Opportunities abound for trustees looking at the private debt markets, but investment is not straightforward. BlackRock's Andrew Stephens equips schemes with the essential information.
Private debt is one area that has become more attractive as a possible investment opportunity.
Key points
Consider whether private debt offers attractive risk-adjusted returns and diversification to improve portfolios
Ascertain whether the trustee board has the in-house experience to enter into private debt investment directly with a bank
Consider working with a third party to negotiate the best possible deal
This has traditionally been the preserve of commercial and international banks – before the financial crisis forced a reconfiguration of the landscape driving bank retrenchment and opened up an opportunity for institutional investors to fill the financing gap.
The regulatory overhaul that followed on the heels of the financial crisis curtailed the lending capacity of global and regional banks by imposing tighter capital requirements.
Non-bank lenders, unimpeded by these requirements and with flexible long-term capital, took a significant role in private credit markets.
Adoption of alternative credit strategies was also fuelled by a continuing search for yield.
Institutional investors often sought to generate incremental yield in the structured credit market across a number of sectors including asset-backed securities, senior commercial mortgage-backed securities and collateralised loan obligations.
The search for yield
As yield has become scarcer – including in structured credit – investors have crossed over into private markets, adopting a range of strategies such as direct lending, real estate mezzanine financing, infrastructure debt and other non-conventional credit strategies.
For investors such as pension schemes, private debt assets also have the ability to provide the benefits of diversification and improved risk-adjusted returns within their portfolios.
In these asset classes, a growing number of institutional lenders are willing to give up liquidity in exchange for stable, secure income with higher yields.
The resources required to find the right opportunities, agree lending terms, undertake due diligence, monitor, value and rate these illiquid portfolios should not be underestimated
Although the opportunity set in private markets in general and private credit in particular remains solid, investors must be increasingly discerning as attractive valuation yields become harder to source.
Despite supply-driven factors and retrenchment of traditional funding channels, capital-raising has been vigorous and many new investors have entered the market.
Additionally, banks are lending aggressively, although only on the most senior part of the capital structure and typically with smaller sized loans.
Some sectors are now characterised by over-abundance of capital and excessive crowding, which has led to stretched valuations and less-compelling risk-return metrics.
This issue can be addressed through a flexible and multi-credit approach, allowing investors to target, in a fluid and adaptive manner, sectors that are less prone to overcrowding and are more attractively priced.
Bypassing the banks
Today, an increasing number of pension schemes and other institutional investors are entering into bilateral, club or syndicated loans directly with borrowers and without bank intermediation.
Most of the large banking groups have fully embraced this transformation and are actively seeking to work alongside the non-bank lenders and asset managers to serve their own clients’ interests.
This is essential, as many pension schemes do not yet have experience and confidence in working with non-bank lenders.
It will take time for relationships to be properly established and developed.
Pension funds and insurers represent the majority of this non-bank lending capacity, but there is still much to learn for many of them.
The resources required to find the right opportunities, agree lending terms, undertake due diligence, monitor, value and rate these illiquid portfolios should not be underestimated.
Most investors have understandably chosen to delegate these activities to dedicated teams within large asset management groups.
Pension schemes will continue to increase allocations to alternative investments, including infrastructure debt and commercial real estate, and direct real asset lending will grow significantly over time.
Trustees need to ask how to increase the likelihood of reaching their stated objectives and then seek advice from a broader set of advisers to ensure they manage the risks inherent in these asset classes.
Andrew Stephens is managing director and head of UK intermediated business at BlackRock
