Choose correctly on the private-debt journey
The short to medium-term outlook for private debt is complex to read, to say the least. There is mounting anxiety that the credit cycle may have run its course.
But this could be driven by the behaviour of managers, who have been lending exuberantly, rather than by any actual sign of weakness by corporate borrowers. At the same time, spreads have tightened across many sub-sectors and lending standards have declined, both in terms of weaker covenants and higher leverage. Investors in private debt may feel this is not a time to deploy more assets.
However, while private debt is not a risk-free investment, it is less about asset allocation than about manager selection. Debt financing will always be in demand in its various forms. The relative value of different kinds of private debt may fluctuate. But the asset class as a whole should continue to deliver returns over the long term, regardless of the performance of individual strategies.
Obviously it is nearly impossible to capture beta for this market. Investors in private debt may incur losses, even significant ones, if they happen to be invested in particularly weak borrowers at the wrong time. But the losses will be determined more by the behaviour of the private debt manager than by the wrong choice of asset.
Different managers may lend in a different way to the same borrower. Investors want to make sure they partner with the most prudent and most transparent managers. Ideally, they will want to partner with managers who have dealt with workouts or defaults in the past. These may be fewer than one might think, given the length of the current cycle.
It takes extra work to gain a deeper understanding of a manager, but it pays. The instances of managers claiming to be prudent while in fact they compromise on lender protection in order to participate in deals are bound to increase. Competition has been so strong that even the most cautious managers have had to accept weaker lending standards just to keep up.
As always, pension funds should focus on the long-term opportunity. The extra yield from private debt is just one of the immediate benefits. By investing in European private debt, investors are taking advantage of a historic structural shift that will benefit their members on many levels. The transition from a bank-dominated system to one where institutional investors play a large role in credit creation is almost irreversible. The European economy will become more dynamic as a result.
Carlo Svaluto Moreolo,
Senior Staff Writer