Safe to say it’s not often that Charlton Heston playing the iconic role of Moses in the 1956 film “The Ten Commandments” will find its way into conversations about private debt, but it happened this week.
A market source was recalling a conference presentation towards the end of 2015. At the time, distressed debt groups were salivating over prospects for the following year. Hence the reason why the late movie star was filling the screen, hinting at a coming event of Biblical scale.
As it turned out, it was famine rather than a flood of opportunities that was sent from on high. The exogenous event that would trigger distressed dealflow is still awaited today (read this recently published article). With major economies performing reasonably well and default rates remaining low by historical standards, distress is largely confined to a handful of sectors, most notably energy and retail.
Allianz GI’s recent RiskMonitor study found that geopolitical concern was now the leading risk factor identified by institutional investors, moving ahead of global economic slowdown and rising interest rates. Moreover, some 91 percent of investors now see “event risk” as a threat, compared with 75 percent last year. Some may reflect on this and conclude that the long-awaited wave of distress may soon materialise.
Our conversations with market sources suggest mixed approaches in the LP ranks. Some already have money locked up in distressed funds that have offered a period of typically up to three years in which no management fees are charged while the capital pool sits idly waiting for more fruitful investment conditions. Some of these will be happy to sit and wait. Others, together with those inclined towards scepticism that distressed will deliver on its promise any time soon, are looking elsewhere in the credit spectrum for the 15 percent-plus returns that distressed credit typically offers.
We are hearing that investors with their core manager relationships already established and their ‘beta’ allocation taken care of, are now increasingly looking to niche strategies and the possibility of obtaining ‘alpha’. Strategies attracting attention in the ‘speciality finance’ bracket include asset-backed finance, non-performing loans, aviation finance, consumer receivables and royalties.
Research from Cambridge Associates suggests that targeted gross IRRs from these esoteric strategies range from around 7 to 20 percent, meaning that at the upper end of the risk spectrum they may be capable of matching or even outperforming distressed credit. Recycling capital is also potentially swifter, with fund horizons ranging up to 10 years for distressed, but typically between five and eight years for speciality finance. Furthermore, competition in the latter market is perceived to be limited in some – though not all – areas.
Anecdotal reports indicate that limited partners are increasingly keen to hear more about speciality finance. There is a prosaic explanation for this, some sources say: such strategies are new(ish) and interesting, while the latest in a long line of direct lending presentations will inevitably struggle to generate much enthusiasm. But will this keen interest in the subject matter necessarily translate into capital commitments?
For investors focusing less on the crowded areas of private debt and perhaps looking to juice up their returns a little, speciality finance may offer a compelling alternative to more traditional choices – while also demanding less patience.