Talk to limited partners about prospects for private debt in 2023 and the theme that becomes most abundantly clear is caution around the market in general – unsurprising given the constant barrage of dour economic news.
To compound this malaise, even those LPs still inclined to be supportive of private debt are finding themselves hampered by the denominator effect – wherein poor performance in public markets has resulted in LPs being proportionately overweight in their allocations to private assets. While reporting of this phenomenon has mainly focused on private equity, it’s worth bearing in mind that not all LPs boast a specific private debt bucket from which to allocate. If the private debt portion is part of a private equity or even wider private markets programme, then the denominator effect is just as keenly felt.
Many of the largest traditional LPs have “suddenly seen [their private markets allocation] shoot up as not only equity but also bond portfolios took a gigantic hit and private markets portfolios didn’t”, says Reji Vettasseri, lead portfolio manager at Geneva-based asset management company Decalia.
“If they are 30 percent allocated to private markets when their target is 15 percent, they are forced to heavily cut back on new investments other than selective re-ups. The result is an increasing focus in fundraising on newer pools of capital such as retail and wealth management (as well as the Middle East) where private markets penetration has room to grow.”
Vettasseri adds, however, that this does not apply to certain types of investors such as high-net-worth individuals and family offices as many had traditionally only small, or even non-existent, private markets or private debt allocations.
One obstacle in allocating to private debt for those able to overcome the denominator effect is the challenge from high yield – at least to the relatively safer, lower-returns parts of the market. Sources point out to us that a yield of 8-10 percent from private debt was enticing while interest rates were bumping along at unprecedented lows.
But that’s not the world we’re living in anymore and returns on high yield are now back up at competitive levels. “Ultimately, most people want to see a benefit for the illiquidity associated with private credit. Doing what the high-yield market does at exactly the same price is not enough,” points out Vettasseri.
Direction of travel: Away from safe, lower-return private debt
If your target is an 8-10 percent yield from private credit, it’s really exciting when interest rates are low. But what happens when you can suddenly get high yield on a similar basis?
That’s why Reji Vettasseri of Decalia argues that investors may need to be a little adventurous and target more opportunistic strategies offering higher returns in exchange for a little more risk. “You can’t rely on just doing the same deal you did last year at the same price,” he says.
“If you are still targeting a 7 percent return and you haven’t increased the return that you have historically got, you will undoubtedly see more pressure from investors. Yet, for the best strategies, there is real potential to not only increase pricing in line with public market yields but also to add an increased premium through more opportunistic deal-making.”
Direction of travel: Towards capital solutions
Maryland may increase its corporate credit exposure.
“The path we’ve taken is not having a whole lot of corporate credit sensitivity with rates so low and spreads so tight. We may change that a little bit in the coming year depending on how markets move,” says Eric Farls of the Maryland State Retirement and Pension System.
One possibility, says Farls, is adding direct lending to the portfolio. Another is to back stressed or distressed-type managers. “We have some exposure to managers with fairly flexible mandates but we haven’t pushed too hard into those areas over the last few years.”
To maintain traditional spreads, investors are being encouraged to consider opportunistic strategies where private debt still maintains both a significant spread and differentiation.
Areas reportedly attracting interest include structured credit – including where it’s used as a replacement for equity – and stressed situations, including where you have a viable borrower constrained by a lack of access to capital.
“I think you’ll see a shift back from plain vanilla direct lending to more specialised credit strategies,” says Vettasseri. “Opportunistic/complex credits and secondaries are places where there is significant value. These strategies have higher returns in all weathers, and they can actually increase the premium they generate during this part of the cycle, when the need for more sophisticated credit solutions increases and competition from traditional lending dries up.”
Most capital in recent years has gravitated to what has become a highly competitive direct lending market. If the focus now shifts to more specialist areas, it may mean capital allocation will fall. Perhaps it needs to. Ari Jauho, founder, partner and chairman at Helsinki-based fund of funds Certior Capital, foresees a decline in private debt deal volume over the coming year.
“In general, terms and conditions will be better in 2023 than 2022 but volumes will probably be lower,” says Jauho.
“On the other hand, fund structures have been taking market share from the banks – and will continue to do so – so there is more demand for private debt on a proportional basis.”
Andrew Eberhart, co-chief investment officer at New York-based investment manager Wingspan Capital, sees plenty of risk in the credit markets in general but thinks the private market is a better bet than its public equivalent where “volatility is high, spreads are wide and there’s a higher possibility of getting whipsawed”.
He does think, though, that private debt needs to adjust its sights to an environment of higher risk and lower returns.
“I think the reality of that hasn’t sunk in,” he says. “People are so used to big returns, and there has been talk of issues in the last couple of years that have not come to pass. But now we have real pressures, interest rates in particular, that weren’t there before. Up to now, a rising tide has floated all boats across the credit spectrum. Now you need to be much more selective. Investors will be seeking the truly differentiated strategies that can perform in more volatile environments.”
Vettasseri is also sceptical of prospects for certain parts of the market. “If you are thinking about undifferentiated segments that are struggling to match the pace of high-yield bond coupon increases – and where that margin was relatively narrow to begin with – there are a lot more questions around whether it’s really worth it anymore.”
But he also thinks that other parts of the market offer real potential: “If you’re in that part of the market where you’re delivering something not a million miles off private equity returns – and bear in mind investors may be worried about private equity and what they’ll be able to achieve from that over the next couple of years – I think you’re seeing a lot more interest. Stressed credits and opportunistic/complex credits I think are places where there’s quite significant interest.”
Many investors see good opportunities to invest in new deals and funds – taking into account the adage that some of the best vintages from a performance point of view tend to arise in downturns.
“Rising interest rates will likely create rather an attractive cycle for private debt managers,” says Jaka Binter, portfolio manager at Slovenian insurance company Triglav. “Most appear to be cautiously optimistic about prospects over the next year. When there’s a recession or economic difficulty it will normally be a good opportunity for the asset class.”
He adds: “GPs are getting better terms with more covenants and I think this is a time where they can do debt picking, like stock picking on the equity markets. They can be really choosy about new loans they provide to companies. We are increasing our allocation to alternatives because we see private debt/private investment as a sort of hold-to-maturity bond because you’re getting predictable cashflows and you get cash yield every quarter.”
Direction of travel: Away from private markets, towards equities
This may seem counterintuitive, but sources say some investors point to an inability to time deals in private markets due to their long-term hold nature – and therefore the relative attraction of public markets in times of stress.
Some investors “would rather do listed equities if the markets are very dislocated because they believe, rightly or wrongly, that they are great at timing the markets”, says Ari Jauho of Certior Capital.
“If an investor thinks it can buy from the bottom when equities are cheap and make 20 percent annual returns, it’s very difficult to do something similar in the short term with private assets, whether private equity, private credit or real estate.”
Direction of travel: Towards venture debt
Asked which strategy looks best placed in the early months of 2023, some investors cite venture debt.
As rates go up, the strategy is seeing higher coupons, warrant coverage going up, higher pre-penalties and a growing constituency of borrowers in need, they say.
With venture companies tending to stay in the private domain for longer, they need the capital to also stretch for longer but have no desire to give up equity. Instead, they are turning to loans with durations of two to three years. “It’s a small market but represents a really good opportunity,” says Andrew Eberhart of Wingspan Capital.
Jakob Schramm, partner and head of credit at Munich-based fund of funds manager Golding Capital Partners, is also a fan of the asset class given current circumstances. “Credit is about downside protection and I think we can all agree, in volatile markets like this, being focused on an area which is about not losing money is a good place to be. Also, it doesn’t trade every day so a lot of the volatility you see in the leveraged loan markets, which causes challenges for investors and companies, is something that it is to an extent shielded from. It gives companies, lenders and sponsors the runway to get through difficulties as long as the underlying company is performing okay.”
But some are wary of the pressures on borrowers from a rising rate environment. Vettasseri sees this pressure coming to bear at the larger end of the leveraged buyout market.
“What I think you’ll find is that the most penalised segments will be those in the upper buyout space where people have taken out a lot of leverage, where a high portion of corporate earnings is going into debt service even before the interest rate rises and something like a 3 percent increase in labour cost can make a very big difference to your margins. There are also a lot of covenant-lite loans in that segment of the market, unlike other parts of the market where people are already asking for equity injections now before things get bad. By contrast, they’ll only be able to react when it’s already a dangerous situation.”
Wait and see
But while there is a lot of conjecture, the truth is that this is a brave new world for private debt and therefore no-one can say with confidence how things will pan out. Jauho points out that, in the context of prior challenges, private debt portfolio companies appear to have coped reasonably well. “I think in general it did better than people thought during the covid crisis. Of course, there have been problems in companies, but actions have been taken by managers and there have not been very severe losses in general.”
Jauho takes the view that the covid pandemic – while not as damaging to the market as many feared – served to open peoples’ eyes to the possibility of sudden shocks after a long period in which benign conditions prevailed. Fund managers steered away from businesses in cyclical industries, dependent on stable energy prices or consumer demand and instead only supported those likely to be resilient in all weathers. “Of course, if interest rates go up it becomes more difficult to service credit and there may be a need for restructurings or contractual amendments, but I’ve seen nothing like that yet.”
One thing under consideration as investors contemplate their allocations for the period ahead is whether certain geographic strategies deserve a more prominent billing. Eric Farls, senior portfolio manager at the Baltimore-based Maryland State Pension and Retirement System, says the organisation is looking more closely at emerging markets while acknowledging that they are “definitely risky and finding managers with strong and consistent performance can be tough”. However, Farls says Maryland already has exposure to emerging markets through some of its specialist private debt allocation, including aviation and mining finance.
Farls adds that capital solutions is another favoured strategy for the organisation. But while this may involve stressed or complex situations, he is not keen to back distressed-for-control strategies “where it can be difficult to put the money out and you can end up sitting with equity positions waiting for managers to exit them. We feel it’s more a private equity-type strategy so we won’t be doing it in private credit going forward”.
Vettasseri notes that traditional distinctions between Northern and Southern European markets may be changing in investors’ eyes, given high leverage levels in Northern Europe and issues affecting certain markets, such as Brexit in the UK and energy prices in Germany. “There are some advantages in Northern Europe which will remain – a number of jurisdictions have better, more creditor-friendly legal frameworks and significant strengths in their economies – but the differential might not be as big as in previous crises.”
Asked whether investors should be bullish or cautious in allocating to private debt, Vettasseri says “both”. On the one hand, “there’s a tremendous amount of risk in the market. Private markets effects are fundamentally linked to the real economy. So while 2022 was a disastrous year for liquid markets, in anticipation of what would happen in 2023, the full impact on existing private credit deals will only become clear when the economy actually skids.”
On the other hand, for new origination: “The post financial-crisis vintages for private markets were some of the best. And this time, I think there will be a double boost for private credit: not only will you have the opportunistic element, but you’ll have the benefit of interest rate dynamics which are actually lender-friendly for the first time in 10 years. You’ve got to pick carefully, but if you do then you can earn better returns than normal, and will probably see a better relative improvement in returns from credit than in equity.”
Put it to work
Certior’s Jauho says that while bullishness in times of uncertainty and volatility may seem counterintuitive, it’s nonetheless likely to pay off. “More investors should be putting money to work because there are statistics showing that during recessionary periods and immediately after, you tend to have the best fund vintages. I see much better times ahead for investing than we’ve seen in the recent past.”
Schramm agrees with the need to stay the course through tough times. “You can look at the post-GFC vintage returns and see it’s true that you should keep investing but one of the reasons these vintages are good is because a lot of people pull back. Intellectually, people understand the concept that you need to invest but one of the reasons it’s a good time to invest is because a lot of people don’t do it. You have to keep doing what you’re doing and make sure you’re not missing a good vintage just because it’s a little choppy out there.”
It will be interesting to note how many investors keep their nerve in the manner suggested by Jauho and Schramm as the year unfolds.