At times of worry humans weigh up two responses – fight or flight. Since global health officials’ first public pronouncements on the covid-19 virus we have seen some of the biggest stock market moves in history. The Fed cutting rates between scheduled meetings for the first time since the great financial crisis has confirmed that this is ‘one of those moments’.
In private credit, where events move in slower motion, this will play out over the medium term with a simple dynamic. If asset managers are not seen to be able to fight to preserve their capital, pensions and insurers will take flight from the market.
After 20 years in the private markets, my view is that the case for directly negotiated, long term, maturity-matched private investments will come out even stronger from this. Where else is there expertly sourced risk and steady income? But first we do need to pass this coming test.
The response to the virus, which will need to err on the over-cautious, will curb business activities across whole swathes of the global economy. Our diverse and global market has almost $1 trillion invested in hundreds of thousands of businesses if you count the SME lending platforms as well as the mid-market transactions. Thousands of institutions and family offices worldwide are invested.
How asset managers respond on investors’ behalf will set the tone for fundraising for a decade. Will private credit managers be seen to be able to work with borrowers through a cash or refinancing crisis in the way the banks perhaps could not in 2008? Will downside protection in the form of asset coverage or senior claims on cashflow protect investors’ capital in the way that they hoped? Will the asset management community communicate openly to investors who themselves need to report their portfolio performance to their stakeholders?
Investor decision time: The perils of simple stories
But institutional investors also will have judicious decisions to make if this crisis drags on. Do they stay informed, work with the best asset managers and stay in the market? This has proved to be the wise choice in every other crisis. That is what the asset managers’ experience and technical ability and contact networks are there for.
But where should institutions now allocate capital? In Robert Shiller’s most recent timely intervention, Narrative Economics – How Stories Go Viral and Drive Major Economic Events, the Nobel Laureate states that “the human tendency to form simple narratives around even the most complex chain of events infects even the most analytical minds”.
Institutional investors have highly analytical minds. However, they often need to get sign-off from committees who are less appraised of the facts of a given market and, collectively, need to make big allocation decisions based on simple narratives. Pension committees will certainly now demand an emphasis on ‘safety’. This may involve one or more of the following actions. Each of them needs to be weighed carefully.
“We may also see an emphasis on senior secured debt rather than growth credit. This is also understandable. However, opportunities should not be ignored”
Firstly, there may be an inclination to move towards funds doing larger deals under the theory that smaller companies are more vulnerable to economic slowdowns. This might be an example of a simple story infecting analytical minds. Local deals now done in the lower mid-market in the regional economies of the US and Europe may actually have less exposure to global supply chains or to foreign export markets hit by a covid-19 lockdown. SMEs served by the small-loan lending platforms may depend on local factors that are idiosyncratic to their business, making them less correlated to private equity investments for example.
We may also see an emphasis on senior secured debt rather than growth credit. This is also understandable. However, opportunities should not be ignored whenever there is a market dislocation. There may be situations where well-run companies are now able to consolidate their positions with new purchases and even grow their customer bases. Investors need to remember that when whenever we look back at when the fear factor was at its highest it was when the returns turned out to be best to those who stayed in.
Non-correlated investments in speciality finance and asset-backed investments through ‘credit opportunity funds’ will now take even more focus. This is sensible. However, investors need to make sure that managers have the local sourcing power and also the technical expertise to manage short- and medium-term risks. Many managers have been careful to build these platforms out and I believe they will pass the test for investors.
Finally, we are likely to see, temporarily at least, reliance on existing asset manager relationships. The comfort of familiarity is understandable. However, it may also be a time to explore other asset managers that are allocating to different uncorrelated sectors. However, where existing managers in an investor’s portfolio are in a position to help portfolio companies to refinance through a temporary crisis such as this, providing follow-on funds may well be an opportunity.
Long-term impact: A bigger secondary market and more technology
Private markets require trust. One trillion dollars does not flow into illiquid assets that are not yet even chosen without a large amount of trust in people. One-to-one meetings are still the main form of trust gathering. Industry conferences are a mainstay of the networking process, sometimes with delegates in the several thousands.
The risk of viral infection and the slower gathering storm of antibiotic resistance only adds to the pressure to bring more technology into private markets. Inefficiencies abound. A private credit fund still takes over a year to raise. Asset managers are sometimes spending as much time travelling to meet investors as they are travelling to meet portfolio companies. Asset management companies are increasingly expected to meet Environmental and Social Governance goals. Four hours of air travel for every one hour of meeting time will not be a ratio that investors will allow. Digitised video, with stop-start features and interactive Q&A will finally start to replace face-to-face interaction.
There may well be an acceleration of the development of the secondary market in private credit which has only just been getting started. Investors will want to see invested, disclosed portfolios and evidence that companies in those portfolios have engaged in risk planning.
This disclosure of real assets and existing company performance will lessen the reliance on ‘looking into the whites of the eyes’, which has been a key part of the process in deciding whether to commit to a private markets asset manager who does not yet have a ramped portfolio.
This may work the other way of course – asset managers who can construct new, risk-mitigated portfolios in certain specialist sectors will also be at a premium now. For example, opportunistic, non-cyclical or secured investments like speciality finance will be attractive.
The private credit market was born in crisis, when a global system based on borrowing short to lend long failed. Our market has more basic financial integrity. It is connecting the savings system with well selected and managed investments right across the economy. It will come through this crisis. But meanwhile, as in any test, we all have wise choices to make.
James Newsome is founder of Arbour, a transaction platform for asset managers, investors and advisors in alternative credit