The hype surrounding private debt is justified, but there are several key issues that need to be addressed if managers are to successfully win commitments, argues Towers Watson’s Gregg Disdale.
Private debt has become increasingly interesting to institutional investors during the ongoing financial crisis. This is perhaps unsurprising given the paucity of yields available in financial markets, a significant issue for investors with liabilities to meet. As a result investors are increasingly considering allocating to risky and/or illiquid assets to achieve their required returns.
One approach is via private debt strategies and the current dynamics in lending markets suggest now is an opportune time to consider it. With increased aversion to illiquidity, increased regulations making lending less attractive for banks and a need for those same banks to deleverage, it is unsurprising that spreads between private and public debt have increased. In the US, for example, spreads between middle-market lending and broadly-syndicated loans reached post-crisis highs in 2012.
Which strategies interest investors?
Despite much commentary about the merits and demand for private debt, capital raised remains below pre-crisis levels. This is mainly because fundraising in mezzanine, which is highly correlated with fundraising in private equity, is below peak levels despite it looking a comparatively more attractive strategy. It is a challenging strategy to undertake on a standalone basis in an environment where high-yield debt markets are being particularly accommodating to companies that can access it.
Where we do see growing appetite is for those strategies driven by bank disintermediation, namely real estate and infrastructure debt and senior secured lending to sub-investment grade and/or smaller companies which cannot access public markets. In the US, private debt strategies have long been part of the shadow banking infrastructure and consolidation in the US banking market and elevated spreads have led to increased interest in these areas. In Europe, these are still emerging asset classes for institutional investors as previously they have been dominated by banks. While we expect banks still to be meaningful participants in Europe, there is an opportunity to participate alongside them to fill what appears to be a significant funding gap.
What are the impediments?
There are numerous impediments to fundraising but key among these is what actually makes these asset classes attractive: a scarcity of risk capital and a desire for liquidity. When looking at these strategies, investors’ first consideration is whether there is sufficient compensation for locking up capital. Answering this question is relatively subjective and needs to be considered in the context of an individual investor’s portfolio.
Hand in hand with the above consideration is the cost of accessing these strategies. Often the spread over liquid alternatives appears attractive but management and performance fees can eat into a significant portion of this. Practices in this space that we believe need changing include investment managers charging fees on leverage and a full catch-up on profits after the preferred return for the performance fee. While recognising a meaningful infrastructure is required to manage these strategies, investors need to fund these assets from liquid alternatives so the net-of-fees proposition needs to be extremely compelling on a relative basis to justify locking up capital.
Tax considerations require careful navigation, as do governance constraints which make allocating across a number of illiquid strategies challenging.
The case still appears compelling
Investor appetite for private debt strategies appears genuine, which is reflected in the proliferation of funds and strategies looking to take advantage of bank disintermediation. This in itself should not motivate investors to invest – indeed caution is advised – but subject to careful consideration, we believe there is a compelling macro-economic case for institutional investors to exploit their long-term capital in these strategies.
Gregg Disdale is a senior investment consultant at Towers Watson.