Strong returns and niche offerings keep private debt on the radar

While leveraged loans and the upper mid-market possess worrying features, there remain compelling opportunities off the beaten path, finds Andrew Hedlund

Private debt investors plan to continue pouring money into the asset class despite the existing influx of capital, according to PDI data.

According to PDI Perspectives, our annual LP survey, plenty of investors plan to expand the number of general partners in their private credit portfolios – with 42.9 percent stating this aim – compared with 32.1 percent planning to keep the number of GPs constant, 2.4 percent who plan to trim the number of managers in their book and 22.6 percent unsure.

This is predictable given how solid returns have been, even considering concerning market trends. Much has been made of the influx of capital, its effects on the deterioration on credit documentation and the flourishing of covenant-lite deals.

But while those are certainly reasons for concern, and no one should assume that shoddy underwriting won’t come back to haunt some credit managers, the reality is that many of those problems reside in the leveraged loan market and direct lending’s upper mid-market – though that’s not meant to imply all is rosy with core or lower mid-market businesses.

Speciality finance continues to be a comparatively less-crowded space and a place for investors to find compelling performance in an era of compressing direct lending returns.

While our LP survey found a preference for direct lending over other strategies, advisory firm Eaton Partners found that approximately 90 percent of the 75 investors they polled planned to commit to asset-based lending, while slightly less than 70 percent anticipated allocating to direct lending.

Explosive growth

Allocations to alternative assets have taken off post-global financial crisis, as investors search for returns at a time when public markets have often had little to offer and encountered periodic patches of volatility, and much of this explosive growth has gone into private debt.

The rush to the asset class is understandable: research by Cambridge Associates found that for the last 12 months ending 30 September, private credit funds, across disparate strategies, returned 10.3 percent, compared with the 1.37 percent loss that public bonds delivered.

That 10.3 percent figure includes higher-returning strategies that rival the private equity index Cambridge Associates keeps. For the year ending 30 September, the three- and five-year returns for that were 14.58 percent and 13.62 percent, respectively. The 10-year return was 12.04 percent.

The fact remains that private debt still represents one of the most compelling investment opportunities in private markets, even when accounting for deficiencies in covenants, EBITDA addbacks and the like – and even if you view alternative assets with a sceptical eye in an era of late-cycle exuberance.

It represents the safest investment – in any restructuring scenario, debt will of course get paid before equity. That’s not to say recoveries will be stellar. But at least lenders will get something.

However, investors need to look closely at investment committee memos and other similar materials to get an idea of how any given credit manager approaches deals.

Track record can only go so far when we are approaching a decade since the last downturn. Even a relatively new manager’s five- or seven-year track record probably looks good when the economy hums along and there are few corporate defaults.