Q How does private debt fit investor needs?
We believe there is a strategic role for private debt in institutional portfolios. With the long-term nature of liabilities, pension funds and other institutional investors are in a position to offer liquidity to the market and thereby realise an illiquidity premium. Considering the attractive return potential of private debt, it is one manner in which investors can diversify from equities, and yet retain a broadly constant expected return.
Q What kind of investors does private debt suit and why?
The broad private debt universe allows investors who have some tolerance for illiquidity to structure a portfolio that meets their individual risk/return objectives, to realise an illiquidity premium and to benefit from further diversification.
Private debt offers several advantages over high-yield or senior bank loans [including higher returns, floating rate, prepayment protection, lower mark-to-market volatility and often stronger covenants]. This comes, however, at the price of lower liquidity, access via closed-ended funds and the need for more resource intense implementation and monitoring processes.
Q By how much are investors increasing their allocations for private debt?
While the institutional interest in private debt is steadily growing, the proportion of European institutional investors with a private debt allocation is still relatively low, based on Mercer’s Asset Allocation Survey 2015, but not far behind the results for private equity.
To justify the implementation effort and to generate a meaningful contribution to the total portfolio, target allocations of 5-10 percent of the total portfolio appear reasonable. Investors should, however, be mindful that it will typically take around three to five years to build up a robust private debt target allocation. Ongoing investments then have to be made to keep that allocation at the targeted level.
Q What factors should investors take into account when setting up a private debt allocation?
Once an allocation level is set, investors have to think about constructing an optimal portfolio structure to meet their targets. As for other asset classes, diversification is key to managing periods of market stress and surviving extreme events. In the private debt case several investor specifics must also be considered: category as in corporate, real estate or infrastructure, seniority, region, currency, managers, deals, vintage, market opportunities and outlook.
Q What are the challenges in implementing this strategy?
For many institutional investors, it can be challenging to consider new asset classes in their strategic asset allocation (SAA) process. While the SAA process is typically beta driven, when allocating to private debt, investors should also be mindful of the implementation and portfolio construction considerations and the impact it can have on the SAA. We believe this is also true for other asset classes that have a significant part of the return influenced by alpha. This is because the risk levels of selected strategies can vary significantly between managers depending on their investment style.
Another challenge, in terms of the SAA, is that three simple inputs – return, risk, correlation to other asset classes – have to be set to describe a complex asset class that doesn’t have reliable, observable monthly return data from which to derive a return pattern.
The private debt implementation process also operates more in line with the implementation of private equity allocations. Private debt funds are typically less diversified, by number of positions, so it is the investors’ responsibility to ensure adequate diversification exists, either by taking over this responsibility internally or by outsourcing the implementation/management of the private debt allocation. Investors need to recognise that it will take time to allocate capital to a set of top managers, and it will take additional time until they have invested the committed amount. Like private equity, strong relationships are needed to gain access to the right managers.
Q How can investors rise to the challenge of implementation?
Unlike in the traditional fixed-income world, there is no reference benchmark managers aim to replicate and the portfolios tend to be far more concentrated.
Detailed due diligence should disclose whether lower performance results are in line with lower risk levels, weak implementation or excessive costs. at $150 million overall. The minimum investment is $1 million and we’ll be doing quarterly closes over the next 12 to 18 months when we expect to reach our target.
This article is based on extracts from a forthcoming book on the European private debt market, edited by EPIC and European Capital, and published by PEI.