Towards the end of May, the Alaska Permanent Fund Corporation (APFC) approved its private market allocations for fiscal year 2017. Among these was a $350 million slice set aside for private credit.
PDI spoke with Marcus Frampton, director of investments/private markets, and Russell Read, chief investment officer, to find out more about the organisation’s view of the private debt markets and which strategies it is focusing on.
When did APFC first begin allocating to private credit, and what was that decision based on?
MF: The private credit programme began in 2007 with an allocation to a distressed debt-focused manager-of-managers. This separate account was expanded and broadened to include private credit broadly in 2011. Around the same time, the APFC expanded its private credit purview to include direct commitments to two mezzanine debt managers.
The decision to include an allocation to private credit was in recognition of the attractive characteristics of these investments in terms of (i) yield generation, (ii) supply-and-demand for private loan capital with bank lending retrenchment in the middle market, and (iii) potential to earn an illiquidity premium vis-à-vis publicly-traded high yield.
What is the role of private credit perceived to be within the overall portfolio?
MF: Private credit provides a mix of income (through cash coupons) and capital appreciation (through equity upside via warrants or equity co-invest). On a total return basis, we believe that private credit provides interesting spread relative to traditional fixed income and, because of the high income and equity participation, less interest rate risk than traditional fixed income.
How do you view conditions in the private credit markets at the current time – and any thoughts on a year or two ahead?
MF: There are two countervailing themes that are probably worth noting:
a. From a supply and demand for capital standpoint, particularly for lower middle market unsponsored companies, the lending market is attractive. Many of the traditional bank lenders are using more rigid underwriting guidelines and will draw a hard line at lending to borrowers under $15 million of EBITDA. GE, which historically was the leading credit provider to lower middle market companies, has very publicly exited the space.
Similarly, the publicly-traded BDCs are mostly trading below NAV and are unable to grow their books. This shifting in middle market lenders has created opportunity for new private lenders to emerge in the lower middle market and certain other niche markets. We are accessing these lenders typically through private equity-style fund vehicles.
b. While the dynamic outlined in point (a) creates some interesting opportunities, it is worth noting that the overall credit cycle is probably at an advanced stage. For example, leverage multiples on private equity buyouts now are similar to those of the prior buyout boom, and in many cases exceed them, and CLOs are back in favour. Larger non-investment grade companies are able to borrow money in “covenant-lite” deals at rates that are unprecedented.
These factors lead to the conclusion that the credit markets for larger non-investment grade companies that can access deep, liquid markets may be getting frothy.
c. Combining these trends results in us thinking that private credit is an interesting space, but one that we will pick our spots in carefully and look for pockets of opportunity away from the large syndicated markets.
Are there any kinds of strategies within private credit that you are particularly drawn to – and any that you would currently not wish to allocate to?
MF: Lower middle market direct lending remains interesting to us as well as strategies where the sponsor has the flexibility (and team and track record) to opportunistically move between new direct lending as well as more opportunistic or distressed situations in the secondary market.
Why was the recently announced allocation target perceived to be the right amount?
RR: APFC has had substantial success in each of the major private market sectors we have focused on including private equity, venture capital, real estate, and infrastructure. Private credit, however, has emerged as a compelling sector opportunity in its own right, especially since it does not fall readily into the investment programmes of many other public funds.
In each of our private market sectors in which we have achieved success, we ramp up our annual pacing only to the extent we are able to target/underwrite to a compelling IRR. This pacing allows us to participate in the best vintage years without accidentally over-weighting poor vintage years. More importantly, we get to systematically build up our overall private market deal sourcing capabilities at times when others are pulling back.