The popularity of private debt amongst institutional investors has seemingly continued exponential growth, while history suggests higher interest rates and a maturing credit cycle signal issues on the horizon. A time to sell? No, we believe it is a time to buy. But why?
Five years on from our 2018 paper, “Finding value in private debt”, the economic and investing landscape has shifted dramatically. The era of low inflation and interest rates have been replaced by high inflation and a rise in interest rates globally, leading to increased volatility and a very different market environment. This has served to accelerate the withdrawal of banks (and some other participants) from private debt markets to a magnitude such that conditions are favorable to lenders who are typically able to achieve better protections and better pricing.
As in 2018, we still see value in private debt sub-sectors benefitting from thematic tailwinds and significant barriers of entry. However, we increasingly also have higher conviction in more “core” areas of the private debt market, such as middle market corporate direct lending, around which we previously expressed concern.
In an environment where outlook calls for diversification, downside mitigation and an opportunity for manager differentiation, we believe private debt presents new and exciting opportunities for investor portfolios.
Regulation within the banking sector continues to intensify in 2023 after several bank failures which will likely constrain the lending capacity of banks further. In addition, public market volatility has further reduced bank risk appetite. As a result, private debt lenders have continued to win market share from banks as borrowers value the discretion, speed, and certainty that private lenders can offer.
Rapid rises in interest rates have the effect of further reducing liquidity in capital markets as many institutional investors saw their balance sheet shrink or shifted to lower-risk assets as yields rose. An example of this slowdown is the reduction of CLO and CMBS formation. This, alongside increased bank retrenchment, has resulted in many borrowers and assets that are struggling to raise finance.
Therefore, the current environment is interesting across many areas of private debt for investors that have the ability and risk appetite to invest. Spreads have increased materially in middle market direct lending and at lower leverage levels with better creditor protections, making new deal activity attractive in our view. However, the flipside to this is that the rise in the cost of capital has meant that M&A and therefore deployment has slowed. Still, this appears an attractive time to be making new commitments to the asset class on a medium-term view.
There are also interesting opportunities in markets that are less well travelled. Lenders can get access to higher return potential and take advantage of dislocations in various facets of the commercial real estate market as volatility and dispersion in that market has led to traditional lenders pulling back. In growth lending, falls in tech and life science valuations have made it difficult to raise new equity for growth companies. This presents an opportunity to lend to these companies at high rates and get access to warrants to help them achieve their growth plans without the need to raise a “down round”. New transaction activity in more complex areas such as bank capital also looks attractive and with good tailwind potential to supply.
The knock-on impact of increased costs of capital will create problems for existing borrowers with high debt burdens. Stressed and distressed strategies have had challenges over the last decade but are likely to find increasing opportunities as defaults rise. However, there are challenging dynamics in this space as private lenders will look to resolve issues on their own. A lack of covenants and creditor protections in public syndicated credit markets also makes it more difficult to enforce rights and assume control early enough. Saying that, skilled managers should already be aware of these dynamics and are navigating these issues.
It is important to highlight that private debt can provide investors with better downside management compared to public and syndicated credit.
Private debt investments are usually held by a single or small group of aligned investors with deep workout experience. We believe having a controlling stake when things go wrong is particularly important to avoid ‘creditor-on-creditor violence’ which has been increasingly common in public markets. In addition, private debt covenants provide the ability to move quickly, which can help preserve an asset’s value and maximise recovery for investors.
Whilst maintenance covenants have gone away in public markets, they continue to remain in private debt. Covenant defaults provide lenders with an early signal of deteriorating trends, allowing lenders to take early mitigating action. Engaging early before an asset is impaired allows borrowers to put in place an action plan to seek better recoveries and enhanced downside protection.
Private debt’s Achilles heel has been the illiquid nature of the assets. The costs of forced sale tend to be high, especially when markets are dysfunctional. Increasingly though, asset managers are creating evergreen vehicles and other structures to address these liquidity needs. These vehicles can provide partial liquidity to bridge the mismatch between assets and investor requirements. However, fully realising an investment within these vehicles could still take years, although we hope this will improve over time.
Private debt investments do have some benefits over private equity and other illiquid asset classes. They tend to have a shorter life, typically pay regular income, and the underlying loans themselves have a maturity date, providing a natural catalyst for investment exit. Secondary transactions for the asset class generally see lower discounts to net asset value as return potential within private debt have a large contractual component.
But ultimately, private debt is still an illiquid asset class and will suffer from the same disadvantages as other private assets, even if not to the same degree. Therefore, investors should always allocate with a long investment horizon in mind and build sufficient buffers into their portfolio. Diversification across vintages is one way for investors to seek to reduce liquidity risk and increase the likelihood that a portion of the portfolio is always returning capital.
Overall, we believe it is an attractive time to be an investor in private debt. Cash yields from private credit are significantly higher from a combination of higher rates and wider credit spreads, providing a wider margin for error.
As with any portfolio, diversification is key when building a robust allocation to private debt. Ideally, this means a portfolio with a range of high conviction ideas diversified across borrower type, geography, sector, credit quality and vintages.
The private debt landscape is vast, and information is scarce, which means finding compelling strategies still requires significant resources and dedicated specialists. Many asset managers within the space continue to charge very high fees, significantly eroding investor returns and hence it is important to invest at scale to negotiate preferential terms.
Investors seeking higher risk adjusted returns and downside protection also need to identify managers that are skilled, disciplined, and experienced. In our view, this is particularly true for private debt where there is no passive way to access the asset class and investing with a manager means investing with them for a long-time horizon.
Whether you are looking to invest in private debt for the first time or looking to review your allocations in this new environment, we believe WTW has the experience necessary to partner with you. At WTW, we have a team of dedicated private debt specialists who have helped our clients with selecting highly skilled managers, building highly diversified portfolios over time, and investing at scale. In addition, we have a proven track record of innovating with private debt managers to design new and creative solutions to address our client’s ever-changing needs.
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