Growing institutional investor demand for private debt has been driven by attractive returns on the back of a robust M&A pipeline. The market is expected to grow at an annual 10.8 per cent to reach US$2.3 trillion ($3.55 trillion) by 2027, nearly twice the US$1.2 trillion completed in 2021 according to data firm Preqin.
In a roundtable hosted by Investment Magazine and global asset manager Invesco, participants from super funds, fund managers and asset consultants discuss the role of private credit in an asset portfolio against a deteriorating global economy, the impact of the Your Future, Your Super performance test on allocations, the challenges in deploying capital in the asset class and how ESG risks are incorporated into direct lending strategies.
While there has been a general de-risking of assets, the banking world is in a much stronger financial position compared to the period leading into the 2007 global financial crisis.
“There’s been a dramatic shift in terms of where the risk resides from on balance sheet within banks to now within funds and asset owners on a global basis,” said Scott Baskind, head of Invesco’s US$40 billion global private credit strategy.
In the current market, the New York-headquartered fund manager is avoiding interest-rate sensitive sectors such as housing-related industries, cars and manufacturers in the supply chain, while lending to sectors such as non-discretionary consumers and subsectors of the healthcare system.
Returns continue to be attractive
The direct lending market is yielding around 11 per cent, compared to around 10.5 per cent in the syndicated leverage loan market and the yields are likely to hold up for some time, said Jeffrey Reemer, managing director at Invesco global senior loan group.
“I don’t foresee loan spreads repricing tighter because of the macro-overlay from Russia, Ukraine and the uncertainty around pulling the money out of the financial system.”
Baskind said that while the re-pricing of the private debt market is less apparent on an absolute basis, it is taking place on a risk adjusted basis. New direct loans incorporate better lending protection, stronger covenant levels, lower debt-to-enterprise valuations and lower leverage multiples.
He said while Invesco would have been comfortable lending to a company at five and a half times leverage a year ago, levels have fallen to around 4.5 to 4.75 times in the current market. Investors were also expecting larger equity contributions from owners and borrowers were also hedging interest rate risk.
“These new vintage transactions have wider yields, much tighter structural protections and therefore, should have lower risks,” Baskind said. “On a combined basis, that repricing has already occurred, but it’s not just on an absolute basis, it’s on a risk adjusted basis.”
Roundtable participants agreed the current market presented attractive lending opportunities.
“It’s never been a better time to invest in private credit with better pricing, better terms, lower leverage and yet better equity buffers,” said Caroline Strahan, senior fixed income analyst at HESTA.
“The good thing about direct lending is that you can be more selective about sectors, so we’ve been positioning to more defensive sectors and what companies and what terms and conditions, we also look at sponsors.”
Current market conditions have forced many asset owners and portfolio managers to rebalance their portfolios into more liquid assets.
“We are risk off at the moment and we’re not looking to increase our allocation to private credit and higher risk assets,” said Strahan.
“What we do like about private credit is that liquidity and complexity premium so there’s that trade off. But, at the moment, we are looking for highly liquid assets.”
HESTA currently has $2 billion in what it terms ‘alternative credit’ with a large allocation to private credit, mainly US and Australian mid-market borrowers.
The $185 billion Insignia Financial began re-positioning its portfolio some six to eight months ago into high-quality credit in the short term said Osvaldo Acosta, Insignia’s head of fixed interest assets, but he expected buying opportunities to open up in the medium term.
“As the economy starts absorbing those higher rates, there’s going to be really good opportunities for us to go into sectors that going forward are going to be generating very good returns.”
Both HESTA and UniSuper engage external managers through single managed accounts to invest in private debt, preferring the control and service afforded in these exclusive arrangements.
“We prefer to have our own mandates with managers and not be part of co-mingled funds. With the mandate, there’s a lot more control and flexibility to invest,” said HESTA’s Strahan.
“We have one manager [for] investment grade, senior debt and we have other managers that are in the more highly leveraged, high return markets.” She said HESTA is also looking at opportunities in the distressed credit space.
YFYS performance test impact
The introduction of the Your Future, Your Super performance test is constraining the ability of super funds to allocate to the private debt asset class due to tracking error. Under the performance test, private credit is typically allocated to the alternatives sector that has a 50 per cent fixed interest benchmark plus 50 per cent equity benchmark.
“How far away you are from failing the test, the more flexibility some people feel to take that tracking error risk,” said Kirsten Temple, general manager investment strategy at asset consultant JANA Investment Advisers. The trade off in returns is quite attractive as “what you’re looking at in terms of return on a relative basis is potentially quite attractive”, she said.
Private credit is also competing with other illiquid assets such as property, infrastructure and private equity.
“In terms of an allocation from a client’s perspective, it depends a lot on that element of a tolerance for tracking error and where they’re actually putting their liquidity budget,” Temple said.
She noted interest in private credit has dropped off with the performance test and the sell-off in listed markets.
The performance test is currently undergoing a review and there is speculation APRA will introduce changes including additional metrics around the credit benchmark.
The test has not dampened UniSuper’s appetite for private debt.
“Private credit is one in which opportunities only present themselves idiosyncratically and over time. Given how illiquid the asset class is, we’ve got a relatively constant appetite for it at this point in time,” said David Colosimo, investment manager at UniSuper, which has close to $110 billion of assets under management.
Fund managers incorporating ESG considerations in their credit portfolios and due diligence is paramount amid increasing investor recognition around the financial impact of these risks.
UniSuper has put sustainable screens on its private credit allocation so “we don’t have fossil fuels, we don’t have alcohol, tobacco, gaming, and weapons or we’ve got very small thresholds or allowances for those sorts of things,” said Colosimo. The super fund has a lending bias toward social and environmental assets that includes loans to wind and solar farms and social infrastructure.
HESTA also has negative screens across its entire portfolio but is also looking to invest more capital in assets with positive impact but has found it challenging to find attractive private credit investments.
“There are more opportunities in that space in private equity, such as social housing,” said Strahan.
“But in private credit, it’s very difficult in Australia to source well priced positive impact projects. You’re either going very high risk and or low return, there doesn’t seem to be a very good middle ground.”
While the consistency and quality of data available in public companies continues to be an issue, the problem is more acute in private companies, particularly within the smaller direct lending opportunities where the lending group is small.
“Within the private universe, it’s even more difficult. With the smaller companies, the less sophistication and less disclosure,” said Invesco’s Baskind.
“So the abilities at upon loan underwriting, to engage with management teams around all of these different considerations is really paramount to understanding where they are in their journey… educating, engaging and developing a process to ensure that there’s opportunities to track and to influence how these companies act and behave on a go forward basis, is really critical.”
The outlook continues to be challenging with stubbornly high inflation levels in many of the world’s major economies, in part continuing to the dislocation of markets, and the lull in M&A activity is expected to continue as many buyers sit on the sidelines.
“There’s a tremendous amount of capital that is sitting on the sidelines today, waiting for what has occurred in the public markets in terms of devaluation to match up with actual sellers,” said Invesco’s Baskind.
“Buyers and sellers continue to be fairly far apart in terms of valuation multiples and that’s why we’re seeing a general pause in the M&A environment.”
Market conditions also make it challenging for investors to deploy capital in the sector. “It’s incredibly difficult to time the bottom in any market, particularly in an illiquid market like direct lending. For me, it’s about trying to average in and making sure as asset owners you are ready to deploy,” said Ashley O’Connor, head of investment strategy, Invesco Australia.
“I think there’s still probably more fall out to happen,” said JANA’s Temple. “For some time, we moved to a more neutral position on risk based on the way markets and opportunities are today. In some cases, where there is a need to put more risk on the table, credit is where we would be supporting incremental risk exposure.”
Private credit also is an investment class that is more resistant to investment cycles.
“I don’t find that this particular asset class is one in which you can make those cyclical credit calls,” said UniSuper’s Colosimo. He said the super fund was selectively adding allocation to credit in the Australian financial sector.
JANA’s Temple said it was important to stand by one’s investment convictions.
“Private markets aren’t the place to be timing your entry,” she said. “Once you have a program, you maintain the program and strategic reason to have it, whereas the liquid markets are the way we see most of the cyclical framework come into play.”