Investors are jumping into private debt in increasing numbers. But what do big LPs really think about private debt – and of those that are active in the asset class, where are they focusing their resources?
PDI gauged the opinions of a diverse group of around 40 institutional investors – including public pensions, funds of funds, endowments, family offices and insurance companies, spread across North America, Western Europe, Asia-Pacific and Latin America – initially through an online survey and subsequently via a series of in-depth interviews.
Just over half of those surveyed already had investments in private debt – mostly as part of their alternative asset allocation rather than their fixed income allocation – while a further 12 percent were seriously considering it.
Of those that had already invested in the asset class, most cited either the attractive risk-return profile or the regularity and dependability of returns as the principal attraction. And while allocations remain relatively small in some cases (i.e. less than one percent of overall portfolios), around one in three of those already committing to the strategy said their allocations were already above 5 percent – despite, in most cases, it being a relatively new addition to their portfolio.
Significantly, most of those already invested in the strategy (73 percent) remain bullish about it, to the extent that they expect to increase their allocation in the next 12 months. Only 13 percent said they were actually planning to cut their allocation – demonstrating that those investors who have already put capital to work in private debt are happy with the results to date.
Around 70 percent of respondents said they were expecting returns in the 6-15 percent range, although some investors are looking for outsized returns of more than 20 percent.
Only a third of those surveyed had no immediate plans to invest in the strategy. Various reasons were offered for this decision. A number of investors cited the inherent complexity of the asset class, while others suggested there weren’t enough quality managers to back. Others believed there were other products that offered similar or better risk-adjusted returns.
Much of the hesitation was simply related to the novelty of private debt as a strategy. As one UK-based pension fund manager put it: “The asset class is relatively new, and most pension funds prefer assets that are already established. Until it becomes more established, we will probably be hesitant to increase or alter our exposure.”
Where to invest
Corporate lending was the most popular sub-segment for investors within private debt: it was cited as the most interesting area by just over 70 percent of those surveyed. Real estate financing is also clearly an area of interest (cited by nearly 18 percent), while there was also more limited support for infrastructure-related debt and distressed debt.
Generally speaking, the LPs surveyed felt senior loans offered the most attractive risk-return profile. However, mezzanine seems to be gaining more adherents too. And others trumpeted the virtues of diversification across different debt strategies. “For us, it is about having a hybrid strategy that invests across all sub-segments of private debt,” said one French fund of funds manager. “So that includes mezzanine, unitranche, senior and junior loans. It also means we are interested in real-estate as much as we are in distressed debt, leveraged finance and so on.”
Nick Cavalla, chief investment officer at the University of Cambridge Endowment Fund, said that while senior loans didn’t necessarily provide the best absolute returns, they were a better fit for investors like him. “Secondary positions in the junior debt and equity tranches of CLOs have been our strongest performing positions [with] returns in excess of 35 percent last year. However, for conservative investors such as ourselves, senior loans are the most secure and reliable source of investments, and generally we find our allocations drawn to senior loans purely because we favour safe assets to risky assets.”
In terms of how investors are building their exposure to private debt, by far the most popular approach is via direct commitments to private debt fund managers (although a quarter said they had gained exposure through secondaries activity).
This is, of course, where a lack of high-quality available managers would be particularly significant. And there’s certainly no sign that LPs are compromising on the calibre of managers they’re willing to back.
“We’re primarily focused on whether the manager can find opportunities to generate alpha,” says Mike Bailey, investment director at MassPRIM. “Is there something about the managers’ edges and process that give it the ability to create alpha … to generate a return that you can’t get by owning a credit market index?”
“We need to see high integrity in the firms that we are investing with,” adds Cavalla. “We need to be assured that what we are being promised is attainable and understand the edge of the manager.”
Some 44 percent of those surveyed said team quality was the overwhelming priority, while 32 percent cited a strong track record of generating returns – something that is not always easy to find in such a relatively nascent market.
This explains why there’s still a widespread reluctance to back first-time managers, which almost 40 percent of respondents said they would not even consider.
One European LP suggested that the complexity of the strategy made this particularly difficult. “We don’t invest in new managers; the economics of it just doesn’t make sense. The fact that opportunities in the asset class change very rapidly shows the complexity of investing in debt. A lot of investors are seeking exposure to it, but the nuances of the asset class mean they have to select managers who know what they are doing in order to make decent returns.”
“We very rarely consider backing a new manager,” admits another LP. “But it does depend on the situation – if they have a specific niche, and their story sells (from an economic point of view) we may be inclined to consider it.”
One likely future development in this area will be an increase in separate accounts. “We have talked about working with managers on separately managed accounts in this world to create a little more customisation in terms of what we like to do,” says Bailey.”That is one thing I could see us doing down the road.”
Direct lending is also an area that is attracting interest from a number of LPs – although many (particularly in Europe) acknowledge that they don’t currently have the resources to manage it.
“Most of the European pension funds don’t have the infrastructure and the skills set to execute the more complex debt instruments,” said a UK-based pension fund manager. “We don’t have the skills set and the budget to execute direct lending, so it is not on the radar.”
So what are LPs’ biggest concerns about the private debt market? This is significant, because it helps managers to pitch their services in the most appropriate way.
When investors were asked to rate a number of potential issues in order of importance, the most challenging issue was considered to be an increase in default rates resulting from poor macroeconomic performance – a very real threat, particularly in developed economies. On a related note, LPs also worry that rock-bottom interest rates in many leading markets may also lead to sub-standard returns for private debt fund managers.
Interestingly however, regulation does not appear to be a particular area of concern, despite the fact there’s a still a degree of uncertainty about what the rules governing this market will be. Only 13 percent admitted to having substantial concerns about the regulatory landscape.
Nor do LPs on the whole seem to be too worried about dealflow – although some individual investors did highlight a potential lack of opportunities in the coming months. “We’re hearing from managers that it’s harder to source attractive investments,” says one LP. “And that that shrinking of supply has been an issue for some of them.”
That’s particularly true in Europe, the same LP added. “I’ve certainly heard in the market that things are tougher in Europe in terms of finding opportunities. And I think some of that might be that people expected some things to shake loose from the banking system there – and that hasn’t happened as quickly as some people would have expected it to.”
However, other LPs believe this situation will be short-lived. “Given the macro environment in Europe and the fact that banks remain overleveraged, there will be distressed assets coming off those banks,” insists one.
Picking the right strategy – or strategies – is also becoming problematic for some managers, says one European fund of funds manager. “One of the main hurdles is the strategy challenge. Debt fund managers are grappling with trying to switch between strategies – because if they focus on one particular strategy, they close themselves to the opportunities in the market. However, if they widen their strategies, they cannot convince investors that they have the resources to generate returns.”
But perhaps the most significant worry for several investors was that the very growth and success of this strategy in recent years could prove to be its undoing. “There is some degree of scepticism associated with anything which appears to have elements of bubble-like characteristics,” as one LP put it.
Tim Walsh, director of New Jersey Division of Investments, had similar concerns about the market overheating. “We get a lot of emails with pitch books for credit funds. I really question if … it’s getting frothy. When you have a lot of money going into an asset class, usually bad things happen.”
Nonetheless, our research suggests that institutional LPs are pouring capital into the strategy in increasing numbers – and once they have committed to it, they tend to be happy enough with the results that they’re looking to increase their allocations. That can only be good news for the private debt fund managers and intermediaries active in the area.