StepStone sees credit secondaries boost
When the going gets tough and liquidity is at a premium, investors looking to raise capital or rebalance their portfolios often seek to unload their best assets first.

Among illiquid assets, private debt appears to be “it” at the moment. According to a new paper by investment manager and consultant StepStone Group, challenges in the liquid markets last year exacerbated the so-called denominator effect, causing institutional investors to be inadvertently overweight in several illiquid assets classes.

“Counterintuitively, the relatively strong performance of private debt meant that accepting a haircut on those valuations would require a comparatively modest mark down (particularly against devalued fixed income and equity holdings), and thus transactional volume arrived reaching $17 billion in 2022 (more than 30x larger 2012 levels) per Coller Capital,” according to the paper.

Indeed, secondaries’ volumes in 2022 fell in all asset classes save for private debt, where volumes increased by more than 30 percent.

Although an investor looking for liquidity today might have to sell a private equity portfolio for a 20-30 percent haircut, the asset class that has suffered least is private debt, John Bohill, the StepStone partner who authored the paper, told Private Debt Investor.

Unsurprisingly, then, StepStone and its peers “became buyers of performing direct lending LP interest at prices reflective of private equity returns”, the paper says. Bohill told PDI that StepStone’s Credit Opportunities Fund 1 is performing strongly, particularly because of its secondaries’ activity. The fund had a 17 percent IRR within a year of its first quarter 2022 closing, and is 90-95 percent invested.

“For more than 10 years, we’ve been in a very benign credit environment without much disagreement,” Bohill said. “Suddenly we’re talking about some elements of a recessionary environment, and we have people disagreeing over the quality of portfolio companies and managers, which creates a volume boost.”

In the last six months, StepStone has been talking with many pension fund trustees who are tactically selling some exposure now but who want to increase their private debt allocations in 2024.

Eleven years after the scandal, goodbye to LIBOR
The last remnants of the London Interbank Offered Rate expire as June ends.

LIBOR was first published on 1 January 1986 and soon became the dominant reference rate for adjustable-rate financial products around the world. It was published daily for more than 35 years.

LIBOR was defined as the average of the rate at which the surveyed London banks represented that they could borrow unsecured cash by asking for and accepting inter-bank offers in reasonable market size.

In May 2021, the UK Financial Conduct Authority announced that one week and two-week USD LIBOR would cease publication at the end of that year, and that the longer-term USD LIBORS would cease publication after 30 June 2023.  Accordingly, the deadline for the adjustment of the benchmarks for existing loans to SOFR expires on that day.

The significance of the transition has been enormous. Two years ago the consultant Oliver Wyman estimated that a typical US bank had between one fifth and one quarter of its balance sheet in LIBOR, and that (including commercial real estate and mortgages) there were nearly $10 trillion of LIBOR-referenced loans outstanding in the US.

Why did LIBOR have to go? Precisely because it is defined by the representations of the banks, not by actual borrowing, LIBOR proved all-too subject to manipulation. The catalyst for the demise of LIBOR was a spate of accusations in 2012 that several major financial institutions – including Barclays, JPMorgan and Citigroup – were colluding as to their rate submissions. Barclays soon admitted to the truth of the accusations. It, and several other banks, settled lawsuits with sizeable payouts.

By the time the scandal’s dust cleared, a general consensus existed among financial regulators, banks and counterparties that there had to be a new reference rate, one with transparency and a liquid underlying market. In the US, that has meant, chiefly, the gradual replacement of dollar LIBOR by the Secured Overnight Financing Rate. The transition has not always been smooth.

Early this month, Barclays said that LIBOR-linked loans still account for about 55 percent of holdings in collateralised loan obligations, and that there was a flurry of deal-switching activity underway ahead of the deadline.

Adams Street: finding managers who will avoid losses
In the private debt world, alpha derives “almost entirely from loss avoidance”, according to a new paper by Jeff Diehl and Bill Sacher of Adams Street, an employee-owned investment manager with $54 billion AUM.

The paper acknowledges that in private equity, market outperformance goes to firms that capture market upside potential above modelled returns. Private credit, though, lives and dies by the “double edged sword” of leverage, where asset-based loans enhance the yields of low-loss portfolios but punish portfolios with material default rates. This situation implies the centrality of loss avoidance.

This centrality may not have been obvious in recent years as a benign climate of macro growth and low interest rates has allowed many managers to avoid losses, creating a narrow return dispersion. To the extent this has created a false sense of security, managers are about to experience a reality check, and investors should know what to look for in a manager as return dispersions widen.

The paper suggests that investors avoid losses by looking for three key characteristics in their prospective managers: a proven approach to underwriting; a differentiated approach to originating deals; and a capital base that is a match for their opportunity set.

Due diligence directed at a fund’s portfolio and its credit agreements will allow an investor to determine whether a manager is satisfactory on all three counts. If not, and especially if a manager who fails any of these tests has been relying on leverage to boost gains, it is best to keep one’s distance.

Essentials