Until recently, an era of low interest rates fed advantageous opportunities for global investors. Cheap borrowing has fuelled the growth of asset prices, driving up valuations globally. But as those opportunities decline, private debt, an asset class which emphasizes capital preservation, aiming to provide stable returns with protection against interest rate fluctuations, may see more demand from investors ahead.
Globally, Preqin estimates that private debt will overtake real estate to become the third largest alternative asset class by 2023, with assets under management doubling to $1.4tn by that time. The chart below shows that among private debt investors in Australia, the proportion active in distressed debt strategies has risen from 55% in 2015 to 69% in 2018. Similarly, special situations vehicles have gained prominence in the period from 2015 (38%) to 2018 (47%), while the proportion of active investors in mezzanine strategies has remained quite stagnant.
Ray King, Portfolio Manager for Alternatives at IOOF, says that entering the distressed debt market is tricky, but opportunities may open up if investors believe there is a sign of a significant market correction.
Opportunities in Asia's Debt Markets
The pace of Australia’s private debt market has thus far trailed behind its global peers. Following the 2008 Global Financial Crisis, regulations forced banks to repair their balance sheets and maintain minimum capital adequacy ratios. Since then, private debt managers have gradually stepped in to grab their share of the global private debt pie, and Australia is no exception. Direct lending strategies that initially shaped the US and European private debt markets have started to present themselves to investors in Australia. Given the recent blight from the royal commission inquiry, in which Australia’s financial services entities were investigated for misconduct, Australia’s four largest banks have struggled to grapple with the fallout. This has reduced their direct lending activity, giving rise to pockets of opportunities for non-bank lenders such as private debt funds to fill the gap vacated by these bulge brackets.
King also noted that direct lending in private debt presents good opportunities, and thinks Asia is looking quite attractive, as good manager skill is more readily available. “It’s true that the quality of managers in Asia has improved,” said King. “We are probably more focused on Hong Kong or China, where I think the opportunities are very good. But the question is, can the managers keep defaults at a reasonable level?”
On the home front, King attests that the skills of domestic private debt managers are quite impressive: “A number of new managers have emerged in the last two years, and a lot of new managers trying to raise their first fund have good experience through previous employment.” Fees have also come down a fair bit domestically, less so offshore. “On average, fees on invested capital, rather than committed capital, have dropped to about 1% or lower, down to as low as 0.5%,” said King.
For King, the most important factor is returns. Australian private debt spreads are currently more attractive than those in the US and Europe. “For example, spreads between 0.5% to 1% are looking relatively attractive,” King asserts.
Preqin data shows that among Australia-based LPs investing in Asia-Pacific-focused private debt, more than half (55%) favour direct lending strategies over other fund types. When comparing the returns of different private debt strategies in Australia and the rest of Asia-Pacific, King adds that “as an example, for good credits but lower quality in capital structure such as stretched senior debt, we typically would seek net returns of around 7% to 8% for an Australian manager. For Asian strategies we expect a bit higher, and would target to garner approximately net 10% to 11% returns, and even higher gross returns, as there are much higher default rates in Asia, hence investors should be properly compensated on the higher landing rates.”
Keeping a Close Watch
According to Preqin’s latest report on superannuation schemes in Australia, allocations have traditionally tilted towards real assets, such as infrastructure and real estate, and this is evident within private debt as well. Nearly a third (29%) of Australia-based LPs active in the asset class invest in real estate and infrastructure debt vehicles. “Infrastructure debt is easier, it is relatively attractive for investors, margins have been relatively tight, and the segment has performed well. Real estate debt is good, we like it, and it is where we are allocating to at the moment,” said King. Liquidity is a huge concern too, “we try really hard to capture the illiquidity premium, and we push the boundaries of liquidity for managers,” he added. King states that “private debt is a defensive alternative, and we prefer to pick down the volatility of that investment, to keep that, you need to diversify within private debt.”
With that in mind, one must tread carefully given the current lending environment; rises in both domestic and global interest rates will most likely impact how businesses obtain their capital needs. Private debt funds may still have some way to go in the credit cycle.
For more information on alternative assets in Australia and the investment activity of superannuation funds, download our free report, Australian Superannuation Funds in Alternatives.