The rise and rise of private debt
By Vic Leverett, head of Alternative Investments at Russell Investments – Since the Global Financial Crisis (GFC), private debt has received increased attention and growth for a variety of reasons. These have included the ongoing low interest rate environment, elevated equity valuations, the diversification benefits and higher yield potential offered by private debt. The case for private debt appears to be a strong for investors with long-term investment horizons and higher risk tolerances.
This case has been further strengthened by structural changes in the financial services industry following the Global Financial Crisis. While still dominating corporate lending, banks have pulled back from the lower end of the middle market, reducing exposure to these loans in response to industry consolidation and increased regulation. This has created higher demand for nonbank loans.
With substantial disruption as a result of the Covid-19 pandemic, and investors struggling to find income from traditional assets, private debt could be set to become a more central cog within diversified portfolios.
Why private debt for investors?
A common theme in recent months has been the desperate search for income. Private debt provides an immediate solution to these difficulties, offering higher annualised income when compared with traditional fixed income asset classes.
Further, investing in private debt can offer additional downside protection through diversification to traditional asset classes, an increasingly attractive characteristic in the context of the events of the last year.
Finally, while some investors might have reservations about the illiquid nature of private debt investments, investing in this space does offer a yield premium.
Dislocations create opportunities
Publicly traded debt and equity securities have surged in price since 2020, after central banks and governments across the world unleashed trillions of dollars in stimulus to dull the economic blow from the pandemic.
Private market activity has surged as a result. The Financial Times recently reported that 520 private credit funds were available to investors in October 2020, up from 436 at the beginning of that year and just under 400 in January 2019. Average fund sizes also grew, with the combined fundraising target of USD292 billion, up from USD192 billion in January 2020.
The fundraising target would add to the significant pot of dry powder for private market managers to deploy, worth approximately USD300 billion.
Where do the most opportunities lie?
Some of the most attractive private debt opportunities are currently within senior-secured corporate, real estate, opportunistic corporate and asset-backed debt. These strategies are attractive from a return perspective but also have enhanced downside protection.
A number of strategies currently have particularly positive outlooks: senior-secured loans to lower-middle market sponsored and non-sponsored transactions are a good example, particularly if in first lien (a legal right to assets used as collateral to satisfy a debt in the event of default). Commercial real estate mortgages on stabilised properties also look attractive in the cities where real estate markets are highly developed.
Similarly, in other parts of the financing markets, restaurant franchise-lending (primarily in the form of senior-secured and stretch-senior loans) offers some enticing opportunities, as does debt-financing for technology companies given that equity injections can be both expensive and dilutive. Specifically, within the US, there are also some interesting areas in completion financings within agribusiness, itself sitting behind the broader farm credit structure.
Where are the risks?
Notwithstanding the opportunities available in the current environment, there are three areas of particular focus when we are selecting managers for client portfolios: higher default rates, managers’ ability to minimise loss and patience in deploying capital.
Credit defaults have remained around historic lows for about 10 years, following a high in 2009 in the wake of the GFC. However, it should be noted default rates for speculative-grade corporates rose in 2020 and this is worth watching.
Several factors influence default rates of borrowers, including the amount of leverage, debt coverage ratios, profitability, growth prospects and size, among others. Managers must balance all these factors to both minimise defaults and maximise the recovery in case of default. An important part of analysis when researching managers therefore lies in examining their ability to handle potential defaults. Allocating to experienced investment teams in a post-Covid-19 will key to determining private markets success.
The third area that investors must watch closely is managers’ prudence in allocating capital. Dry powder is on the rise across all of private markets, including in private debt. Significant investor demand can lead to the deterioration of lending standards, which could in turn increase risks as well as defaults. It is important to focus on those managers that prudently allocate capital, lending to high-quality borrowers with high-quality assets as collateral in the event of a default.
All of these are key to long-term success.
The bottom line: Plenty of opportunities but be practical and prudent
With senior secured loans in private debt offering returns in the range of 5-10 per cent, a significant premium over similar credit risk in liquid markets, investors will continue to seek opportunities to place capital with private lenders.
There are a plethora of high-quality companies who need to borrow money to grow and others with sound businesses who may have temporary challenges but will come through with strong balance sheets.
Ultimately, in 2021 well-managed, diversified portfolios of private debt can provide robust and resilient returns to investors with long-term investment horizons.