As the investment universe evolves, so do investors. Investors are becoming increasingly knowledgeable even while investment options are becoming increasingly complex. Using a simple formula for equities and fixed income in differing proportions, hoping to generate alpha while controlling beta, is becoming harder to do. Investors today are realizing that they need to diversify away from public securities — and one good way to do that is to include an allocation to alternative strategies.
A growing category of alternative investments is private investments in debt, equity, real estate, special situations, among others, that have little or no correlation to publicly traded securities. They are less volatile and less market-driven than equities yet can often provide attractive returns, particularly for those who remain patient. It’s no wonder that significant institutional capital is expected to continue flowing into this asset class, as shown in Figure 1.
In general, however, alternative investments are less transparent than public equities or bonds, have no meaningful benchmarks, have little or no secondary markets and are relatively illiquid. As a result, strategy and manager selection along with ongoing oversight are critical.
Nowhere is oversight and careful selection more important than in the fastest growing segment within alternative investments — private credit or private debt as it is also known.
Why is so much capital flowing into private debt? There are several reasons, which are best understood within a historical context.
Source: Preqin, 2019
The financial crisis of 2008-10 had a meaningful impact on the financial sector. Increased banking regulation moved banks out of the business of mid-market lending, creating a broad range of opportunities for non-bank lenders.
For investors, the rise of private debt has been positive, creating the potential for:
While private debt has attractive benefits, it is important to bear in mind that we may be approaching the end of a credit cycle. Rising interest rates, indications of stagflation and inverted or flat bond yields are all pointing to a broad contraction in equity markets, the results of which could have a spillover effect across the economy. This could include private loans.
Increased capital flow into private debt, while good in one sense, is creating a frothy market where there is pressure on pricing, covenants and structures, suggesting that some Private Debt managers may accept lesser-quality deals and lower returns. Figure 2 illustrates the increase in pressure on pricing in the private debt space.
Source: Preqin Q4/2018
When investing in any alternative asset or strategy, patience is a virtue. When that alternative asset is private debt, other important factors include:
While initial due diligence on a manager is very important, it is even more important to have ongoing oversight. Private debt is a very transactional; it is a loan-by-loan business. With continuous change in borrowers’ businesses, managers must proactively monitor loans and supporting collateral and be prepared to act if any borrower strays from the agreed terms of the loan.
As part of oversight it is important to:
How much of an investor’s portfolio should be allocated to alternative investments? The answer depends on individual circumstances, but in most cases will range from 10% up to 50% for more advanced investors, with roughly two thirds drawn from fixed income and the remaining one third from equity. Allocating less than 10% would have little effect on overall performance while allocating more than 25% could affect liquidity and risk profile. Please consult your professional asset allocator for your specific situation.
As the famous saying goes, “the devil is in the details,” and when it comes to private debt, true oversight involves asking the right questions at the right time and proactively evaluating and managing risk. As this asset class is used to stabilize and diversify more retail portfolios, finding the right manager to provide this oversight for you will be a critical factor in your success.