Why GPs may need a different pitch

As competition causes yields to fall within private debt products, managers could find greater success touting the asset class’s diversification benefits.

There was a healthy dose of scepticism among investors at PDI’s recent Germany Forum. With competition increasing between debt funds and yields falling, does private debt still have its allure?

The answer from some managers was that the asset class will always maintain an appeal, in part because it offers significant diversification benefits relative to other assets. There’s evidence to suggest institutional investors believe this.

Almost one-third of investors in alternatives, such as private debt, view them as a diversifier, according to Allianz Global Investors’ most recent Risk Monitor study. Only 14 percent view such positions as an opportunity to achieve higher returns than through conventional debt or equity investments.

This isn’t to say debt managers can’t include yield in their pitch to potential investors. Touting diversification of income streams, not just total returns, may be attractive to investors looking to use the asset class to match liabilities. However, it’s fair to say the income portion of private debt has been squeezed as competition increased in recent years.

In 2005, the median IRR for a private debt offering was 15 percent, according to data from CEPRES. Ten years later, the now more-established asset class returned 7 percent. Last year, the median return was 10 percent.

A look at where managers are seeking to expand also hints that diversification, and not yield, is on the agenda. A clutch of firms have looked to Germany recently – a strong and sizeable economy, but one where debt pricing is compressed significantly due to a significant banking presence.

The good news is private debt has the potential to be a significant diversifier, according to CEPRES data assessing fund performance since 2000. European debt funds have a beta of 0.48 to the MSCI World Index, meaning for every 1 percent fall in the value of global stocks, private debt funds fall by just 0.5 percent. If it’s downside protection investors are looking for, the asset class seems to deliver.

There are some caveats, however. Diversification is relative to each investor and the impact of private debt on different portfolios will vary. The increasing number of cov-lite deals may also negatively influence the performance of the asset class during a significant down market.

Diversification, like liquidity, is a quality that only shows its value when it’s really needed. Since many debt funds have been established since the financial crisis in 2008, there is trepidation regarding how some of these funds will perform during the next significant global economic downturn. Therefore, diversification within the asset class could prove equally as vital as that at the portfolio level.