Private debt: Star performer or laggard?

Confidence in prospects is high, but up to now investors have been more impressed with what other alternative asset classes have delivered.

When we examined two decades’ worth of return data from CEPRES towards the end of last year, the conclusion seemed clear: relative to private equity, private debt had recovered well from the crisis and quickly returned to more or less the same level of performance it was showing before.

Indeed, 2016 proved to be a particularly stellar year, with private debt demonstrating a gross IRR for direct deals of 25 percent, a couple of percentage points ahead of the return delivered by private equity. Given the deliberately conservative risk/return of some private debt strategies, it’s fair to assume the more opportunistic end of the market was overachieving – quite possibly by a wide margin.

But the portrayal of private debt as a star performer was arguably undermined a little by our own recent LP survey. Let’s be clear: on an absolute basis, the verdict of LPs was a thumbs-up. Sixty percent said the asset class had met return expectations and 23 percent said it had exceeded them – a very healthy 83 percent apparently content with what they were getting.

However, on a relative basis, the picture was not quite as flattering. Compared with private equity, real estate and infrastructure, private debt came fourth and last in terms of exceeding return expectations. Likewise, 17 percent of respondents said private debt had fallen short of the accepted mark – the highest number, and well above private real estate’s equivalent figure of less than 10 percent.

Given private debt’s youth compared with other asset classes, it may have taken until now for LPs to begin effectively sifting the wheat from the chaff. The tendency for LPs to get behind a group of elite managers, accounting for an outsized proportion of capital raised, has only recently become evident in private debt – and was a theme picked up by last year’s PDI 50 survey. In other alternative asset classes, this trend has been around for some time.

Having now been exposed to the asset class for a reasonable length of time and gained valuable insights into what works and what doesn’t, LPs appear more bullish about performance from this point forward – around 21.5 percent said they were either more or much more confident about private debt performance over the next 12 months relative to the last 12 months (a higher level of confidence than for the other three asset classes).

Consequently, as we know from all manner of sources including our survey, investors are keen to allocate more to private debt. The data show that many are sticking with direct lending as the strategy they want to offer most support to, which seems a little counterintuitive given the frequently voiced concerns about fierce competition and inexperienced managers in that space.

However, preferences may be changing – special situations and venture debt are among the strategies showing increasing LP appetite, especially in Europe. Those rooting for the asset class will hope that improved relative performance and greater strategic diversification are two of its defining themes in 2018.

PS: A huge thank you to all those who supported our 2017 awards. The poll closed at the end of last week with a record number of votes, and the results will be made known at the beginning of March.

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