The next wave of LP capital

Alternatives-loving sovereigns are taking a growing interest in private debt – as are central banks.

At a time when investors appear to be wavering in their support for private debt (see story here), consolation can be found in a report published this week by Invesco looking at sovereign appetite for alternative assets (the Global Sovereign Asset Management Study).

For one thing, the average allocation to alternative assets among the 126 sovereign investors canvassed has now reached an all-time high of 20 percent – double the 10 percent average recorded when the first such study was undertaken six years ago.

According to the report’s authors, sovereigns started boosting their alternatives allocations based on two main factors: income and liability matching. Since then, they have found other reasons to invest, such as inflation protection and diversification.

While alternatives across the board have benefitted, private equity has been the traditional sovereign favourite. However, the latest report notes a softening of demand for the asset class as investors begin to worry about competition for assets and subsequent valuations. They are also noting that, in a still very low interest rate environment, strategic bidders have a cost of capital advantage over private equity bidders.

Therefore, while not a single investor said they wanted to decrease their exposure to alternatives, more attention is being paid to areas such as infrastructure – where sovereigns believe the struggle to deploy meaningful amounts of capital is easing – and private credit, where investors are buying into the bank displacement theme and where, as a relatively new asset class, competition is perceived to be less fierce.

While private debt therefore stands to benefit from this reallocation of capital, it may also get a boost from a new source. Over the course of its six iterations, the study has been noting the increasing significance of central banks. In last year’s version, 35 central banks were approached for the study – this year, the number went up to 62.

As yet, according to someone who worked on the report, central bank allocations to alternatives are “minimal”. But what is catching the eye is their increasing interest and willingness to start dipping their toes in the water – especially in credit.

The background to this is the strong growth in central banks’ foreign exchange reserves, which has been happening over a long period of time and for a variety of reasons. Up until now, the reserves have typically been invested in developed world government bonds and the main aim has been capital preservation.

However, in some cases, burgeoning surpluses – capital above and beyond what the reserves are expected to require for the medium term – have encouraged a movement away from these poorly performing areas in a hunt for yield and better returns. With the main building block still being fixed income, these reserves have cautiously ventured into asset-backed securities and then into private credit.

Private debt fund managers should not be getting too excited just yet. On balance, central banks still prefer fixed income and have a focus on short duration to provide liquidity. However, they are on the radar and – as the wider sovereign universe continues to embrace the asset class – there are real reasons for optimism regarding capital flows at a time when the fundraising figures, by contrast, appear a little sobering.

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