PDI 50: Where the capital comes from

As more capital floods into private debt than ever before, Christian Allgeier of First Avenue looks at the reasons behind the increase in LP appetite for the asset class and the new areas of investment.

Last year was a record year for private debt fundraising and although 2018 fundraising looks slightly lower, we still see a strong demand for this relatively young asset class. Most of this is driven by investors searching for higher risk-adjusted real yield – the holy grail of illiquidity premium – now that traditional fixed income risk-adjusted return is hard to come by in a low interest rate environment.

Christian Allgeier

Not only does private debt offer diversification and steady cashflows, it is also uncorrelated to the stock markets and tends to present investors with less volatility and uncertainty than public market instruments. Stable performance through market cycles and its increasingly broad, mature universe of asset managers are additional factors of increased support for private debt.

Institutional investors’ knowledge and experience of private debt has grown substantially in recent years. Due to a benign market environment and stable returns, more investors are allocating dedicated capital for private debt where they had once allocated from their fixed income or private equity buckets.

From a geographical standpoint, US-based investors continue to take the lead, particularly when it comes to searching for higher returning private credit strategies. Asian investors – particularly in China, Korea and Japan – have been big allocators to private debt and continue to build their programmes. In Europe, there is more interest in private debt from investors in the Netherlands, Spain and Italy with many aiming to make their first private debt allocation in 2019. A rally in the US dollar and associated forward FX levels and hedging costs have led to an increased aversion to US dollar private debt from non-US investors.

Local government pension schemes continue their fondness for private debt given the funds’ preference for exposure to assets that derive the majority of their returns from income as opposed to capital growth. Moreover, investment sizes have increased since LGPS have proactively teamed up to work together to achieve significant fee discounts and improved control.

We are very conscious of the extended cycle and increasingly consider the private debt opportunity set in the context of the imminent market correction. As a result, we find appetite among our investor base for more flexible credit strategies that are opportunistic and nimble in the face of a dislocation in credit markets. Speciality lending, special situations, asset-backed strategies and distressed debt are coming to the forefront of investor demand as LPs look for higher returning, differentiated strategies that will theoretically fare well in the aftermath of a correction.

The overall capital raised by the PDI 50 – a five-year total – has increased by 8 percent. The top 10, however, have increased their fundraising total by 15 percent. This shows a trend of ever-larger managers raising ever-larger amounts capital. But is bigger really better?

There are many advantages to being a large, global, multi-asset GP, including: a longer track record; increased brand awareness; market penetration; cross-platform intelligence; and economies of scale. This inevitably leads to a loyal investor base that can support a GP’s growth and expansion. That is why LPs who are new to the space – and are typically more risk averse – will often choose larger platforms over less established GPs.

The concern with larger managers comes as they grow. For example, a specialised GP may have to alter its original investment programme to build the team needed to draw investments from a larger pool. As the GP and fund sizes grow, these alternations to its original remit will continue to a point where the GP may become more conventional and less differentiated.

Smaller managers can bring large GP expertise and experience to their smaller platforms, which can be more nimble and flexible in response to market changes and new opportunities. They are often more efficient and more differentiated, meaning for the experienced investor they are a better addition to their portfolio.

As this differentiation is something that investors are looking for, we believe there is room for both larger and smaller players. So, is bigger really better? Like most things, there is no simple answer – large and small GPs both play vital and symbiotic roles in good portfolio construction.