From the pen of Tamsin Coleman
As investors emerged from the pandemic, the sense of relief and hopes for a “return to normal” were sadly short lived. We find ourselves in yet another turbulent period characterised by the Russia-Ukraine crisis, geopolitical turmoil and ongoing supply chain issues.
The crisis has accelerated a number of trends that were already front of mind for many investors. Supply chain disruption has caused surging energy and raw material costs, pushing inflation to levels not seen for 40 years, with expectations that this can increase further and persist. As a result, central banks around the world are responding with the sharpest interest rate rises we’ve seen in decades, and the winding down of quantitative easing.
A rising rate environment is new territory for many institutional investors, who have grown used to falling and rock-bottom interest rates. Investors will need to consider how to navigate the impact of rising rates, which can be particularly unfavourable for fixed-income assets, where asset prices move inversely to their yields. However, Private Debt could have an integral role to play in seeking to protect portfolios from these effects.
Private debt is a predominantly a floating rate asset class and, as such, returns have historically tracked in line with rising rates, offering some protection from inflation. However, this is only part of the story, as rising rates will require borrowers to stump up more cash to service higher debt interest payments. If borrowers are unable to keep up with the rising costs of servicing their debt by either passing costs onto customers or absorbing them, we may start to see a higher rate of defaults, and eventually losses, coming through. We have seen these worries materialise recently in liquid credit market pricing – in particular broadly syndicated loans.
Private debt really only emerged as an asset class in Europe post-Global Financial crisis and as such, the COVID-19 pandemic was arguably the first test-case for how the asset class might perform during a period of uncertainty. Although, generally, risk asset classes were supported by the massive monetary and fiscal response, the crisis gave some tangibility to the resilience that Private Debt can potentially offer.
For example, during the pandemic governments and central banks weren’t the only source of support for ailing businesses. We also saw Private Equity firms (in some cases paying record multiples to buy these businesses in the first instance) stepping in to inject capital to keep these businesses afloat. In return, some Private Debt lenders made concessions for a period of time on select assets, for example “capitalising” interest charges for a limited period to ease liquidity bottlenecks, delaying coupons to be paid alongside principal repayments at a later date.
This type of two-way interaction was enabled by the existence of leverage covenants which are still prevalent in Private Debt loans, and goes some way to proving out that the ability to have control or lead a bilaterally negotiated transaction has value in terms of seeking downside protection.
It seems inevitable that defaults across the credit spectrum are only likely to move upwards. The extent is uncertain, however on a relative value basis we see merit in an asset class which may provide a large spread cushion to start with, in addition to the floating rate nature of the asset class and other potential downside protection characteristics.
We do, however, view that these are optimal ways to build and maintain an allocation to Private Debt, particularly in the context of growing market uncertainty.
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First and foremost, it is critical (essential) to consider an adequately diversified portfolio both by number of individual credits but also across different risk factors. Investors should consider investing across multiple geographies, sectors and vintages where possible, and should consider diversifying a Direct Lending allocations by adding differentiated credit strategies, like asset-based lending, structured credit or specialty finance.
Secondly, there is value in building a certain level of flexibility into Private Debt allocations where possible. This can not only result in some potential capture of higher credit spread opportunities during periods of volatility, but if investors can identify asset managers who can look across a reasonable number of opportunity sets then there may be higher probability that the next dollar invested will be in the best risk-adjusted return opportunity. This helps to build further resilience Finally, investors need to consider a significant focus on manager selection.
Dispersion in returns is always highest during periods of extended volatility, therefore choosing the right manager couldn’t be more important. Investors should ask questions: does the manager have a track record of investing during turbulent times? How has the manager fared in previous periods of stress? How have they performed during asset restructurings? How do their loss rates and recovery rates compare to peers? How is the asset manager aligned with the success of my portfolio allocation?
It will also be important to collaborate with a manager who will offer transparency about the underlying portfolio. This is often taken for granted in ‘normal’ market conditions but will be fundamental in turbulent times when Investment Committees require more frequent updates.
Liquid markets have suffered at the hands of market turbulence in the 2022-to-date, and more volatility may be on the horizon. In this context, we believe Private Debt represents compelling relative value, however an investor should go the necessary extra mile to maximize the benefits they can derive from the asset class – through diversification, flexibility and manager selection. This has never been more important.
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