More investors have steered toward private debt in recent years, adding a new category to their asset mix. The asset class offers the potential for attractive yield and portfolio diversification as concerns about market turbulence, slowing growth and economic uncertainty rise.

A niche market 20 years ago, private debt assets and number of funds continue to multiply, according to Preqin data. Through September 2018, private debt funds have swelled to more than $1 trillion under management, with more than $400 billion in dry powder. Fundraising in 2018 crossed the $100 billion threshold for the fourth consecutive year and the number of funds has expanded to 407 through April, compared with 237 four years ago.

As interest rates hover near historic lows, many investors are using private debt strategies to preserve capital or maximize returns. These strategies appeal to institutional and high-net-worth investors looking to rebalance portfolios, trimming profits from equity and real estate strategies that face market volatility and interest-rate uncertainty, and placing those realized gains where they perceive more runway for growth. In addition, private credit is an attractive option to allocators who want to put cash to work in assets that aren’t volatile but generate equity-like returns.

Private credit strategies range from conservative to aggressive, and different strategies are appropriate for different stages of the business cycle — though, senior-secured private debt can be regarded as an “all weather” strategy. Across strategies, the asset class posts returns of between 5 percent and 20 percent.

WARY OF ECONOMIC JITTERS

Private debt, particularly the capital preservation strategies, holds appeal because investors are increasingly uncertain about global growth, trade and market volatility. Central banks have leaned toward looser monetary policy, applying downward pressure to bond yields. And interest rates remain low by historical standards; the benchmark Federal Funds Rate has held below 6 percent since January 2001 and below 3 percent since March 2008.

Though many sectors, such as real estate and equities markets, have pushed to the perceived upper ends of a decade-long cycle, the U.S. economy continues to send mixed directional signals that leave investors on edge. Stable GDP, decades-low unemployment rates and stock-market indexes reaching record highs could signify that the economy’s run still has legs to it.

Meanwhile, falling consumer sentiment, 10-year Treasury yields below 2 percent, hefty corporate debt levels and broad uncertainty over U.S. trade policy all paint a more foreboding picture. Perceptions of wobbly corporate earnings and bouts of stock-market volatility over the past 12 months have driven investors toward assets such as U.S. Treasurys, the Japanese yen and gold, all of which tend to hold their values in downturns.

RIDING OUT THE STORM

In this environment, allocating to private credit may provide a stabilizer. More investors can choose among strategies with different risk/reward profiles to fit their interpretations of the market’s and economy’s direction. Allocators have many choices in private debt to consider.

Some mid-market strategies within niche parts of the sector have proven appealing; these can deliver equity-like returns without volatility as several strategies exhibit low correlation to other risk assets. Many of the more prominent private credit strategies can be broken down into capital preservation, return maximizing and opportunistic/niche categories, according to a Cambridge Associates report on the asset class.

Capital preservation strategies:

• Senior debt is highest in the capital structure, making it the first loan to be repaid if the borrower defaults, and is typically backed by collateral. Senior debt can be viewed as a public company private debt issuance. Returns come from current cash pay coupon.
• Mezzanine debt is an unsecured position that falls between senior debt and equity in the capital structure, generating returns between those of senior debt and equity. Mezzanine debt is frequently used to finance buyouts and acquisitions. Interest can be in the form of periodic cash payments or payable-in-kind (PIK) interest, whereby the principal amount owed increases (per the stated coupon rate) and is paid out at the end of the period.

Return-maximizing strategies:

• Distressed debt can be nonperforming notes or companies that are on the verge of bankruptcy. This strategy can be used to create a liquidity event where the business raises money through financing without selling, thereby allowing business owners to retain control. Returns can be similar to private equity returns.
• Subordinated debt is riskier debt that is repaid after senior creditors are paid in full. Subordinated debt is also used as a means for allowing owners to retain control of their firms. Managers often generate higher returns from fees, interest and penalties.

Opportunistic/niche strategies: These strategies run the gamut, covering sectors that include aviation, real estate, insurance, etc. Credit investors seek out these corners of the market to generate returns where liquidity is low and the upside potential is high. Executing in these strategies requires specialized expertise to identify, assess and properly structure the best opportunities.

• Rediscount: issuers offer debt multiple times at increasing discounts to par and pay full par value at maturity.
• Life settlement: a secondary market for life insurance policies where investors buy another’s policy or into a pool of policies for a one-time cash expense, taking on obligations and beneficiary rights.
• Catastrophe bonds: high-yield, insurance-linked debt that raises money for insurance companies for specific natural disasters, letting investors receive higher interest rates.
• Aviation finance: issuance of debt to provide capital to airline and leasing companies to buy aircraft, from which investors receive fixed payments.

In another example of a niche strategy, senior secured real estate lending can provide equity-like returns without equity-like volatility. A commercial real estate income fund can serve as a nice defensive ballast in client portfolios for advisers who are wary of allocating money to equities at the current levels. Additionally, senior secured real estate strategies offer a high-yield with regular distributions. These appeal to advisers who require quarterly distributions to supplement income for retired clients, or who have conservative investment profiles that don’t allow for sizable equities allocations.

DIFFERENT INVESTORS LOOKING FOR DIVERSIFICATION

The various segments of private debt offer a range of styles and risk/reward profiles. This part of the debt sector can be used as a diversifier or in place of equities when cash is generated from a liquidity event, such as the sale of a business or a large asset, and must be invested. Allocators who are nervous about adding more to the stock market or are trimming back their equity exposure as they rebalance portfolios are also turning to private debt.

Among the largest investor groups, private and public funds comprise 28 percent of investors in private credit, according to Preqin. Institutions such as foundations, endowments and insurance companies represent 31 percent of total assets; wealth managers and family offices make up another 16 percent.

The private debt market continues to expand in an environment of low interest rates and growing concern about global economies, growth, trade and markets. As the hunt for yield continues, private debt offers a viable and appealing alternative. In this space, investors will find an array of strategies with flexible structures that offer the potential for both diversification and an attractive risk/return profile.

Laura Catalino is senior vice president, investor relations at M360 Advisors.