Despite the risks and economic uncertainty, asset owners are bullish on private credit.
If investors were pressed to point a finger to one of the riskiest parts of the financial markets, private debt is likely to be high on their list. Yet, paradoxically, institutional investors still seek exposure to the asset class.
If anything, the recent Covid-induced market volatility appears to have increased their appetite for private debt. Examples include the $227bn (£175bn) California State Teachers Retirement System (Calstrs) and the $215bn (£165.8bn) New York State Common Retirement Fund, which are planning to increase their exposure to the asset class.
Closer to home, defined benefit (DB) pension schemes, such as the schemes sponsored by Centrica and Border to Coast, which manages £45bn, are also targeting private credit. But many investors fear that the semblance of business as usual across markets might just be the calm before the storm. So where does this leave those with exposure to private debt?
Rise of the shadow bankers
Perhaps the most significant change in the global financial system following 2008’s crisis was the retreat of banks from private lending. This was to de-risk their balance sheets while new regulation forced them to hold more capital in reserve.
Non-bank lenders were quick to step in and fill the void. But gone are the days when these lenders, colloquially known as shadow bankers, were considered niche.
Indeed, by January this year, the non-bank financial intermediation market was worth $50.9trn (£39.2trn), accounting for 13.6% of the world’s financial assets, according to the Financial Stability Board, a watchdog.
This is the result of more players entering the market. The number of private credit fund providers doubled in the past five years to more than 1,700, Prequin’s latest private debt report shows.
Pension funds might not see themselves as part of the shadow banking sector, but by issuing private debt mandates they have become the biggest direct lender to private markets. Public and private sector pension funds issued 27% of all private debt mandates in 2017, compared to 12% by family offices and 10% by insurers.
Meanwhile, private debt assets under management have reached $812bn (£625.8bn) and could hit $1trn (£770.7bn) this year, according to Prequin.
In doing so, they have fulfilled an important role of funding small and medium-sized businesses, many of which do not have the scale to issue public debt and would struggle to strike a deal with the retreating mainstream banks.
This is also a trend that Rohit Kapur, pensions investment research manager at Centrica, has observed. “This is an asset class that over the past 10 years has grown, especially in
Europe. “Bank disintermediation has been a big driver of this growth and that creates some interesting opportunities for investors.
“Borrowers, especially in the SME space, still need capital and banks stepping away has created this opportunity for private lenders,” he adds.
Silver bullet
The trend towards private debt was further accelerated by a combination of two factors: low yields on public debt and a rise in mature defined benefit schemes across the developed world. Private credit offered itself as a silver bullet in that it helps to manage cash-flows, offers higher returns and provides liquidity to small and medium-sized firms.
Most defined benefit schemes in the UK are far from fully funded and with a growing number of retired members, stable cash-flows have become a key concern. With yields in public debt markets entering negative territory, the average private 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 three private debt strategies, while Border to Coast launched a £581m private 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 longterm time horizon.
A typical private credit fund has a life of seven years, so during that period you should be paid a premium over what you can achieve in liquid markets.
“That’s the big benefit of private credit, in exchange for liquidity 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 collaboration with private equity and private equity firms are increasingly launching private credit funds.
“As an asset class, there is now a range of underlying strategies to choose from making it possible to construct your portfolio in a targeted way to help meet your risk and return objectives. As you might expect, fees in private credit are also lower compared to private equity,” Kapur adds.
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 opportunities as well. Private credit can also offer more bespoke structuring and that flexibility may offer a return premium,” he adds.
Russian roulette
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% probability that the gun will fire.
Most investors that place their capital in private debt are acutely aware that it comes with added risks, but it remains unclear how many times they will be allowed to pull the trigger until the gun discharges.
Default risks in private debt are, by definition, hard to measure, as loans tend to be arranged privately and are often held in a single fund. Another part of the problem is a lack of covenants 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 documents, 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.”
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
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 managers have borrowed against their fund’s assets and 40% of portfolio managers use subscription lines based on their fund’s dry powder, Sirio Aramonte, a senior economist for the Bank for International Settlements argued in a recent article.
Rising default levels resulting from the four-month shut down of the global economy could lead to an escalation in some sectors, Lyon predicts. “The obvious one is energy, certainly in the US. We saw that in 2014 and 2015 when a sharp fall in oil prices led to a significant increase in defaults. But there will be a broader economic impact from Covid – with retail, real estate and some auto manufacturers having challenges.”
Kapur also believes that interesting times could be ahead. “What will be key when problems start to emerge is the bandwidth some of the private lenders have to deal with credit issues and how that impinges on their ability to deploy fresh
capital.”
Outlook
“History never repeats itself, but it often rhymes,” is a famous quote, rightly or wrongly attributed to Mark Twain, but an axiom that many private credit investors might be able to relate to.
While the volatility in recent months may have been reminiscent of the 2008 crash, there are some crucial differences, argues Lyon.
“2008 was a banking liquidity crisis which caused an economic downturn,” he adds. “This time you have an economic downturn, but central banks have stepped in to try and mitigate any liquidity crisis.
“It has had more of an impact on the real economy this time. The other key difference compared to 2008 is that debt levels are a lot higher and covenants a lot lighter.”
This is aggravated by the fact that most private loans have floating interest rates which could lead to rapidly rising funding costs for smaller firms in particular. Most debt is held in closed ended funds which could offset some of the cyclicality.
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 borrowers market
Rohit Kapur Centrica
The flipside is that the end investors would not be able to withdraw their cash if funds offer poor returns. But investors are also keen to stress that the sector should not
be painted with a broad brush.
Doug Heron, chief executive of the Lothian Pension Fund, argues that diversification could offset some of the risks. “While it may be convenient to label the entire class as exposed to elevated default risk, the reality is that, like most risk asset classes, there will be a wide range of good to bad exposures today that could remain stable, deteriorate or improve.
“Much depends on the borrower’s sector, level of total gearing and structure of the credit. Our approach has been to diversify by fund manager and vintage, with underlying sector diversification also helping to provide protection from widespread default.”
Lyon believes that recent volatility has created opportunities. “We were cautious before we started deploying capital as we felt that we were somewhere close to the top of the cycle. We had no idea of the disruption Covid would cause but we felt that there were enough pressures in the market that made us cautious. “Deploying capital just after a market correction gives our investors a real opportunity,” he adds. “
While our core focus is on the senior secured parts of private credit, with some exposure to opportunistic and mezzanine credit, we have an allocation to distressed debt as we wanted to take advantage of pressures in the market as they arose.” By focusing on sectors such as consumer stables and industrials, the local government pension scheme pools hope to offset some of the risks in the sector.
Centrica pursues a similar approach. Having been cautious to deploy capital for the past year, Kapur argues that now might be n /the time to do so. “Prior to Covid, we were more focused on the niche, specialist parts of the market because we wanted to focus on those parts where there wasn’t an oversupply of capital because that brings down returns and puts pressure on lenders to put money to work under less than ideal terms.
We also focused on distressed debt, thinking quite carefully about which part of that market to deploy into. “Niche strategies for us include specialist lending, such as in healthcare, for example. While we had no idea about what was about to hit, it is not the worst area to have exposure to at the moment because of its defensive characteristics,” he adds.
