HNWs: A new source of capital for private debt

With a thirst for diversification and yield, private investors are eyeing the likes of CLOs and special situations. Claire Madden of Connection Capital says fund managers should be alive to this trend.

Claire Madden

How can fund managers expand their client bases and tap into new sources of capital? It’s a question that is often asked, but seldom answered well and is rarely acted upon effectively. Outside of their core market of institutional investors, fund managers typically see very little scope to attract investment from other types of investors such as private capital (high-net-worth individuals and family offices). Added to which, many fear that it may simply not be worth the effort.

However, there’s a lot more opportunity value here than many think. Although accessing large pools of private capital isn’t always easy, the appetite and the requisite risk profile for private debt investments is out there. Fund managers that can find a worthwhile way to connect with this hitherto largely unexplored potential client base could find it a rewarding relationship.

Dispelling the knowledge gap

There are a number of misconceptions which may be preventing fund managers from considering private capital as a serious option. One is a query over whether private investors truly understand what private debt is and whether there’s a place for it within their portfolios.

Among sophisticated, experienced HNW investors (we’re not talking about retail investors here), the answer is very much yes to both. In a recent survey we conducted amongst our private capital clients, more than a third (36 percent) of respondents said that they are interested in investing in specialist credit funds and nearly half (47 percent) flagged up special situations funds as a key area of interest.

A different mindset

In today’s uncertain economic climate, when volatility is buffeting public equity and bond markets and interest rates remain stubbornly low, it’s hardly surprising that investors should be looking for ways to further diversify their portfolios to spread risk and drive alternative sources of returns. One of the main reasons why private debt funds appeal to private capital is that investors are looking for strategies that generate yield. It’s a very different mindset from an institutional investor: for people who are investing their own money, income is often a top priority these days.

Building resilience into portfolios is also a major concern. So, if private capital is offered the chance to invest in a collateralised loan obligation (CLO) fund, for example, where a diversified portfolio of senior secured corporate loans to large multinationals is primed to withstand market stress, investors are likely to seize it with both hands.

Special situations funds run by experienced managers that can take advantage of dislocation in the public credit markets is another example. These are investors who are knowledgeable enough to assess opportunities on their own merits and decide whether they are a suitable option for them personally, as they seek to generate risk-adjusted returns from exposure to a range of different strategies.

With that in mind, it’s worth noting that private capital investors see the macro picture of reduced bank lending to UK SMEs as a real opportunity. The boom in peer-to-peer (P2P) lending demonstrates the strength of investor sentiment to plug this gap in the credit market, and points to the level of latent enthusiasm for private debt funds.

Private capital’s investment outlook differs from institutional capital in several other ways that might interest fund managers too. Sophisticated HNW investors tend to be far more open to illiquidity. They’re not put off by closed-ended structures per se, provided the opportunity is good quality and the fund is structured appropriately for the underlying assets (as the demise of the Woodford Equity Income Fund has made retail investors all too painfully aware).

Private capital may also be more open-minded about the types of strategies it will consider. Institutional investors’ junior appraisal teams often screen out opportunities that don’t fit with narrowly defined investment criteria and are rarely incentivised to think outside the box. HNW investors by contrast only have themselves to please and are often entrepreneurial by nature, making them more amenable to consider options that the bigger players might overlook.

The search for alpha returns

For example, they may be more willing to consider first-time fund managers who can demonstrate a good track record in their careers with previous employers but have not yet established a strong ‘brand’ in their own right or achieved a high enough level of assets under management (AUM) to attract institutional attention.

Or they may be more likely to look at strategies that are highly specialist or niche, but that are too quirky to feature on institutional radars. Private capital is also well-placed to back small funds without the critical mass to whet institutional appetites. Short-dated strategies that accelerate returns are also very much in the frame.

Such funds are operating in markets that aren’t flooded with institutional capital and can offer some exceptional opportunities to generate alpha returns. However, they’re unlikely to be a target for private banks or feeder funds that channel private capital, as they will tend to stick to more mainstream options. In any case those avenues are only open to the very wealthiest individuals with extremely high entry minimums, excluding all but the super-rich.

Access is opening up, though. Alternative models have now become established in the marketplace that can pool private capital from multiple HNW investors (not just the uber-wealthy) and connect it to suitable private debt funds. These models act in a similar way to institutional investors in terms of professionalism, expertise and a single point of contact, but with a more flexible, open-minded and entrepreneurial approach.

There’s significant untapped potential here for fund managers who want to broaden their investor bases, and private investors who want to diversify their portfolio composition, to come together in a mutually beneficial way. Private capital is clearly a very different beast from institutional capital, both in terms of the scale of the opportunities it targets and in the way it evaluates investments.

Though dealing with private capital won’t suit all fund managers in the private debt space, there will be many for whom it could fill a gap or provide an innovative way to tap into new sources of capital. If the two can marry up, it could be an ideal match.

*Claire Madden is managing partner at Connection Capital, a London-based firm which offers syndicate investments in private equity, private debt and other alternatives.