When its clients are considering investment in private debt, investment consultant Mercer suggests to them broad diversification, both globally and within the type of private debt they are seeking, according to Bill Muysken, the firm’s global chief investment officer for alternatives. Consultants at Aon recommend using private debt to diversify a portfolio heavily weighted in stocks and bonds: “There are a lot of different types of private debt; it could be a replacement for return-seeking fixed income or high-yield bank loans or emerging market debt,” said Eric Denneny, senior consultant, global private equity research at Aon. Neils Bodenheim, senior director, private markets at the London-based consultancy bfinance is experiencing a greater client demand for direct lending opportunities ahead of real estate and infrastructure private debt.
In interviews last week with IA, one important requirement of a private debt investment strategy all three consultants agreed on was “diversify, diversify, diversify,” both within the asset class and in a portfolio. The consultants shared their succinct thoughts on risk factors investors in the class should consider, along with the types of investors that are comfortable with the class, the way they should think about structuring an allocation, and where pension funds’ view the class differently from F&Es’.
They also highlighted the differences between the various segments within the asset class. “Most investors think about private debt as corporate private debt, which is the main area, but there is also real estate debt and infrastructure debt,” said Muysken. “So, we encourage clients to have allocations to those as well,” he said. “After analyzing portfolios and realizing that the bulk of clients’ risk is in the equity markets, we are looking for higher-risk strategies and equity substitutes that can provide growth in portfolios. Clients are not making tactical calls, but they also don’t want to have all their eggs in one basket—they want to spread it around a bit,” he said.
Mercer’s clients approach private debt in two different ways: They are either looking for low-risk, low-return vehicles in order to match liabilities or high-risk, high-return products. “For high-risk, high-returns, we have been talking to clients about putting it in their portfolio as a replacement in place of equity allocations, in the riskier part of their portfolio,” Muysken said.
On the lower-risk, lower-return end, we are talking to clients about putting private debt in their portfolio in place of cash, in the defensive part of their portfolio,” he said. “Either way, we think you don’t get paid to take concentration-risk in private debt, because if things go well your upside is contractually capped, and if they don’t go well, the downside is potentially quite bad,” he said. Mercer generally recommends clients invest 5% to 15% of their portfolio in the asset class, noting that it varies by clients and circumstance.
For high-risk, high-returns, we have been talking to clients about putting it in their portfolio as a replacement in place of equity allocations, in the riskier part of their portfolio.
Bfinance touts direct lending opportunities within the space because the sub-category offers enhanced yield, perceived better security positions, and a natural hedge against inflation with floating-rate debt, said Bodenheim. “Senior debt in direct lending generates a higher return vs real assets senior private debt, given that the underlying security position is different. Real assets are not able to generate similar levels of returns with the same security position, and so an investor needs to go to subordinated products in real assets to generate the same levels of return,” he said.
The consultancy’s first-time allocators are allocating as little as 1 % of their portfolio to the asset class with the more seasoned investors, who are more comfortable with direct lending, going up to 3% to 5 % percent of their portfolio.
Private debt “managers have been able to show better default rates and loss recoveries vs the more liquid corporate loan space and, with the enhanced yield, it makes sense to have reasonable allocations, even though it’s a relatively new asset class, historically,” Bodenheim said.
In fact, “the biggest issue is under-allocation, because typically these private debt products don’t provide immediate exposure on day one,” he noted. “It takes time for general partners to make investments, and so there is a delay on drawing down of the investor commitments over time, often two to three years,” he said. “After that, they have a capital repayment back to investors, so the delayed drawdown and swift re-payment requires a lot of cash management from the investors in order to maintain their percentage exposure,” Bodenheim explained.
Who should invest in it?
The same types of investors that are more comfortable with other alternative investments are typically comfortable with private debt, said Eric Friedman, partner, retirement and investment at Aon.“That’s because those investors typically have a tolerance for illiquid investments, understand the complexity, and have a governance structure that is comfortable with complex investments. They also have the in-house expertise or access to expertise, and are willing to do things that are different,” he said.
“We have clients that are comfortable with all parts of it,” Aon’s Denneny said. “We find strategies within private debt that institutional investors, in many instances, have been investing in for years: distressed debt, mezzanine, private real estate lending strategies, and opportunistic credit type strategies that may have been within a hedge fund strategy,” he said. Private debt is more illiquid, so there are many different underlying strategies that fall within it, so that you find investors that range across all strategies, he said.
Real estate bucket vs fixed-income bucket
Because most private debt being offered today is corporate direct lending, followed by real estate and infrastructure debt “for some institutional investors, those assets sit in different allocations, because those sectors have different levels of return,” said Bodenheim. For instance, “some clients see private real-estate debt as part of the real-estate buckets in their portfolios. Globally, they probably have 10 % of their allocation invested in real estate, with private real-estate debt being part of that allocation, he noted. Canadian investors typically have a larger portion allocated to real estate (10-15%) and infrastructure (5-10%), given their comfort around real assets, he added.
Overall, however, “allocations from clients that we work with globally mostly come from a fixed-income perspective, and they tend to be looking at more senior-debt related products,” said Bodenheim. “They look for first priority interests and security positions that tend to yield roughly 6-8% net IRR (internal rate of return) range,” he said.
“When we look at traditional fixed-income products, by comparison, there is a significant yield enhancer by making these re-allocations,” Bodenheim said. “For investors that are seeking the equivalent level of return they need to go to the subordinate level or 2nd ranking debt in the real asset categories of private debt. We are seeing activity there, but the most popular is still direct lending with the complement of real assets behind it, like real estate or infrastructure,” Bodenheim said.
For investors that are seeking the equivalent level of return they need to go to the subordinate level or 2nd ranking debt in the real asset categories of private debt.
Institutional investors are very aware of the potential for an upcoming downturn, given the bull market run, Denneny offered. “So when we talk with our clients about direct lending as an opportunity, part of the discussion has been how are you viewing a direct-lending strategy within the portfolio, and in many cases, because it’s senior secured debt lending there is more of an aspect of a fixed-income lending alternative approach, he said. “If you are approaching it from that perspective, it changes the discussion. If you have the view that fixed income would be negatively impacted with a credit down turn defense than private debt would also be negatively impacted, but not as much as with public fixed income, so it’s still attractive, as a strategy,” he said.
Different strokes for different investors: Pension vs F&Es
Investment officers at pension funds look at private debt differently than foundations and endowments do. “For defined benefit pension schemes, those clients seem to divide assets into two pieces; one piece is the liability matching component, the other piece is the growth component, for which investors are seeking to take risk and to add value,” said Muysken.
For the liability-matching component, investors are typically using futures overlays as a way to match the duration profile of their liabilities, Muysken said. “But many find that they are sitting on lots of free cash in their portfolio that is not earning them very much. So, what they are looking to do is to replace part of the free cash in their portfolio with senior private debt to earn a healthy margin above a cash-like return,” he said.
In the growth part of portfolios, most clients find the risk part is dominated by equity risk, so they are looking to take some equity down and substitute it with high-risk higher-return private debt. For foundations and endowments, the same broad principle applies, but there is no liability component. “So, most of it is just return seeking for the growth part. They want higher risk and higher returns,” he said.