Present market conditions have generated many opportunities in private debt but the challenge is finding the right deals 

Key points

  • Disintermediation remains a powerful force behind growth in assets
  • There is a complicated due-diligence process
  • Finding the right credit characteristics presents a challeng
  • Investors are structurally positive but treading more cautiously as signs of ‘exuberance’ emerge 

There is a plethora of names for private debt/credit, such as ‘alternative’, ‘illiquid’, or ‘non-traditional, as well as ‘private’. Whatever the nomenclature, private debt has maintained enthusiastic support over the past year, despite growing headwinds in the more traditional fixed-income arena.

Some repercussions of the global financial crisis are key to the growth of private debt. “Regulatory changes, particularly for the banks, have been a key driver, changing the landscape and throwing up opportunities in this increasing focus on alternative credit,” says John Dewey, head of investment solutions at Aviva Investors.

“As well as changing supply dynamics, regulation for insurance companies is also driving demand to an extent,” he says. Under the EU’s Solvency II Directive, certain alternative-income assets benefit from a lower capital charge. However, Aviva Investors points out that the heterogeneous European legal landscape means European insurers may have different perspectives on the implications of Solvency II for alternative assets. 

john dewey

The appeal of alternative assets has increased, says Thierry Vallière, global head of private debt at Amundi Asset Management. “Our clients are evolving in an unprecedented challenging and evolving environment with unconventional monetary policies having a number of adverse consequences across most asset classes,” Vallière says. “We have seen considerable inflation in asset prices due to very low interest rates, even negative in some classes, leading to stronger portfolio concentration and increased correlation amongst the asset classes, coupled with a fall in both volatility and liquidity. In that context, private credit is a good alternative to traditional fixed-income and is, we think, too big to be ignored.”

Garvan McCarthy, partner and chief investment officer alternatives at Mercer says, “The easy money has been made in the public markets. With low credit spreads, and the prospect of returns significantly lower than the exceptional returns we have seen in the past decade, pension funds do still need those incremental returns, but without taking elevated risk. The key to investing in private credit is essentially the same as in public credit – building a diversified portfolio of loans.”

While credit analysis is certainly a skill-set that fixed-income managers should already possess, credit analysis for private, unlisted debt investing requires significantly more resources. Aviva’s Dewey describes having to dig deeper, adding: “Being able to digest the often huge amounts of literature as well as studying the covenants, needs a lot of technical resources and plenty of specialisation. This extra work is not because the investments are more risky, but they are more idiosyncratic and complicated.” 

Vallière agrees, describing how Amundi carries out intensive due diligence throughout the life of the investment. “There is no magic; we need to be rigorous and disciplined, we need to fully understand how each deal is structured, and how it will perform in a more challenging environment, given the risks identified. 

“Sourcing is critical. Amundi are extremely careful when selecting the investment, and on average we invest in only one in 20 of the investments presented to us,” says Vallière. He argues that this selectivity allows Amundi to only invest where it sees demonstrable value, rather than when faced with a paucity of deals, having to lower investment standards.

M&G sees illiquid credit, or private debt, as essentially embodying the qualities that investors have always sought from fixed-income – the additional return available from the credit spread at the point of purchase and the delivery of a steady cash income. “Whether investing in senior finance or the more junior tranches, as private debt rarely has a public rating, it is essential that managers have the skills and resources to rate their investments themselves,” says Annabel Gillard, director, global institutional distribution at M&G. 

This labour and resource intensity presents considerable hurdles to investors, particularly smaller funds. Neuberger Berman’s CLO [collateralised loan obligation] Income Fund is aimed at investors who cannot open a separate account, or who do not have the resources to invest directly in CLO debt. As manager Pim van Schie states: “We know that some of the smaller investors do not have an easy way to make a dedicated allocation to CLO debt, and this fund provides such a way.”

The pan-European UCITS-compliant fund will invest primarily in CLO mezzanine debt securities. “There will also be a 10 to 20% exposure to high-quality US high-yield security, to aid the liquidity requirements,” says van Schie. “This is for sophisticated investors who are familiar with high-yield or with loans, as a more efficient way to access the same underlying credits. Floating rate, very diversified and carrying significant fundamental downside protection, with a 3 or 4% additional yield over comparably rated high-yield.”

This fund is not intended to get too large. Neuberger Berman acknowledges the dichotomy between the liquidity requirements for UCITS compliance and the fundamentally less liquid characteristics of the alternative credit market.

“It is essential that managers have the skills and resources to rate their investments themselves”

Annabel Gillard

The illiquidity premium is one of the key attributes of private debt. Mercer emphasises the importance of fully understanding the liquidity of its private investments, and matching it carefully to its own time horizons. McCarthy adds: “For many pension funds, with horizons 20 to 40 years into the future, they do not need the same liquidity offered by a publicly traded instruments.” 

Although strategically upbeat about future prospects, many managers are striking a more cautious tone today. Neuberger Berman’s Van Schie says: “We are still constructive on the default rate because, in our view, the underlying issuers of the debt we are looking at are overall healthy, with decent earnings growth ahead. In CLOs generally, we would agree that the quality of the collateral overall may be declining, but we also think critical problems are still quite a way off as we do not see the near-term catalyst to cause a credit event.”

Mercer’s McCarthy adds: “There is evidence that spreads are tightening, especially in the upper/mid-market in the US, in infrastructure and real estate especially, where so much of the new money has been raised, although lower down [the capital structure] spreads remain quite stubbornly wide.”

Today’s market may need even greater care and deliberation. “There has been a great deal of money chasing the opportunities and yes, we do see slippage in the market’s risk management,” says Vallière. “And credit metrics are deteriorating. It is possible that we will encounter difficulties over the cycle, but that is why sourcing is so critical; we have to be able to decline what we do not like. Perhaps, for example, we might like a particular business, but if we do not appreciate features of the business restructuring, then we will not invest there.”

Aviva argues that this uncertainty may further justify consideration for private assets. “Private debt offers assets that are genuinely different, offering downside protection and real diversification,” says Dewey, as well as the possibility to allocate to areas where fewer are going. “Pension funds, for example, typically less heavily regulated from a capital perspective than insurance companies, can choose maturities less favoured by insurance companies, or below investment grade, or perhaps to accept a little prepayment.”

Bank disintermediation is ongoing, and investors remain keen to embrace this new role of providing debt financing to mid to smaller-cap companies. In this resource-demanding domain and with tailwinds abating, investors will need to ensure they keep digging deep.