Top considerations for alternatives in 2023 – Private debt
“Success is where preparation and opportunity meet” — Bobby Unser, Motorsports Hall of Fame automobile racer
During 2022, the initial anxiety around whether or not inflation would prove to be transitory rapidly transformed into substantial concern that a tectonic shift in global monetary policy could result in a hard landing for economic growth. Following the conflict in Ukraine and the ensuing supply chain and energy price shocks, central banks raised interest rates in the face of stark inflation readings. As we look to 2023, so far, performance in private debt has remained steady*. By way of example, default rates in the broadly syndicated leveraged loan indices in the US and Europe, which serve as a proxy for private debt, remain at low levels.
However, a prevailing sense of uncertainty is clearly reflected in market sentiment, with “traded” loan issuance falling precipitously compared to the prior year, and the weighted-average bid for loans falling steadily.
Where pricing volatility becomes a challenge for investors
and financing options are reduced for larger, “liquid” corporate borrowers,
private debt becomes an increasingly viable alternative to the liquid credit
markets. Combined with a predominantly floating-rate structure, private debt
offers one of the few bright spots on investors’ radars, despite the prognosis
for rising default rates across all credit asset classes.
Private debt has demonstrated a premium versus liquid credit over a long period, often combined with lower default rates and higher recovery rates.1 Given the current economic backdrop, it’s more crucial than ever to build your allocation to private debt in the right way. Naturally, diversification should be a core tenet for any private debt investor, and we strongly advocate avoiding concentration risk. Taking this approach is playing defense at a time when the market environment strongly suggests that more dispersion lies ahead — between asset managers, investment strategies, sectors and portfolio companies.
In this paper, we choose to highlight another, perhaps underappreciated, tenet for private debt investors: flexibility. A flexible approach is not only defensive, but, to some extent, it can also be an attack.
To us, flexibility means:
• Maintaining broad coverage of the expanding landscape of private debt: Consider where the imbalance of capital demand and supply is likely to be most acute over the next 3-4 years. The world of corporate direct lending has traditionally demonstrated this imbalance: reduced bank lending to the midmarket (supply) and the rising requirement for debt capital from private equity (demand). As the world of private debt continues to expand, we see new themes and avenues for exploiting imbalances that may become even more acute over the next 3-4 years — structured credit and specialty finance spaces, in particular —therefore improving risk-adjusted return potential.
• Cultivating broader relationships: In the traditional model, investors commit assets to a narrowly defined investment strategy. Instead, we advocate that investors access broader credit platforms (that is, an asset manager with multiple credit capabilities) with the potential to bring a diverse opportunity set together at a single point of access. An asset manager that can look across its credit platform has a higher probability of committing the next dollar of capital to the best risk-adjusted return opportunity. The resulting portfolio should be more robust, and able to achieve a greater level of diversification. Underwriting the various underlying capabilities may mean more work, but we believe it is worth it for the benefit of the overall portfolio.
• Becoming a provider of liquidity in stressed or dislocated situations: Periods of secondary market volatility can escalate as a result of liquidity, concentration and leverage limitations imposed on other market participants. We believe opportunistic credit strategies are well placed to meet their higher return targets when these circumstances proliferate in the wake of a broader credit market dislocation. Being a provider of liquidity in these situations — whether through secondary tranches of CLOs or individual broadly syndicated loans — offers capital gain opportunities while allowing investors to retain a focus on credit fundamentals and downside protection. The ability to pivot toward credit dislocation funds, special situations and distressed debt at opportune points in the cycle can be rewarding.
The market environment is highly uncertain. In many respects, private debt currently looks attractive, both on an absolute basis and relative to other asset classes. However, there will be greater dispersion ahead. Opportunities will present themselves as the asset class continues to expand and the macroeconomic picture develops. In conjunction with diversification, incorporating an element of flexibility into portfolio planning, construction, and implementation can help private debt investors effectively prepare and increase the odds of a successful outcome.
Private debt is currently an attractive asset class, both on an absolute basis and relative to other asset classes. However, there will be greater dispersion ahead. Given the current economic backdrop, it is imperative to build your allocation to private debt in the right way. Naturally, diversification should be a core tenet of any private debt investor, and we strongly advocate avoiding concentration risk.
* Past performance is no guarantee of future results.
1 For more information, see https://www.mercer.com/content/dam/mercer/attachments/global/gl-2022-private-debt-report.pdf
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Partner, Global Head of Private Debt, Mercer