Investors shift from offence to defence

In a turbulent world, protecting what you’ve got is more of a priority than diversification.

Limited partners’ love affair with private debt shows no immediate sign of diminishing, as you will discover when viewing slides we have put together here based on our PDI Perspectives survey.

Notably, 88 percent of investors said they were either looking to keep their current level of allocation to the asset class (60 percent) or increase it (28 percent). Nor is this surprising in light of performance to date – 61 percent reported that private debt was hitting its benchmark, while 26 percent said it was exceeding it.

But this good news is only half the story. When LPs were asked whether private debt deals are structured sufficiently well to survive a downturn, 55 percent expressed a “neutral” view, while only just over 1 percent were “very confident” – a lower figure than for private equity, real estate and infrastructure.

This reflects concerns over various aspects of deal structuring that have been well documented by us and others recently. Moreover, many LPs have no doubt been anxiously watching political events in the UK this week as further evidence that the world is becoming an increasingly unstable place. The clock appears to be relentlessly ticking towards a more challenging market environment.

As a result, investors appear to be focusing ever more urgently on downside protection. A white paper published by Bfinance last week – “DNA of a Manager Search: Equity Overlay” – found investors favouring “explicit” forms of protection for their equity strategies as “the era of artificially stimulated asset prices” gives way to “rising market volatility, tighter monetary conditions, geopolitical tensions and trade war concerns”.

There are various types of equity overlay – and some are way too complex to satisfactorily describe here – but what they all have in common is that investors are prepared to pay for products, at various degrees of expense depending on how much protection is offered, to stem any potential losses from their dealings in the market.

So which investors are increasingly opting for this? According to a source at Bfinance, it is sophisticated investors including pension funds, insurers and endowments. Many of these investors have spent the last decade creating what Bfinance describes as “implicit” protection by building up their diversifying strategies – notably by pushing into alternative investments, including private debt.

Asked whether the new focus on “explicit” downside protection would see a negative implication for “implicit” protection in the form of less capital flow into alternatives, the same source said it was unlikely to be an “either/or” scenario. As our Perspectives survey indicates, alternatives such as private debt have proved their mettle in recent years and investors are unlikely to start withdrawing capital in any material way.

However, as investors become increasingly worried about the prospect of a severe downturn, it is clear they are seeking to fireproof their investment portfolios as rigorously as possible. And here there is a clear relevance for private debt: this is not a time for reckless deal structuring and undue risk-taking.

Write to the author at andy.t@peimedia.com