Over the last few years institutional investors – particularly U.S. public pensions – have been on a shopping spree. They have piled billions of dollars in private debt/credit, a rare asset class where hedge fund and private equity managers seamlessly overlap.
Those managers outside of the space have questioned wonder it is a bubble that is set to burst or if it is really the outperforming cousin to traditional fixed-income strategies that they are being billed as by consultants.
A recent industry survey done by KPMG and the Association of the Luxembourg Fund Industry estimated that the private debt fund market has grown from $44 billion (€40 billion) in 2017 to $62 billion as of June 2019. The growth of almost $20 billion over less than two years is indicative of the market’s success and the general belief in its continued rise in years to come.
Many of the strategies in the space are in direct lending (32% and senior loans (25%) and nearly 70% of the investors are based in Europe, where the search for yield has been the most acute.
Perhaps adding to private credit’s allure, the majority of funds surveyed by KPMG do not charge a performance fee and when they do it tends to be below 20%.
The backdrop to the rise of private debt, of course, is the increasing fee pressure on hedge fund managers as well as performance concerns in the space relative to traditional equity fund investments. Many hedge funds have seen their private debt offerings raise fresh capital over the last few years.
But perhaps the greatest driver has been low interest rates implemented by central banks following the financial crisis of 2008.
Still, some industry observers are pointing to a diminishing of volatility of credit spreads in the past year and whether that means central bankers are getting the outcomes they bargained for in keeping interest rates low or in some cases negative.
When it comes to performance in 2019 it has been a mixed bag for sure, according to indexes and published reports.
The event driven strategy of the MidOcean Credit Opportunity Fund was down 5.34% in 2019, while Ellington Credit Opportunities was up 6.61%. CVC European Credit Opportunities Sarl was up 0.29% last year and Napier Park European Credit Opportunities Fund was up 5.02% over the same time frame.
All these figures highlight the manager dispersion that investors and consultants are analyzing going into 2020. Much depends on the geography, levels of distress, underlying structure of the investments (loans vs. structured debt) and so much more.
According to Wade O’Brien, managing director of capital markets research at Cambridge Associates, investors in liquid credit will earn lower returns this year both because yields have fallen over the course of the year and because the macro backdrop is deteriorating.
He added though in his investment outlook that a handful of attractive opportunities remain in structured credit and investors that can lock up capital in private strategies will find both higher returns, as well as opportunities to find “less economically sensitive assets”.
According to Cambridge, U.S. high yield bonds are unlikely to generate another 11% plus return as yields as of last November were around 5.5%. Investment grade bonds and BB-rated corporate bonds seem to be stuck at their current yields too.
The flavor of the day remains structured credit, particularly in U.S. residential mortgage-backed bonds. CLO debt also remains attractive he said despite concerns over the quality of new loan issuances. For example, CLO debt offers 3x the spread of BB corporate bonds, according to Cambridge.
J.P. Morgan in its investment outlook says that a variety of private credit opportunities are likely to do well in 2020. Those include longer duration, less liquid mid-cap company debt; distressed lending and non-performing bank loans; and commercial mortgage loans.
“If risk-free (and even corporate bond) rates’ plunge continues, private credit yield spreads may continue to widen – lifting demand and helping the asset class march into the mainstream,” according to J.P. Morgan.
They point to a second emerging theme that is the strength of the American consumer in contrast to the concerns surrounding corporate debt, including high yield, leveraged loans and middle market direct lending. They point to a healthy U.S. consumer and continue deleveraging making for an attractive investment theme that is expressed in mortgage lending opportunities.
The team at J.P. Morgan does add that due to what they call a leveraged finance bubble, where companies are over borrowing, there may potential future opportunities in special situations, distressed and other less liquid sectors if those companies should default.
Not matter what the outcome of the leveraged loans space there will likely be working capital at the ready if the institutional investor allocation trends of the last two years are any indication.