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More investors than ever currently describe their positions as overallocated to private debt, but they are nevertheless planning to invest the same or more capital in the asset class in the year ahead.
According to Private Debt Investor’s LP Perspectives 2023 Study, nearly one in five (18 percent) of respondents say they are overallocated to private debt today, significantly up on the 3 percent that said the same in 2022 and the first time the proportion has risen above 10 percent in the past six years.
Nevertheless, 89 percent of LPs say they plan to invest the same or more capital in the asset class in the next 12 months compared to last year. When asked to describe their investment policy in the case of overallocation, 44 percent of LPs say they will remain overallocated, 20 percent plan to wait for a market correction, 25 percent will adjust allocation targets and just 11 percent intend to reduce exposure in the secondaries market.
Jeffrey Griffiths, partner and co-head of global private credit at Campbell Lutyens, says: “A lot of investors will include private credit in their alternatives allocation or their private markets allocation, and that is where the overallocation issue is as a whole. Private markets have not been valued down as aggressively as public markets, creating overallocation issues, but we have not seen investors saying they have reached their private credit limits or are fully invested.”
Rather, he says: “We are seeing continued activity from investors wanting to do private credit or wanting to do more of it. That’s partly driven by a market view that it is the right place to be in a more difficult economic environment, and also by a number of investors still building out to their target allocation.
“Private credit programmes are broadly less mature than private equity, and in a challenging economic climate investors naturally flow to less risky strategies. Private credit is viewed as a less risky strategy in alternatives versus private equity.”
More LPs than ever before tell us that private debt has exceeded benchmarks over the past 12 months, with 39 percent saying it has outperformed and a further 52 percent saying it has met benchmarks. A year ago, just 21 percent saw the same level of outperformance in private credit.
Looking forward, investors are also more optimistic about the outlook for the asset class than they had been: 37 percent expect private debt to exceed benchmarks in the next 12 months, up from 21 percent in 2022.
Robert Molina, managing director and head of origination at Briarcliffe Credit Partners, says: “We have seen a lot of innovation and diversity growing up in private credit, which is no longer so dominated by mid-market direct lending strategies. We now identify some 26 different strategies within private debt, and that diversity and opportunity to invest in less crowded areas has allowed LPs to earn higher returns. That does not mean managers are taking on higher risk to generate those higher returns, just moving into less competitive markets.
“We are also seeing more bilateral discussions between GPs and potential borrowers, which means the lender ends up being a deal maker rather than a deal taker.”
Looking at strategies, an overwhelming 94 percent of LPs plan to invest either the same amount or more capital in direct lending over the coming year, well ahead of the 67 percent that feel the same way about speciality finance and the 60 percent that plan to invest the same or more in mezzanine and subordinated debt.
Molina says: “Direct lending has been fortunate because it has not suffered significant stress. Everyone was concerned about that in the midst of covid, but there was no material impact on direct lending strategies and as a result LPs continue to re-up with their current relationships in the direct lending space, and those will continue to be a core part of their portfolios.”
Griffiths agrees that in a market where investors are anticipating more risk, direct lending appeals because it allows them to stay senior in the capital structure and relatively well-protected.
“Within direct lending, we see investors moving towards non-sponsored lending,” he says. “That is a big trend. We are also seeing investors moving down the size scale to support more lower mid-market managers, because there is a recognition that some of the larger-cap strategies are really where credit standards have loosened the most.”
Across all asset classes, LPs anticipate the proportion of their total assets under management that will be allocated to private markets to grow by 6.1 percent over the next five years. Nearly a third of investors (31 percent) expect to have a greater interest in North America within private markets over the next year, while 20 percent will increase their interest in Western Europe and Asia-Pacific, and around a quarter (26 percent) plan to reduce their interests in Central and Eastern Europe.