Feature – Private debt
lic debt markets entering negative territory, the average pri- vate debt fund returning 7% a year looks a more attractive alternative. While many schemes still open to new members tend to have most of their return portfolio invested in listed stocks, private debt is catching their interest. Examples include Nest, which has allocated £500m across two private debt strategies, while Border to Coast launched a £581m pri- vate debt fund at the end of last year. Centrica has a strong focus on cash-flow awareness and has 11% of its portfolio invested in private markets. It is currently overweight on private debt, Kapur explains. “Private credit can make a lot of sense for pension schemes if they have the ability to hold on to these investments over a medium to long- term time horizon. A typical private credit fund has a life of seven years, so during that period you should be paid a premi- um over what you can achieve in liquid markets. “That’s the big benefit of private credit, in exchange for liquid- ity risk, you receive this additional spread premium, albeit you may need to factor in additional credit risk,” he adds. Private debt is increasingly linked to private equity in several ways. Around a third of private debt deals are financed in col- laboration with private equity and private equity firms are increasingly launching private credit funds. “As an asset class, there is now a range of underlying strate- gies to choose from making it possible to construct your port- folio in a targeted way to help meet your risk and return objec- tives. As you might expect, fees in private credit are also lower compared to private equity,” Kapur says. Border to Coast has about 15% of its private debt allocation invested and two more in late stage due diligence, which would result in half of the portfolio being allocated to the asset class. The local government scheme pool aims to have the entirety of this portfolio invested by February 2021. “Private credit potentially gives you a wider scope compared to public bond markets,” says Mark Lyon, head of internal management at Border to Coast. “If you are in investment grade or high yield you are typically with the larger issuers. However, private credit enables you to access mid-cap oppor- tunities as well.
“Private credit can also offer more bespoke structuring and that flexibility may offer a return premium,” he adds.
End of cycle risks Russian roulette is a risky game, but one which allows for a relatively precise forecast of fatality. If participants were using a six-shot revolver, the average number of pulls before a gun discharged is three-and-a-half. The likelihood then increases exponentially until after the fifth pull, there is a 100% proba- bility that the gun will fire. Most investors that place their capital in private debt are
40 | portfolio institutional August 2020 | issue 95
acutely aware that it comes with added risks, but it remains unclear how many times they will be allowed to pull the trig- ger until the gun discharges.
Default risks in private debt are, by definition, hard to meas- ure, as loans tend to be arranged privately and are often held in a single fund. Another part of the problem is a lack of cov- enants in loan documents, warns Lyon. “Default rates were very low because we are at the top of the credit cycle. I think default rates are going to increase. The headline numbers might not be as high as they have been in previous corrections partly because there is a lack of covenants in a lot of loan doc- uments, which means you do not necessarily get the formal defaults. But there are certainly a lot of problem loans which managers are going to have to spend time dealing with.” Amid those rising concerns that the industry might be in the late stage of its cycle, placing capital in private credit has not been an easy task. By the end of 2019, the industry sat on a record $296bn (£228.3bn) of dry powder.
“There was a lot of capital to be put to work,” Kapur says “It’s inevitable that when you have a lot of capital in a certain part of the market you will see weakening returns and it becomes very much a borrower’s market.”
The growing level of cash waiting to be invested has to some degree been added as leverage. About half of portfolio manag- ers have borrowed against their fund’s assets and 40% of port- folio managers use subscription lines based on their fund’s dry powder, Sirio Aramonte, a senior economist for the Bank
The other key
difference compared to 2008 is that debt levels are a lot higher and covenants a lot lighter
Mark Lyon, Border to Coast
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