There is no clear definition for private debt shared among market participants, but it has become somewhat synonymous with corporate direct lending or mid-market lending, given the popularity of the investment strategy since the financial crisis. This narrow definition doesn’t do justice to the breadth and diversity of the asset class, in our view, and the role(s) private debt can play in a portfolio. Investors may therefore be better off looking at private debt holistically and focusing on the investment outcomes it can deliver for them.
Institutional investors already allocating capital to the asset class have essentially gone looking for what they cannot find in public markets, whether that’s stable, contractual income streams to help fund cash flows; higher risk-adjusted returns that can help to reduce funding gaps over time and additional yield in a world of negative rates; or the desire to diversify into new asset classes less correlated to traditional equity and fixed income markets. These benefits exist in addition to the structural credit protection and information advantage over the reporting norm of public markets that these opportunities invariably offer. More importantly, perhaps, investors have been prepared to forego some liquidity in exchange for this.
Can private debt continue its march higher and, more importantly, continue to deliver the outcomes investors expect? As private markets continue to add flexibility, depth, and sophistication, it’s unsurprising that investors have built larger and more complex portfolios over time as they have become more confident about the long-term viability of the asset class. What’s more, the opportunity set is ever-expanding, and investors have a greater range of debt strategies to choose from.
Creating Access for Private Capital
We advise people to invest flexibly, rather than focus too heavily on specific subsets, so that they can take advantage of newer investment opportunities that may arise as private debt and banking markets evolve. Non-standard, complex, and less explored areas, such as asset-based lending and trade receivables, tend to require a high degree of expertise and experience to navigate, but may be too small, too local, or lack the depth to attract dedicated pools of capital in their own right. Pipelines can be equally difficult to anticipate.
These types of opportunities are not ready-made and can, in some cases, take years of hard work to come to fruition. This can be a time-intensive approach, but we have found that investing early in growing markets has its advantages. Of course, as new money starts to crowd around certain deal types then it becomes a borrower’s market and terms can become more challenging for investors. If you go back to 2009 when we made our first foray into direct lending, it was very hard to attract investors because it was very new, but there were huge opportunities out there. Now it’s the other way around.
Relationships and networks also matter. Much has been made of the competition between banks and non-bank lenders in the years following the crisis, but often non-bank lenders lend alongside banks. This points to collaboration rather than competition. In the area of consumer finance (or ‘specialty finance’ as we refer to it), because of the extensive commercial and legal due diligence needed to acquire loan assets from retail banks – which can include the likes of mortgages, auto loans, credit cards, student loans, and personal loans – we are looking to build symbiotic, long-term relationships with banks, which are selling these assets for regulatory capital reasons, such that the time, cost, and effort of the diligence is worth it for both parties.
We see the private credit markets continuing to evolve and take market share away from the banks, not least because policymakers and regulators are quite keen to see a far deeper and more structurally robust set of markets. Nothing is stopping banks and non-bank lenders from finding new, mutually beneficial ways to free up balance-sheet capacity in a capital-constrained world, either. The broader range of funding solutions available, often on more flexible terms and longer tenors than bank finance, has proved attractive to borrowers too. Increased demand from borrowers for alternative sources of funding has been a central tenet of the growth in private debt and will remain part of its ongoing development.
Living with Risk
The intensity of competition tends to vary, but some parts of the market are undoubtedly competitive given the influx of new entrants in recent years chasing a limited number of opportunities, making managers inherently more cautious and selective in their approach. Market observers point to the high levels of dry powder that have built up over recent years in areas like direct lending, creating concerns about spread compression and looser documentary protection for investors. These levels of uninvested cash only become challenging if the pressure to deploy capital quickly leads managers to go after investments they would have normally decided to pass on – deals that lack the transparency to fully evaluate the creditworthiness of the borrower or issuer and/or come with high execution risk.
Any decision to invest requires careful assessment of both benefits and risks. You have to look across the entire market to see what is available at any one time, what the demand is like, what the pricing is like, and whether the deal offers adequate compensation for the risk taken, or whether a more attractive way of accessing this risk is available in the public markets without assuming the illiquidity risk.
Lending Is Becoming More Broad-Based
Investing in private debt calls for a much broader opportunity set than ever before. We have found ourselves not only looking to avoid the popular, overly competed trades, but proactively exploring new and innovative ways to drive value for our clients, expanding further into private corporate credit and building our expertise and resources in other areas to position for the next iterations of market development. With specialty finance set to become quite an important market in Europe, non-corporate lending could be the next phase of market growth. The market for private loans backed by real assets – infrastructure loans and commercial real estate debt – is expected to expand further as debt funds become a growing source of capital for real assets project financing.
Investors should also keep an open mind and not wed themselves to a particular definition of private debt. As long as they are clear about why they are investing in private debt and the outcomes they are looking to achieve from the asset class, then definitions are much less important.
This article is taken from the 2020 Preqin Global Private Debt Report
. For more expert commentary on the private debt industry, please visit: preqin.com/gpdr
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