The stars align for private debt? 

Private debt funds have grown in popularity over the last decade and are well positioned to thrive in the current economic environment

Private debt has enjoyed considerable growth and success for several years now, particularly across North America and Europe. The emergence from what was considered a niche and not well-understood segment of the market has turned into a trillion dollar asset class as investors continue searching for yield in a sustained low interest rate environment. Private debt has demonstrated its ability to generate attractive risk-adjusted returns, whilst diversifying away from traditional asset classes, such as public bonds and equity. By taking on illiquidity, investors can access higher and typically reliable income streams from private debt, priced well above fixed income, and experience a lower volatility of returns as investments are not as readily marked-to-market.

Competition between private debt lenders has increased in recent years, with more players entering the market. However, there is still room to grow as private debt managers continue to take market share away from banks as they focus on capital efficiency and regulatory requirements. In addition, private equity mangers continue raising significant amounts of capital which will require debt financing – often sourced directly from non-bank lenders in return for flexibility and speed of execution. With more than $2 trillion of private equity dry powder sitting on the side-lines ready to invest¹ the opportunity set for private debt looks encouraging. As a result, deal features continue to be positive in terms of pricing and lender protections.

Private debt has also evolved from direct lending to single name corporates. We have three other broad private debt sub-asset classes in structured credit, specialty finance and credit opportunities. This can cover anywhere from collateralized loan obligation, to asset-based loans, bespoke private capital solutions and distressed debt. Each has its own risk / return characteristics and adds to private debt being a dynamic and multi-dimensional asset class, which can accommodate individual investor preferences.    

Inflation sensitivity

Private debt loans are typically floating rate, and therefore offer investors some protection from inflation eating away their returns, in comparison to fixed rate bonds which lose value in a higher inflation or rising interest rate environment. In a deflationary period, with a decline in interest rates, rate floors in private debt deals can also help soften the impact of rate declines.

From the borrower’s perspective in a rising rate environment, the higher returns for private debt managers means there is a greater obligation to service that debt. That is, the cost of ongoing repayments increases, which would obviously weigh on the company’s bottom line. Thus, it is incumbent on private debt fund managers to remain vigilant and carry out sensitivity analysis, to see whether underlying companies can service their debt as interest rates increase. For advisers, ensuring fund managers maintain comprehensive underwriting standards and investment discipline on companies that potentially have cash flow sensitivity is crucial.

Investor objectives

Private debt is a broad and versatile asset class, and due to the availability of many sub-categories, investors can choose from a variety of approaches when building out a portfolio. It is important when creating a private debt program that it is aligned to the objective of the investor. We construct portfolios around these objectives, factoring in not only return, but also risk, in addition to diversification across borrowers and strategies. At one end of the scale, aiming for a 15%+ return typically means investors accept a higher risk profile, with some level of capital appreciation as a driver of returns, as opposed to just income. For example, taking exposure to special situations, distressed and more opportunistic funds. In contrast, for investors seeking a fixed income alternative, a 5-8% cash paying contractual return, in defensively positioned investments higher up in the capital structure is appealing.

The opportunities in private debt are clear and prominent. Less than ten years ago, there were concerns about its longevity, but it can now confidently be said that it is here to stay. The resilience of private debt through the pandemic so far has validated this, where the buy-to-hold strategy and having disciplined asset selection has shown to be robust.

At Mercer, we use a range of tools and solutions to assist clients with private debt portfolio construction and implementation. At the heart of this is manager selection. Team quality, long-term alignment, sourcing and underwriting capabilities, and portfolio management skills are just some of the areas we consider when selecting funds. This has been especially important during the pandemic, where we have closely monitored how proactive our manager relationships have been in engaging with portfolio companies to successfully work through this challenging period. 

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