In some cases, investors are building exposure to collateralised bridge loans with returns of around 17.5%.

With the Covid-19 vaccines now being rolled out, prospects are rising for a strong business recovery, which is likely to propel more M&A activities among businesses. On the other hand, the lingering impact of the virus has also opened up distressed debt opportunities in several new sectors, notably travel and leisure.

The acceptance of private credit by institutional investors can be seen by the increase in private credit dry powder, as highlighted in a Morgan Stanley report in December 2020:

Private credit fund dry powder

One wrinkle in the appeal of private credit could be the growth of environmental, social and governance (ESG) principles among asset owners.

Institutional investors across the world are increasingly focusing on ESG-friendly alternative assets, given a mixture of regulatory and member pressure. A BlackRock survey of 425 institutional investors in 27 countries released in December found respondents planned to increase their sustainable assets under management from the current 18% average to an average of 37% by 2025.

This emphasis could certainly bolster private equity, where investors can easily identify companies that are ESG aligned. Venture capital start-ups in particular often have an ESG mandate from the outset.

Private credit, in contrast, is currently being channelled towards older, middle-market companies in which sustainable principles are less engrained. However, private debt investors could use their influence to push for an ESG angle, not least because it is good for valuations.

Another factor to watch is the pace of the global economic recovery. A delay in vaccine rollouts or renewed lockdowns, courtesy of new virus flare-ups could put a dampener on the global economy, and layer further pain onto indebted corporates. That could offer opportunities and challenges alike for private credit, and the would-be investors into it.

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