Over the years we at Mercer have been discussing the suitability of private debt with a number of institutional investors of all types and sizes based across the globe. There have been a number of common threads to discussion. First, even those who have their misgivings cannot dismiss the attraction of the asset class in principle, despite the number of different investment opportunities available.
Second, the illiquidity of the asset class can initially present a potential deal breaker when it comes to investing. However, investors nevertheless recognise that risk-adjusted pricing remains attractive relative to other credit strategies, at least in part due to the illiquidity of the asset class.
Once we progress into further discussion, and once initial illiquidity concerns have been addressed (and, in most cases, overcome), one of the common questions investors have is, “Where does an allocation to private debt fit my current strategy?” It is around this question that we have seen some of the widest dispersions of views, and changes in approach, from investors.
Around five years ago many of the early investors in the asset class were allocating from an opportunistic (or private equity) bucket and targeting mid to high teen returns from their credit investments (largely focusing on mezzanine).
Rolling forward to the current day, with the continuation of an opportunistic theme into the medium term, investors are now considering whether the investment might have a longer term strategic, rather than purely opportunistic, role. While it will still take another generation of fundraises to determine whether such a change is actually afoot, current indications are pointing in that direction. Discussions we have held with a number of participants across the market also suggest that the European private debt market is set for longer term structural change.
The other significant evolution is the emergence of a wider range of investment strategies in the European private debt market. Although the opportunistic mid to high teen return-seeking funds still exist, a number of funds have been seeded at the lower risk and lower return end of the spectrum. Investors are looking for increased security and, potentially, investment-grade quality assets as alternatives to public credits.
Investments like senior real estate debt and senior infrastructure debt are two such examples, where expected returns are in the range of LIBOR+2 percent to 4.5 percent. The core of the illiquid senior corporate debt market is, however, focusing on LIBOR + 6 to 8 percent expected returns and total expected returns of 8 to 10 percent IRR. Certain strategies in the corporate senior debt market can be expected to generate higher returns, but the underlying risk levels are proportionately higher. Many fixed income-biased investors appear to be less comfortable with this approach. In contrast, investors with a bias towards alternatives often find this appealing.
The range of strategies, risks and expected returns available today are helping investors to construct robust private debt portfolios to meet a diverse range of investment objectives. A prime example is when building growth fixed income portfolios, an allocation to private debt can be supported to represent around 20-40 percent of the portfolio. Private debt would sit alongside other credit assets such as multi-asset credit, high yield, emerging market debt and absolute return bonds.
On the lower end of the risk spectrum, we are beginning to see private debt gain traction as part of investors’ larger and growing de-risking defensive, often seen in fixed income and/or quasi matching portfolios. Overall, with the European private debt market finding its feet, the future of private debt looks bright. n
Sanjay Mistry is director of private equity fund of funds and of private debt at Mercer.