Private debt marries access with opportunity for insurers 

22 October 2023

When it comes to private debt, how do investors strike the right balance when determining a suitable allocation for their portfolios in this asset class?

Private debt has been a hot topic in the insurance industry, and with good reason. Today’s fertile market opportunity coupled with an increasing spectrum of collateral choices, and the proliferation of capital efficient vehicles, has made this long-standing asset class even more accessible to the insurance industry.

When evaluating the potential benefits of private debt, investors should focus on origination and sourcing platforms, loss mitigation, investment structure and, of course, fees.  As we experience a period of higher loan yields and dwindling global lending by banks in the wake of the recent bank failures, the value proposition for credit investing is clear.

Private debt and insurers

Insurers have complex needs compared to other institutional investors. There has been an accumulation of structured assets in insurance company portfolios and potential changes to the regulatory framework have weighed on allocation decisions. Historically, private debt has been able to align portfolios to accommodate these obligations while offering yield enhancement, diversification and other strategic considerations.

Characteristics of private debt

Private debt investments often involve regular contractual interest payments, providing insurers with a stable source of income. This aligns well with insurers’ liability profiles, as they typically have long-term obligations to policyholders and need consistent cash flows to meet these commitments.

Historically, the greater protections embedded in private debt have been an attractive feature. In the current market environment, we find these protections have been ramped up via decreased net leverage and tighter covenants. All else being equal, this lender-friendly structure should help reduce the risk of loss and allow investors to capture the attractive features of the current market.

Private debt offers insurers an opportunity to diversify their portfolios beyond traditional asset classes like equities and public bonds. This diversification can help spread risk and reduce the impact of volatility on overall portfolio performance.

Private debt investments can be structured to meet specific needs and objectives. This level of customisation allows insurers to align their investments with their liability profiles and risk tolerance. Importantly, options exist across the credit ratings spectrum for investors that need to remain investment-grade oriented. 

Since the start of 2022, the combination of sharply higher base rates and wider credit spreads has led to significantly higher yields for the asset class. Overall, new-issue private loans are registering yields of approximately above 10% on an unlevered basis, which we find highly compelling given the relatively low risk associated with senior secured debt.
While many market participants may be worried that tightening credit conditions and high overall levels of yield will lead to more defaults, experienced managers have been able to minimise this risk through underwriting, due diligence and structuring capabilities.

Moreover, the proliferation of new private debt strategies and collateral in recent years has given investors more opportunities for increased diversification and customisation, offering greater choice but requiring close examination to evaluate the appropriateness for each unique balance sheet. 

An example of this is asset-based finance – an emerging subset of private debt where the cashflow profile is driven by the performance of a pool of collateral rather than the performance of a single operating company.

The proliferation of new private debt strategies and collateral in recent years has given investors more opportunities for increased diversification and customisation.

Privately originated investments secured by large and diversified pools of financial and hard assets that generate recurring cash flows.

A growing number of interesting asset-based finance strategies are coming to market that we believe could offer differentiated risk/return profiles versus more traditional private credit assets. Features such as attractive yields, potential as an inflation hedge, the potential for loan amortisation and the possible downside protection of returns backed by hard assets or contractual cash flows further increase the appeal.

Overall, we believe the growth of the private asset-based/speciality finance market will continue as bank disintermediation leads more borrowers to seek private, alternative lending solutions.

Potential characteristics of an asset-based finance allocation:

  • Diverse opportunity set across various collateral types
  • Downside protection through structural security
  • Increased yields available via illiquidity and complexity premiums
  • Cash flow generating and amortising asset profiles
  • Ability to target both investment grade and non-investment credit risk
  • Risks around interest rates and refinance, consumer weakness and overvaluation
Another strategy that offers increased diversification is opportunistic credit – a subset of private debt that is attractive when the dispersion in credit may offer equity-like upside with the downside protection afforded to secured lenders.

Strategies that target risk-adjusted returns in debt securities that are tied to market dislocation caused by inflation, rising interest rates and overall market volatility and are potentially attractive for companies that do not have access to traditional credit.

The catalyst for opportunistic credit is monetary tightening by central banks as inflation remains persistent despite the rise of interest rates. The rising rates are squeezing the same sectors that benefited most from the low rates of the post-GFC and COVID period as well as the financial institutions that provided them financing. 

Therefore, stress on banks will only worsen capital scarcity but also give investors options to access special situations and distressed strategies positioned for potential dislocation. With careful manager selection an opportunistic mandate can provide significant diversification benefits to an investor’s portfolio.

Potential rationales for investment in broad based credit opportunities are:

  • Tightening lending standards at banks create opportunities for patient providers of capital
  • Discounted performing credit is attractive when asset owners require liquidity
  • A potential value-add when flexible capital could provide bespoke financings and restructuring
  • Access to alternative credit alpha throughout a market cycle

Evolution of capital-efficient vehicles in private debt

Alongside a greater spectrum of opportunities, one of the biggest drivers of growth of private debt in insurers’ portfolios has been the emergence of capital-efficient investment vehicles designed to optimise risk-adjusted returns while taking a range of regulatory and capital requirements into account.

Insurers are subject to various regulatory requirements that govern their investment activities. Capital-efficient vehicles are structured to align with these regulations, allowing insurers to invest in private debt assets while staying within their regulatory limits.

Capital-efficient vehicles often incorporate risk management techniques, such as diversification, credit analysis, and portfolio optimisation, to ensure insurers maintain a balanced and well-managed investment portfolio.

The evolution of capital-efficient vehicles has brought improvements in reporting and transparency, helping insurers better understand their exposures and make informed investment decisions.

Capital-efficient vehicles often partner with experienced fund managers or investment teams with specialised knowledge in private debt markets, providing insurers with access to expertise to help them navigate the complexities of the private debt landscape.

These vehicles are designed to optimise the allocation of insurers' capital, allowing them to achieve competitive returns while efficiently managing their risk exposures.
New capital-efficient vehicles have supported the growth of private debt investments by the insurance industry and can play a key role in a well-diversified portfolio of assets for insurers, where private debt can offer resilience and contractual return-based characteristics that are particularly helpful during periods of market uncertainty.

Reviewing the current opportunity

Why might now be an opportune time to invest in private credit? In short, we believe the environment is ripe for dispersion, which means opportunities are available for skilled providers of capital.  Yields are up across the credit spectrum, the supply of capital is dwindling, and higher debt servicing costs are weighing on economic growth. As a result, private credit lenders with access to capital are well positioned to fill the void for borrowers who can no longer access traditional forms of bank financing.  

Historically, central bank tightening has led to crises of one form or another, and most hiking cycles are driven by inflation – which remains high, along with the core ingredient for sustained inflation: a tight labour supply. Rising rates are also squeezing those that benefited most from low interest rates, as well as the financial institutions that provided them with the financing. 

The economic backdrop then, remains challenging. Meanwhile, timing, diversification and fund selection remain critical elements to be evaluated. A diversified approach across the components of a distress cycle may be best accomplished through a multi-manager approach, and, not surprisingly, dispersion between fund returns remains an investor’s top consideration, with manager selection a key to success.

The private credit opportunity is one that many insurers have taken note of and others may want to explore further. If you would like to speak to one of our insurance or private debt specialists, contact us via the form below.

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