The case for private debt in LP portfolios

In the last 18 months, private debt has seen a resurgence as an asset class and is now on the radar of many investors as a potential hedge to their private equity portfolios or a way to lift returns for fixed income portfolios. It can still be a challenge to convince some investors where they are wedded to historic return targets and haven’t yet adjusted to the next cycle where we expect a softening of the superior returns seen in the last few years for buyout and venture. This article briefly describes a best practice approach to evaluate the asset class and GPs in the context of risk-adjusted alpha and beta correlation to public markets.

Basis of analysis
CEPRES (formerly known as the Center of Private Equity Research) supports around 420 LPs in their investment due diligence and portfolio management with transactional analysis of private equity, private debt, infrastructure and real estate deals. This currently encompasses 3,303 funds and cash flows of over $7 trillion worth of private market companies. Because CEPRES analysis is based on verified cash flows and the most granular fund, deal and tranche data, you can perform unique analysis not otherwise possible. Thus we can understand how private debt correlates to other strategies (beta risk) and calculate risk-adjusted returns (alpha).

Private debt vs private equity:
A simple comparison
A simple comparison of fund net median returns for 495 private debt funds versus 1,868 private equity (buyout) funds shows net median returns for private equity normally outperform private debt but the spread reduced after 2005. In 2009 private debt outperformed private equity by financing companies after the global financial crisis when traditional credit markets dried up. By looking through to the underlying deal performance in PE.Analyzer, we can compares the gross deal IRR of private debt versus private equity. From this, we observe much bigger swings and volatility in private equity buyout deals. Thus we can conclude that private debt has better downside protection than private equity and less volatility, but also less upside as a ‘pure’ alpha strategy.

Private debt vs public equities:
A correlation approach
Because PE.Analyzer uniquely processes deal cash flows, a deal-by-deal PME approach can be applied to make a correlation and risk-adjusted performance comparison versus chosen public markets. It is assumed cash flows in each private debt deal are simultaneously invested in a given comparative market index. An IRR for the market investment can then be calculated and compared to the IRR generated by the real investment. In this way, a like-for-like comparison can be made.

PE.Analyzer shows the IRR of individual private debt deals versus the IRR of a simultaneous cash flow investment in the MSCI World index (a broad basket of global developed market traded stocks). This includes all private debt tranches, thus has cash flows from current income as well as PIK and any equity kickers, etc.

Applying a regression analysis based on the Capital Asset Pricing Model (CAPM) we can derive the alpha and beta of private debt versus the MSCI World index. This shows the gross risk-adjusted alpha for private debt versus the world stock markets is 14.7 percent and the beta correlation is 0.2. Thus on average, private debt deals outperform the world stock markets moderately on a risk-adjusted basis and returns are not particularly influenced by changes in stock market prices.

Private equity vs MSCI World
A similar analysis of 31,632 realised private equity buyout deals produces a gross risk-adjusted alpha of 28.5 and beta correlation of 1.6. Thus, on average, private equity deals outperform world stock markets significantly on a risk-adjusted basis and are 60 percent more volatile. This can partially be explained by high correlation to equity market pricing and leverage effects.

Cepres case study — a US private debt GP investing in mid-market companies
Translating this to a real investment case, we can see how a US private debt GP investing in mid-market companies compares with the high yield market. All but two of this GP’s 38 deals significantly outperformed versus the high yield market. This results in a strong risk-adjusted alpha of 22 percent and a low beta correlation of 0.3. This illustrates how private debt can deliver significant outperformance compared with liquid fixed income strategies. This analysis was done in PE.Analyzer with the GP’s permission.

Conclusion
Many private debt strategies provide consistent and robust performance with less volatility than other public and private asset classes. Its positive alpha and low beta can be used to balance portfolios, especially in times of market downturns. Compared with private equity, private debt offers less upside and absolute alpha, but lower downside risk and better consistency of returns and cash flows. Private debt should be a consideration for every institutional investor, but with diverse strategies available, should be modeled against individual investment targets to ensure the optimal portfolio allocation and choice of investment partners.