Given where we are in the cycle, how can investors best plan their future private debt allocation with respect to jurisdiction and strategy?
Private debt is something that is becoming an all-encompassing term and it is something that is becoming far more mainstream. The exciting part about that is the investable opportunity for our clients.
The ability to access a certain risk/return profile that was not necessarily available to them 10-15 years ago, has grown dramatically. Some of this is because the banks are reducing their exposure to private debt and the market has become far more accustomed to dealing directly with different fund managers.
Clients are now struggling with how they can best position their portfolios for their long-term goals and the market continues to be a challenging environment. Fixed income rates give you a very low level of return right now, so how do you balance all the different kinds of risk, whether it is equity risk in the volatility and drawdown or duration sensitivity? Private debt in aggregate has grown dramatically and gives our clients the ability to invest in a variety of different risk spectrums from senior secured risk to distressed.
It really comes down to what is the goal of that client, what are their liquidity needs, their distribution needs and their long-term return targets. We look at private debt as something that offers different opportunities through the cycle, but in general, provides long-term alpha and diversification sources for a client that invests throughout the cycle.
Can today’s environment be easily compared with what we saw during the last cycle?
“One area we like most right now, because of the balance of risks, is senior direct lending in areas where you can get a floating rate instrument with first lien. In the public market, we like broadly syndicated loans to high-yield and similar.”
It is always hard to look back at things in the last cycle because that culminated with the financial crisis. Every cycle has some similarities to it and every cycle has some difference. I think the structure of the global financial system and the global markets is very different today compared to 10 years ago. Yes, we still have an aggregate debt problem but that is largely sitting on government balance sheets and with the central banks, so households, private companies, and the US and European banking systems are in better shape overall.
The similarities are that there is a lot of optimism in the market; growth has been good, monetary policy is predictable, inflation is stable and earnings are good. Downside risks are present in the market but there is no obvious cause for concern, so we have an issuer friendly market. Spreads are going to be lower, structures are going to be more issuer-friendly and there is some loosening in the larger middle market.
I think the question is not just where you are in the cycle but what does that cycle look like and what is its breadth and depth. I don’t think where we are now is similar to the 2006-07 environment. For example, the M&A environment is different. There are idiosyncratic things that you have to be disciplined and careful about, but I would say the average quality of companies, relative to expectations of earnings, is strong on aggregate, relative to the last cycle.
What strategies do you feel are the most attractive when looking ahead?
One area we like most right now, because of the balance of risks, is senior direct lending in areas where you can get a floating rate instrument with first lien. In the public market, we like broadly syndicated loans to high-yield and similar.
We have found first lien direct lending in the US, Europe, and even Asia attractive. We like to be able to build that downside protection and find good companies where we are comfortable with the value proposition they have and the sustainability of their earnings.
We are also actively involved in opportunistic lending. Opportunistic is not distressed companies but companies that we see need some inherent value proposition that requires a capital solution to realise. That might be executing a new strategy, bringing them to an IPO, or funding an M&A or major capital expenditure. They have a level of complexity that requires a specialised solution and are willing to pay a premium to access capital.
“We feel clients should think about how they will invest proactively when there is a downturn. There are risk factors that are fairly benign right now, but things can change rapidly”
Those are the strategies that we think are the most attractive based on our risk profile right now, but we do see opportunities in distressed and mezzanine. I think the volume of those transactions is smaller, and you need to be far more disciplined and selective.
Do you anticipate more distressed opportunities in the market?
I don’t think it is wrong for people to be thinking about it. We feel clients should think about how they will invest proactively when there is a downturn. There are risk factors that are fairly benign right now, but things can change rapidly if inflation data does move, Federal Reserve policy accelerates tightening or trade rhetoric escalates. There are lots of factors that can cause the cycle to evolve and investors should be prepared.
You can’t necessarily predict when a downturn is going to happen because again the risk factors are going to change in a dynamic world, but when it does happen you must be positioned to capitalise on the opportunities created in each phase of the cycle. Our clients have long-term investment goals and long-term liabilities to meet. When the world becomes more volatile and asset prices decline, investors need to have a plan for which part of their portfolio they will want to take increased risk.
Volatility has already increased in 2018, and we see this continuing. The size of that opportunity is unknown because it really relies on the depth of a potential drawdown. We don’t see a huge opportunity today but over the course of the next several years, there is no doubt that there is going to be an opportunity to deploy capital in both the public and the private markets at very attractive risk/return profiles.
Do think niche strategies will have more appeal in a competitive environment?
There are two ways to look at it, one is through the client lens and the other is at the market opportunity. Clients have certainly been increasing their exposure to private strategies, as private credit offers an alpha stream they are not getting in the public markets. They are willing to give up liquidity to get a risk premium above and beyond the public market and have access to different companies, different structuring and different idiosyncratic risk. In a balanced portfolio, they are always looking for things that might be unique and different, specifically if they are looking for things that are less correlated to other strategies in their overall portfolio.
To create long-term returns, people are either going into more risk, they are finding new alpha sources, or they are concentrating those alpha streams. There are gaps in the financing and they happen at different periods in time. You might see something in transportation, consumer lending or project finance. We have an aviation platform because there are always unique things getting done across real assets in aviation and aircraft. We have certainly seen opportunities in infrastructure around the world as many countries look to enhance infrastructure globally. I think all of these things at different points in time have different risk rewards.
There are different periods where there is uncertainty and volatility in certain sectors in the capital markets. So, the amount of capital flowing into a space can shut down causing periods of dislocation. Commodities in 2016 was a good example, there was a significant blow out in public credit spreads and there was a gap in capital availability there. From a debt perspective, you can incorporate certain alpha streams and unique strategies into a bigger, broader strategy.
How do you think market consolidation is going to affect the private debt market in the long term?
I think there will be continued consolidation. In August we acquired and closed on an acquisition of Tennenbaum Capital Partners, which is a middle market direct lending as well as distressed platform. The acquisition is highly complementary to the existing team and business we have been building out at Blackrock over the last decade.
It all comes down to the maturity and the evolution of the asset class and the strategy. I mean that holistically, from senior secured direct lending risk, all the way through to opportunistic and distress. If you think about the market when there was less availability, the investment universe was more dominated by the banking system. If clients wanted to access the market they would turn to banks. It was either owned by the banks or syndicated out in the public market.
In the early days, fund managers and credit managers were building more boutique strategies that were in areas of interest that were not necessarily complementary to the banking system, or outside the banking system. That market has evolved and grown. I would say corporates, private equity sponsors, and intermediaries are far more willing to access fund managers directly.
What we have seen on our side are unique advantages and the strategic advantage of a scaled, global platform. I would say that scale provides the ability to access sourcing and origination because you have a deeper relationship with sponsors, intermediaries and corporate management teams. You have the potential to be disciplined and only select the opportunities you find the most attractive. So, the greater depth of a platform, the more access you will have.
You also have the information edge. The scale of your platform can bring to bear information for better quality underwriting that will lead to better investment decisions. I think you will continue to see consolidation because the opportunity for clients is only going to continue to grow over the next decade.
This article was sponsored by BlackRock Alternative Investors. It appeared in the Future of Private Debt special supplement that accompanied the October 2018 issue of PDI magazine.