Why risk is at the heart of LP calculations

How do you view your glass: half full, or half empty? Speaking with investors as we researched this month’s upcoming cover story on the outlook for 2023, it appears to be both the best and worst of times. Some urged their peers to up their allocations to private debt – and private markets in general – as the evidence of past crises tends to suggest that hitting rock bottom in a crisis is almost invariably followed by returns from current vintage funds hitting peaks some years later.

But others say the pressure of interest rate rises on borrowers will create problems the likes of which private debt has never had to deal with before, and that risk is at all-time highs. Furthermore, while public markets declined last year in anticipation of economic woes ahead, private markets are tipped to reflect the downturn in real time. In other words, as the economy hits the skids so, too, will many portfolios.

Given the volatility of the situation, it seems surprising that some investors appear keen to avoid traditionally safe, lower-return parts of the market. But it speaks to risk-reward calculations. There is a view that the public markets may now offer a similar return for less risk and, in order to still obtain a sensible premium, investors should be setting their sights more on the opportunistic end of the credit spectrum.

Eric Farls of the Maryland State Retirement and Pension System told us how his organisation had not wanted to expose itself to corporate credit sensitivity with rates low and spreads tight, but was anticipating this may change somewhat in the coming year, with capital solutions-type strategies favoured. Maryland is far from alone in being tempted by capital solutions, and other strategies catering to the particular demands of borrowers in today’s market.

Some investors cited enthusiasm for 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 stretch further but have no desire to give up equity. Instead, they are turning to loans with durations of two to three years.

But while the general mood is to stay the course in private markets, one investor posed the question as to whether public markets might be a better bet in times of stress. Not every investor will have the ability to successfully buy at the bottom and make outsized returns over a relatively short timeframe – but it’s more than possible that some might fancy their chances.

Write to the author at andy.t@peimedia.com