Investors demand mid-tier returns to fill grey zone

Despite booming private credit activity, a bifurcation of in-vogue strategies until recently created a fundraising graveyard for approaches in the middle of the risk/return spectrum. This gap, often termed the ‘grey zone’ by LPs, is starting to be filled as LP allocations mature and adapt to take advantage of a range of emerging strategies that offer low double-digit IRRs and attractive risk-adjusted returns.

Direct lending strategies have been among the most popular. Providing senior secured loans and targeting single-digit IRRs, they have attracted large volumes of fixed-income replacement capital from pensions and insurance investors adapting their portfolios as part of their relentless search for yield. The issue for grey zone GPs has been that as soon as their strategy moved into offering either junior debt, more complex lending solutions or an increase in perceived risk, the fixed-income taps turned off. This happened regardless of how attractive the underlying risk-adjusted returns on offer were.

Instead, these sorts of strategies either had to rely on slim pickings from a small group of more specialist credit investors or find ways to push their return profiles up sufficiently to be palatable to LPs’ ‘alternatives’ buckets, which typically seek high-returning, equity-like strategies. It has typically only been distressed credit and high-returning special-situations strategies that consistently appealed to this other well-established LP portfolio allocation, leaving other mid-returning strategies in the grey zone.

Portfolio allocations do appear to be shifting, though. Rede Partners has noticed that LPs in North America and Europe are beginning to create specific private credit allocations with greater flexibility to invest in the overall credit asset class. From a recent analysis of 68 conversations conducted between June and August with credit-focused LPs, 49 percent said they had the appetite for credit strategies targeting 10-15 percent IRRs; this compared with only 19 percent of LPs in a similar analysis Rede Partners conducted in 2017. This shift should allow LPs to add further diversification to their portfolios and benefit from areas of the market where returns have not been eroded by excessive competition.

The proof is seen in the emergence of larger mid-returning European funds. Pemberton raised €1 billion last year for its Strategic Credit Opportunities Fund, targeting more junior debt than its core senior lending funds. Albacore has also emerged with a €1.4 billion fund offering a more flexible and opportunistic strategy and targeting higher returns than traditional direct lending funds. There has even been fundraising success for managers offering significantly more complex strategies targeting high single- or low double-digit IRRs. Among these is Chorus Capital, which raised close to €500 million for its last fund to invest in bank risk-sharing transactions.

These portfolio shifts do not happen overnight, and not all LPs are nimble enough to flex their allocations in such a way.

However, as the sector continues to evolve, we can expect to see an increasingly diverse set of strategies emerge as GPs innovate and LPs take an increasingly sophisticated approach to the full range of debt strategies.

Alastair Baird is a principal at Rede Partners, a London-based fundraising advisory business