US Special: Charge of the small brigade

Like the elephants on ancient battlefields that charged the enemy before the humans mopped up the broken ranks, it was the larger institutional investors that braved the US private debt market first. Today, however, the investment consultants who advise institutional investors are noticing a subtle but significant change in their client base.

The low yields on offer in public fixed-income are now tempting smaller institutions too, they say. This includes smaller public pension plans, such as county schemes, and smaller endowments. 

“I have seen more and more smaller clients get warmed up and move into private debt over the last few years,” says Ping Zhu, a member of the private credit team at the San Francisco office of Verus Investments. “The need to generate returns has pushed them over the fence.”

Keith Berlin, senior vice-president and director of global fixed income and credit at Fund Evaluation Group in Cincinnati, says that investors can aspire to annual returns of 12-15 percent for private mezzanine. The coupon accounts for the bulk of this, but investors sometimes benefit from other features, such as the Original Issue Discount that allows them to buy at below par. For private senior debt he thinks returns of 8-10 percent are realistic. 

Of all the possible virtues of private credit, investors like the return most of all, say consultants. This is all the more so because yields on public bonds have been crushed by loose US monetary policy, with 10-year Treasuries at 1.5 percent in mid-August. 

Investors also see some appeal in the boost to diversification within their portfolios, add consultants. This benefit exists even within the fixed-income allocation. Because the average duration of private debt is high, “sensitivity to market interest rates is very low”, says Zhu. “This creates good diversification relative to the core fixed-income portfolio.”

Many investors even prize diversification at the fund level – favouring generalist rather than niche vehicles, with a particular interest recently in diversified direct lending funds. Many consultants endorse this generalist approach. 

“Most of our clients prefer more diversified funds,” says Laura Wirick, principal in the San Diego office of Meketa Investment Group. “A fund that’s a bit more diversified is usually able to respond better to different market environments.” 

Those consultants that favour generalist funds say that niche vehicles are, by contrast, trapped by the narrow market in which they operate. For example, a specialist in New York real estate has to keep lending into that market even if the city’s property market takes a turn for the worse.

However, the debate over diversified versus specialist continues to rage, with where consultants stand in the debate largely reflecting the circumstances of their typical client.

“Our clients tend to be very well-diversified, so they’re generally attracted to the niche strategy,” says Berlin. His firm sees the advantages too. “We prefer funds focusing on particular areas where that’s all they’re thinking about and they have a dedicated skill set.” 

He cites complex areas such as mid-market restructuring and a fund that the group has recently backed focusing on collateralised loan obligations. Berlin says these are an improvement on the old CLO model because they are subject to the new risk retention rules, brought in by the Dodd-Frank Act, under which loan originators must hold 5 percent of the assets to align their interests with the investor’s. 

Interest in niche strategies has been piqued by the increase in niches available to invest in. “A lot of groups are getting creative and trying to appeal to different parts of the market, so many niche strategies are popping up,” says John Kyles, managing director of Darien, Connecticut-based Portfolio Advisors. 

In particular, he sees the “very attractive opportunity” in sponsored junior debt. “When the high-yield market faces challenges and the second-lien market shuts down, sponsors want to get transactions done, so they’re going to be looking for relationship-based lenders,” he says. The second-lien market came to a virtual standstill in late 2015 and early 2016.

Kyles argues that investors can achieve good diversification by using a variety of specialist funds. “There’s a lot more variety now,” he says. “You can build a very nice balanced portfolio across senior, unitranche and junior debt, levered and unlevered, across geographies, asset-backed and cashflow funds, sponsored and unsponsored.” 

Kyles thinks that because funds are increasingly willing to accept small amounts from investors, this balance can be achieved with a little as $50 million, based on $5 million apiece in 10 funds. 

NOT FOR EVERYONE

But even those consultants who advocate complex niche funds urge caution. “Even many sophisticated investors have no idea what CLOs are and how they work, so the CLO fund is not one for broad consumption,” says Berlin as an example.  

Moreover, even those consultants who like niches are wary about the proliferation of specialist energy funds since the plunge in the oil price in 2014. “We’re not attracted to this space,” says Berlin. “No matter how beautiful a fund’s strategy is, the dominant issue is still the same: where will energy prices be in three or five years?” 

Consultants add that this kind of bet is more suitable for the real assets part of their allocation, since it offers more upside if the price is high. In private credit, by contrast, the upside is always limited when compared with risk assets, outside of a few fields such as distressed credit.

Distressed credit might, in fact, be the next trend for investors to consider if default rates continue to rise, say some consultants.

Wirick has observed a recent trend for distressed debt funds that plan to keep some dry powder in store over the next year or two, while they await more promising times. “They’re taking advantage of the current market environment, but also keeping money aside till they see more market opportunities,” she says.

WHICH POT TO PICK FROM?
If investors want to put money in private credit, they have to decide first where they are taking the money from. In the past, private credit was typically part of the fixed income allocation, says Ping Zhu of Verus Investments. “This made the discussion very easy, because the target return for public pension plans is about 7 or 8 percent, and publicly traded fixed income currently returns about 2 or 3 percent.”

Private credit helps to close the gap between the two sets of numbers.

However, Laura Wirick says Meketa Investment Group counsels clients against reducing allocations to liquid fixed-income securities in order to invest in illiquid private credit, because it increases the portfolio’s overall level of risk. Instead, she favours taking the money from other asset classes, such as equities.

Some consultants also emphasise the need for flexibility when it comes to allocating to private credit. Zhu points to the State of Tennessee’s 2012 decision to create a strategic lending allocation, which included not only private credit but also bank loans and credit-focused assets offered by hedge funds.

“It was pretty broad, so that it could cherry-pick from a range of interesting strategies,” says Zhu,who worked on the initiative while at Strategic Investment Solutions, a consultant later acquired by Verus.