This year’s LP Perspectives Study shows almost half of all investors in private debt are planning to increase their allocation in the next 12 months, significantly higher than the 33 percent that said the same at this point last year. In all, 97 percent describe their position as either at target or underweight in relation to private debt, compared with 90 percent who felt that way in our 2021 survey.
The asset class has performed well through a turbulent two-year period and this desire to increase allocations may be a result of that proven resilience.
Andrew Konopelski, managing partner of Bridgepoint Credit, whose owner Bridgepoint is the owner of Private Debt Investor publisher PEI Media, says the pandemic was not all bad news for the asset class: “The market has increased in stature because of its ability to provide creative capital in difficult times, which creates stronger relationships. We are seeing more sponsors looking at this and more LPs talking about increasing allocations.
“In credit opportunities, a bit of volatility proves the thesis. Managers need to be able to invest across the capital structure and there are attractive investments to be made when the market is under stress.”
On direct lending, Hamish Grant, deputy managing partner at Bridgepoint Credit, adds: “The pandemic demonstrated the resilience of the asset class and further weakened the position of the banks, who we expect to retrench further to make direct lending the dominant source of lending to the European mid-market.”
Nine out of 10 investors say their private debt investments met or exceeded performance benchmarks in the past 12 months, which is a considerably higher proportion than the 67 percent who said the same a year ago. But looking ahead, just one in five (21 percent) expect the same exceptional performance in the next 12 months, showing a drop-off in optimism against the 31 percent that expected portfolios to exceed performance benchmarks last year.
Certainly, there is a widespread expectation that problems might yet emerge in certain private credit portfolios as the pandemic continues to impact key sectors and government support wanes.
Jess Larsen, founder and CEO at Briarcliffe Credit Partners, says: “Any high street in any city has empty store windows and for some reason that hasn’t yet translated into defaults in direct lending portfolios.
“One could think that will probably come, particularly in relation to retail assets. We are going to see default rates going up and that will put some pressure on direct lending.”
Credit funds will need to maintain discipline in 2022 as economies move into an inflationary period and demand for borrowing intensifies.
“The pandemic demonstrated the resilience of the asset class”
Alexis Maged, head of credit at Owl Rock, a division of Blue Owl Capital, says managers have learned lessons from market disruption: “We don’t have a lot of small company exposure, unlike other direct lenders, and we have also sought out to have low volatility, staying away from cyclicals, concentration risk, commodities and the like. Much of our portfolio is in food and beverages, business services, technology and software and logistics and distribution. These sectors generally held up well and some outperformed.”
While not all managers have been so fortunate, such a story is common in the asset class. Larsen argues LPs are concerned about performance in the next 12 months in part because of the strength of the asset class: “I suspect that relates to direct lending, because direct lending is becoming such an efficient and growing asset class that we have a lot of LPs lowering their expectations.”
In terms of investor focus going forward, we see LPs reporting an expectation that the proportion of their investment portfolio allocated to alternative assets will increase by 6.9 percent, on average.
Over a third plan to boost their interest in investments across Asia-Pacific, Western Europe and North America. Dan Simmons, partner at OCP Asia, says appetite for private debt in Asia is particularly strong. “There is very robust demand from borrowers across our Asia-Pacific markets,” he says. “The Asia-Pacific market is far less mature than the more sophisticated markets of the US and Europe, which have almost reached saturation. Asia-Pacific is not even close to the level of those markets, so we see a lot of future potential.”
When it comes to strategies, the majority of investors plan to invest the same or more into strategies such as direct lending and mezzanine/subordinated debt, while nearly a quarter of LPs say they will reduce allocations to distressed/special situations strategies. Venture debt and speciality finance are also garnering less interest from investors.
First Avenue’s head of EMEA, Tavneet Bakshi, argues there is still growing interest in these niche strategies in Europe: “The beauty of the European opportunity set is that the region is highly fragmented. Beyond the vanilla private debt opportunities in direct lending, we are seeing an expansion in the toolkit of many European private debt platforms.”
This includes a growing interest in strategies like fund finance, venture debt and speciality finance, which are growing in Europe. “Venture debt is an established part of the US framework of private debt strategies but very nascent here with only a handful of GPs,” says Bakshi. “Similarly, consumer lending and specialty finance strategies are interesting because there are not many players here and we are talking about highly granular pools of underlying loans that have proven to be fairly resilient because of the diverse nature of the exposure.”
The biggest concerns for investors looking forwards centre on macro issues, with worries over extreme market valuations, the continued impact of the pandemic, and recession in core markets echoing the sentiment of a year ago.