How will private debt weather the storm?

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What can investors realistically expect from private debt – and how will the Covid-19 pandemic impact the ‘asset class’? 
Private debt has seen high levels of interest from pension funds in the recent past, to provide income amid low gilt yields or diversification in the growth portfolio. 

A recent survey of 101 trustees and pension professionals, conducted by mallowstreet in partnership with M&G, shows that three-quarters of schemes (76%) already have some exposure to private debt assets. Half of these were looking to further increase their allocations, while a quarter of the schemes not yet invested were planning to gain exposure. 
Experts stress however that investors looking to allocate to this area should understand that while the different forms of private debt can help pension funds in different ways, they should reality-check their expectations of returns and security. 
  • 76%  
of UK pension schemes invest in private debt 
  • 1/2  
are satisfied with private debt returns and the quality of opportunities 
  • 50%  
of existing investors are increasing allocations 25% of those not invested are planning new allocations 
  • 46%  
prioritise the quality of opportunities sourced 
The mallowstreet Private Debt Report revealed a gap between what investors think private debt can deliver and what it actually offers – only half of those surveyed were satisfied with the returns obtained and the quality of the opportunities, and 53% did not agree that private debt fees offer good value. 

Manager selection is crucial 

To avoid future disappointment, manager selection is therefore key, as a manager should be open about what is available at what level of risk and for what type of return. 
“Many clients, especially those new to the asset class, may have seen a small selection of managers and might have been promised high single digits returns on ‘vanilla’ senior secured lending. I would advise some serious peeling back of the layers before accepting such assurances,” says Trevor Castledine, senior director at consulting firm bfinance. 
He says that a good manager should be able to originate deals where they don’t find themselves in competition with many other lenders, and be willing to remain conservative in their underwriting standards to avoid dropping investor protections or ramping up leverage in the end investments. “In private debt, I’d rather miss a couple of good deals than get into one bad one,” he notes. 
However, for some investors, speed of deployment can be a concern, as dry powder had been building up and only reduced last year when fundraising activity slowed compared with previous years, although it is still at an impressive $261bn according to Preqin. 

To avoid sitting on capital without enough deals to put it towards, a manager should therefore have limited the amount of money it raised for its fund, having based this on the amount it can reasonably expect to put to work during the investment period, says Castledine. 
“I want them to deploy calmly and smoothly, across around about the number of deals that they said they would,” he says. 
For Castledine, investors who are keen to avoid capital losses should be interested in strong credit underwriting skills first and foremost. Where they want higher returns, this will require either fund level leverage or a manager with strong structuring skills and a willingness to take risk further down the capital stack; for either of these, avoiding poor investment decisions becomes even more important as the sensitivity to errors becomes much higher.   
“Many investors see private debt as being a somewhat defensive strategy which still throws off a predictable cash yield and doesn't require a huge amount of compromise on the returns one can make. If cash generation is what is being sought, an important capability in a manager is to deploy reliably and maintain investment levels over time,” he observes. 

Returns, fees and expectation management 

While return expectations of 5-7% are realistic according to those surveyed by mallowstreet, the specialist knowledge required for finding and making good deals is not cheap, although this varies depending on the model a manager uses. 
Simple strategies focusing on larger deals lending to sponsor-backed deals can be expected to yield cash plus 4-5% before fees, and should be able to be accessed for mid-double digits basis points per year in terms of fees, says Castledine; more niche strategies will come with higher costs, which should however be more than compensated for by the additional return.
He finds performance fees controversial, but says if they are there, they should be capped to the upside and can provide alignment with the investor. 

Diversification is preferred 

Diversification of opportunities was the third most important quality pension funds said they seek in a manager, after the quality of opportunities managers can source, and finding managers with direct access to borrowing companies, according to mallowstreet’s survey.
Some consultants echo this view. Brendan McLean, an investment researcher at Dalriada Trustees, says managers offering many different types of loans are preferred over single strategy funds.
For McLean, as well as diversification, security is a key consideration. “Generally, we prefer managers that look at the more senior part of the capital structure,” such as senior secured loans,” he says, as these provide more of a cushion if something goes wrong and are available across the globe. 
Having invested in more secure assets will benefit investors in a scenario like the current one, with markets falling and the economy at risk of recession because of a pandemic. 
For Castledine, the current environment means “we are about to find out how resilient various private debt strategies are to a major economic slowdown, which I think is a good thing”. 
The market has developed significantly since the last major economic crisis, he notes, and although there has been speculation about what might happen, there has been no evidence one way or another.  
“It will be good to have some comparative data for how private debt strategies which have been invested over the last couple of years perform versus other possible portfolio constituents,” he says. 

Will Covid-19 affect private debt investors?

While this data is not available as yet, it is not clear if private debt will be exposed to the virus-induced downturn – or on the contrary, relatively well shielded. Jo Waldron, director of fixed income at M&G, says while a prolonged disruption of companies through the virus would impact everyone, private debt investors could be better protected than others. 
“With private debt, what you hope your manager has done is negotiate good security packages and covenants that allow the manager to interact with the people who run the business, to make sure that should performance not meet expectations, there is something you can do about it,” she says.  
Covid-19 could even be a buying opportunity, she opines, “just not immediately”, as the lead time for creating a private debt asset is typically three months. 
The severity of the impact of the current crisis will also depend on the type of private debt that schemes are exposed to. Waldron is keen to stress that private debt is not synonymous with direct lending but includes a range of things from leveraged loans and real estate debt, to social housing and even pools of consumer lending.  
They can be long-dated, high quality assets delivering cash flows, shorter dated assets delivering equity or DGF-type returns, or high-yielding drawdown funds more akin to private equity. Having a manager who can look across asset classes can diversify risk for pension funds – and could even offer access to valuable opportunities.