Investor demand and a strong M&A deal flow have historically driven the growth of the private debt market, particularly when global interest rates were low. The asset class is predicted to grow an annual 10.8 per cent to hit an all-time high of US$2.3 trillion ($3.55 trillion) in 2027, close to double the 2021 volume of US$1.2 trillion according to data firm Preqin.
“There has been a lot of investor interest in this asset class, especially when the rates were down as this created a higher yield strategy,” said Young Jo Bae, asset consultant at JANA.
“The most attractive thing is that private debt offers equity-like returns with materially lower volatility. The higher returns are due to illiquidity and complexity premiums.” In today’s market, these loans generate around 10 to 11 per cent cash yield.
The growth of the market started around 2013 in the aftermath of the global financial crisis and higher capital adequacy rules imposed by Basel III.
“In the past two or three years, there has also been an increase in products launched by managers, due primarily to active merger and acquisition activity that needed a lot of financing in the leveraged buyout space,” she said.
Interest rate hedge
Private credit is typically floating rate loans which can give investors protection in the current interest rate environment.
“The private debt universe is predominantly comprised of loans with a floating rate base. The nature of the loans makes it one of the few asset classes which could see yields increase in a rising interest rate environment,” said Elizabeth Kumaru, head of private corporate assets at Australian Retirement Trust (ART).
The $230 billion super fund has a five per cent allocation to private credit with the majority in the US due to the sheer size of the market.
Manager and credit selection as well as portfolio construction are key given the complexity of the product and the market.
Global fund manager Neuberger Berman’s private debt strategy focuses on first lien and unitranche loans to private equity-owned companies in North America with EBITDA of between US$20 million and US$250 million.
The firm avoids cyclical industries, capital intensive industries and industries with unpredictability such as retail, restaurants, energy, leisure and most consumer companies.
“We look for recession resilient industries, that grow faster than US GDP and then within those industries, we’re looking for the market leading companies that have very high free cash flow,” said Susan Kasser, portfolio manager of Neuberger Berman Private Debt.
The firm currently manages US$13.1 billion in private debt across more than 130 companies with up to US$500 million committed per investment. The firm most recently closed a US$8.1 billion private debt fund – its fourth – in June.
Portfolio diversification is also vital said ART’s Kumaru. “Having a highly diversified portfolio prevents a single underperforming position derailing the overall portfolio outcomes,” she said.
Performance test constraints
Notwithstanding the investment proposition, the Your Future, Your Super performance test is imposing limits on some super funds’ ability to allocate capital to this asset class due to tracking error. Under the performance test, private credit has a 50 per cent fixed interest benchmark plus 50 per cent equity benchmark.
This product is at the extreme end of benchmark risks in terms of duration, liquidity and fees, explained JANA’s Bae. “If the super fund has enough buffer against the performance test, this could be a very good allocation in the medium term,” she said.
“But if the fund doesn’t have enough buffer against the performance test, they will be unlikely to withstand the volatility that this asset class may cause.”
Funds like ART who have sufficient headroom against the test believe the risk justifies the return. “It does mean from a Your Future Your Super performance perspective, we have less confidence in being able to outperform the benchmark over shorter time horizons due to the equity market volatility, but ART considers that these strategies offer attractive risk adjusted returns that have the ability to exceed the YFYS benchmark over the cycle,” said Kumaru.
Deteriorating macro conditions
The private credit market is expected to hold up reasonably well despite the deteriorating credit conditions and an expected rise in default rates.
“If interest rates go too high, you’re obviously going to see an increasing number of defaults. But still, you’re going to be higher up the capital structure and as long as you’re in the right companies with the right balance sheets and the ability to handle the current environment performance should remain robust,” said Kumaru.
Many of these financings have maintenance covenants which aim to give investors protection in a downturn. In Neuberger Berman’s portfolio, 80 per cent of the loans have these covenants resulting in a 0.04 per cent annualised default rate and a 0.02 per cent annualised loss rate according to Kasser.
Private debt asset selection is also vital, and this is where Neuberger may have a leg over the competition as a diversified asset manager.
The firm is a limited partner in 600 private equity funds and this close relationship with private equity sponsors provides deal flow for Neuberger Berman’s private lending business.
“This competitive advantage makes [our] life so much easier because [we] don’t have to balance deal flow and selectivity. You know you’re going to have a ton of deal flow so you can be as selective as you want,” said Kasser.
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