Long-term investors, as their name suggests, tend to be a patient bunch.
Yet they would be forgiven for running out of patience when it comes to finding yield from fixed income assets. Luckily there are signs that the stars are aligning for Australia’s private debt market, rewarding long-term investors with an under-explored investment opportunity.
S&P Global estimates that the global private debt market has grown tenfold in the past decade. But it remains a relatively immature investment opportunity in Australia. That said, the conditions that shaped private debt markets in the US and Europe some 20 years ago are beginning to play out here. If we rewind to the US market of the 80s and 90s we see similarities to what’s occurring in Australia right now. In the US back then, bank consolidation, M&A activity and leveraged buyouts were gathering pace, with banks focusing their energy on lending to larger companies and businesses rather than smaller and mid-sized ones.
Appetite for privately-sourced debt
Private debt managers came along to fill the funding void, shifting the US lending landscape in the process. According to industry figures, in 2008, the bank share of US and European Primary Loans was 55 per cent, while non-bank was 45 per cent. By 2019, that had switched dramatically, with the bank share at 21 per cent and non-bank at 79 per cent.
An appetite for privately-sourced debt was further compounded in the US and Europe by the GFC as well as tighter financial sector regulations. These forces combined to hobble the global banking sector and crimp its risk appetite. Mid-sized firms and companies were desperate for sources of capital and banks weren’t willing to lend. And with the central bank handbrake on interest rates, yield-hungry investors looked beyond the public markets to private lending.
Dry powder in the private equity space piling up
We’re seeing the trend towards private debt now taking place on our shores. At the same time, dry powder in the private equity space is also piling up, setting up something of a ‘diamond in the rough’ for yield-hungry institutional investors. Private equity managers are actively looking for debt to deploy this capital, fuelling the private debt market and creating an opportunity for institutional investors as a source of debt.
This opportunity is playing out in the M&A space where deals are typically a 50/50 split between equity and debt. M&As are running at a record-breaking pace and show no signs of slowing down. Deals worth $1.52 trillion were struck in the September quarter alone, up 38 per cent from the same time a year earlier, according to Refinitiv data. Closer to home, the figures show that third-quarter volumes rose 21 per cent in Asia Pacific to $365 billion.
Private equity firms are continuing to look for a slice of this action and ways to finance their aspirations. Recent figures from Preqin show investors allocated $4.3 billion to Australian private equity firms throughout 2020, and they stand ready with more than $11 billion in dry powder to deploy.
The appeal of private debt funds is that they tend to have a buy-and-hold approach, meaning lower volatility than equivalent public market debt. For those with a longer-term investment horizon – five years or more – its illiquid nature tends to equate to higher yields. Industry figures from March this year show private debt yields ranged between 6 per cent and 17 per cent. This compared to yields of 1.7 per cent for 10-year government bonds or 4.4 per cent for Broadly Syndicated Loans (BSL).
The signs that Australia is on a similar trajectory to the US and Europe are increasing, and investors such as insurance companies, endowments and foundations are getting involved.
Capitalising on opportunity
Superannuation funds are also capitalising on the opportunity that private debt brings. And in light of Your Future Your Super where all fixed income is benchmarked against a public market index, we might see their allocations to private debt ramp up even further, given the yield available versus the equivalent public market debt.
Although Australian banks escaped the full extent of the GFC, their dominance of the funding landscape has begun to shift as they increasingly grapple with increased regulation brought about by the recent Royal Commission and changes in APRA lending guidelines. These tighter lending conditions are flowing through to impact smaller borrowers, creating a similar dynamic to what occurred overseas. Coupled with record low interest rates, buoyant M&A activity and enthusiastic private equity firms, it’s likely that the Australian private debt market has plenty of upside left to run.