The vast majority of investors in private debt plan to either increase or maintain their commitments to the sector over the year to September, according to Private Debt Investor’s LP Perspectives 2021 Study.
This enthusiasm for private credit is based on performance, with 42 percent saying their allocations to the asset class met or exceeded benchmarks in the previous 12 months and only 14 percent expecting it to fall below benchmarks in the year to September 2021.A third of the LPs surveyed plan to invest more capital in private debt in 2021 than they do currently. Although 30 percent of the investors interviewed do not currently invest in private debt, a further 32 percent consider themselves to be under-allocated to the asset class and only 6 percent feel they are overallocated.
David Golub, president of Golub Capital, believes 2020 put all investment managers and strategies to the test: “What we have found to date is that our borrowers have generally performed better than expected – and especially those in the covid-impacted sectors.”
He puts that down to three factors: good underwriting, which has seen funds such as Golub Capital’s lending to resilient companies in resilient industries, backed by strong private equity sponsors; strong, adaptable management teams; and supportive, agile sponsors.
Golub says: “Our investors have told us they are pleased with both our returns and our transparency. We don’t sugar-coat. When we had lousy results in Q1, we explained why, we explained what we were focused on and we explained what we expected for the rest of the year.
“Our team has done a great job of helping our investors understand our approach to underwriting and portfolio construction, which is immensely helpful during periods of turbulence.”
Investors now anticipate that the share of their portfolio dedicated to alternatives will increase by 7.3 percent, on average, in the next five years, with credit strategies set to be a beneficiary.
Jeffrey Griffiths, co-head of global private credit at Campbell Lutyens, says: “The economic environment will result in some increased default rates and loss rates, which is actually a healthy development for the private credit market.
“Private credit managed through commingled GP-LP structures has not been in existence for long – senior direct lending only really started in its current form around 2010 – so we are going to get to see how funds perform in a more difficult economic climate.
“As the market is tested and comes out well, we expect allocations to increase still further.
“The average pension fund is currently only allocating about 2-3 percent of total assets to private credit, and that is very low when you consider how natural it is as a market for most of these investors, who are looking for mid-to-high single-digit returns.”
LPs expect to increase their interests in Asia-Pacific, Western Europe and North America in 2021, while emerging markets move down the agenda.
They also plan to invest more in distressed and special situations, direct lending and speciality finance strategies, at the expense of mezzanine and subordinated lending. David Waxman, managing director at Azla Advisors, says: “Private debt’s biggest current opportunity is the distressed opportunity that will likely be brought on by the coronavirus-driven recession.
“The environment should also see the emergence of smaller niche private debt distressed managers or niche private debt managers that unveil distressed funds specifically geared to their space. These should generate higher returns than the more generic, larger distressed managers.”
Khizer Ahmed, co-founding partner at Elm Ridge Advisors, shares a belief that the crisis will create opportunities for the asset class. “This period of heightened market stress will reinforce among borrowers the benefits of diversifying their lender base with respect to meeting the fund financing needs,” he says. “Specifically, the attractiveness of sourcing liquidity from non-bank lenders such as speciality finance companies or funds, and institutional investors, such as insurance companies and pension funds, is likely to become more evident.”
Thinking about their private markets portfolios, LPs say the three factors likely to have the greatest impact on performance over the 12 months to September are recession in core markets, covid and extreme market valuations. Only 6 percent of respondents identify the impact of the UK’s departure from the EU as a major concern.
“Brexit would certainly be a much bigger issue in the minds of fund managers at the moment if it wasn’t for covid,” says Clive Short, commercial director at fund services firm TMF Group. “The majority of managers have been planning and putting contingencies in place for a while.”
Instead, it is the threat of a global recession brought about by the pandemic that is weighing most heavily on the minds of private debt investors.
William Brady, partner with Paul Hastings in New York, says: “The uncertainty of the current situation, combined with pressure on managers to deploy capital and the underwriting pressure to invest wisely, really puts a premium on managers doing an even deeper dive in terms of due diligence. They need to be looking under the hood to make sure they get it right from a credit risk perspective.”