The Your Future Your Super (YFYS) performance test has placed the investment portfolios and strategies of super funds under more scrutiny than ever. With existential consequences of failing the test, CIOs and investment professionals have begun probing their portfolios, ensuring each allocation is playing its part to promote member best interests without increasing risks of failing the test in the future. In a turbulent market that seems to be battered in recent years by crisis after crisis, one asset class has cemented itself as a new cornerstone allocation: private debt.
Private market investing is not new and Australian super funds need to increasingly look to new private markets as a way to capturing long-term risk adjusted returns. This will especially be the case where the outlook for listed bond and equity markets are more challenged than previous years.
Private debt is a broad universe of investments where capital is loaned to a corporate entity in exchange for interest repayments and the original principal is to be repaid at a defined point in the future. Globally, the asset class has tripled in size since 2008, primarily driven by the Global Financial Crisis, and locally the Hayne Royal Commission which impacted the capacity of traditional lenders.
It’s easy to see why the super sector is turning to private debt. Funds are facing new performance benchmarks and the implementation of the Retirement Income Covenant, which will require funds to demonstrate how they will assist members in maximising their retirement incomes. With these challenges in mind, the returns, resilience, and diversification offered by private debt is an attractive proposition.
Rising yield environment
In a rapidly rising yield environment driven by global inflationary pressures, private debt offers returns that are more attractive than traditional fixed income securities, which typically carry more duration risk – that is, the risk of capital loss when bond yields are rising as we saw in the first quarter of this year.
Private debt returns are typically ‘floating rate’ in nature with little duration risk. Returns are driven by a combination of factors that reflect how complex the private debt transaction is and the credit quality of the borrowing party. Borrowers in the private debt market tend to be lower-rated entities that find it more expensive to borrow through mainstream channels, meaning private lenders can more readily dictate loan terms, benefit from greater control, and capture a premium due to the borrower’s illiquidity. While absolute returns vary depending on the type and risk profile of the loan, margins above cash rates can range anywhere between two per cent and 10 per cent.
Under the YFYS performance test, private debt is benchmarked against the Bloomberg Global Aggregate index, currently carrying a duration of approximately 7.4 years (as at 31 March 2022). Being able to invest in an asset with little duration risk in a rising yield environment provides scope for outperformance of the YFYS benchmark. Very simplistically for example, in a typical diversified balanced/growth strategy, a five per cent allocation switched from a global aggregate fixed income indexed fund into the evergreen Mercer Global Private Debt Fund1,2 could have contributed to outperformance (on a gross basis) against the YFYS benchmark of 0.175% p.a. over the 71/4 years since the Fund’s inception (1 October 2014) until 31 December 2021, at a total portfolio level3. This includes an additional 0.45% excess return over the last year alone, where we have seen interest rates rising.
No silver bullet
While private debt is an attractive proposition, it’s no silver bullet. There are key risks for any portfolio and some unique to the asset class. Its illiquidity means that any allocation must be considered within a super fund’s overall illiquidity budget. There’s also an inherent additional credit risk given borrowers are typically considered non-investment grade. Investors must consider whether expected returns are appropriately reflective of the borrower’s credit quality.
There’s also the challenge of a high dispersion of returns generated by different private debt investment managers. We estimate more than 600 asset management firms and more than 1,600 funds/vehicles have private debt investment capabilities. Forward-looking qualitative research is critical to identify high-quality fund managers with the specialised expertise and talent required to succeed in investing in this asset class.
The high-level tailwinds remain in place and we believe are set to further propel private debt as a mainstream asset class, particularly for a sector that’s under increasing regulatory and consumer pressure to deliver greater returns while lowering costs. The time for funds to act on the private debt opportunity to achieve their objectives is now.
Marcus De Kock is alternatives investment director, Pacific, Mercer
- Benchmarked against Bloomberg AusBond Bank Bill Index + 3% p.a
- Actual outperformance would vary based on actual allocation size, underlying fees and taxes. Past performance is not an indication of future performance.
- Assumes investment in the AUD-denominated Mercer Global Private Debt Fund on 1 October 2014 with all distributions re-invested, compared to the Bloomberg Global Aggregate Total Return Index (AUD Hedged) over the same period.