Private market investments, a key component of an alternatives portfolio, can provide opportunities to generate non-correlated returns within portfolios and enhance overall portfolio risk/return, while still providing for meaningful upside. At Defiant Capital Group we believe alternative asset portfolios should be built holistically like any other asset class (e.g. equities), with one of the key building blocks the use of Private Debt and and investments in private credit.
When we look to deploy assets into private markets we weigh the risk/reward associated with the structure of the vehicle (non-regulated private investment), illiquidity, the potential for loss, and the potential for upside. Given trends in alternative investments and the current environment our recent focus has been on two segments within alternatives – private credit and venture capital.
In this post we examine the current opportunity set for private credit markets, why we think they continue to present a compelling investment opportunity for investors, and some of the investor factors to consider when allocating them into a portfolio.
1. Private debt strategies tend to have shorter fund lives (i.e. capital lock-ups) than other private market assets
Shorter fund lives lower the required illiquidity premium for investors, as well as provide the opportunity for investors to redeploy capital faster. In addition, the potential return drag from poor investments is minimized (compared to other private market investments) given the shorter fund lives and regular distributions. And with most funds drawing only 75% – 80% of commitments (assuming a 20% – 25% recycling of early investment returns), the illiquidity timeframe and cash drag is further reduced.
2. Inefficient segments of private credit markets (e.g. lower middle market) benefit from wide spreads, high cash yields, and can have equity-like return potential
From a return perspective, levered senior debt and opportunistic credit (e.g. growth based debt) can produce returns that are in-line / above public market comparisons (both on the equity and fixed income side), and also approach those of some private equity strategies. The need for non-dilutive growth based debt results in many private companies willing to pay higher coupons and transactional costs in exchange for transactional efficiencies (i.e. speed to close) with more aligned debt partners vs. traditional banks.
When compared against traditional fixed income investments private credit has historically experienced higher returns with less volatility and downside risk. And with many private debt investments incorporating equity warrants skilled managers have the ability to generate upside in-line with Private Equity, but at a significantly lower risk profile given the higher placement in the capital stack and asset-backed debt.
* Cliffwater Direct Lending Index
3. Loss rates on private credit have historically been below those of speculative grade bonds, and more in-line with investment grade bonds
Strong underwriting and highly engaged investment teams have resulted in private middle market loans having attractive loss rates that are below those of speculative grade bonds. In addition strict covenants, asset-backing, personal guarantees, and tight monitoring of loans and business operations by lenders helps limit downside loss potential in the event of a business downturn.
4. Private Credit presents a compelling opportunity for yield hungry investors, with regular distributions also helping to minimize illiquidity drag
Private debt strategies are designed to produce regular income, appealing to investors that are searching for yield in the current environment. With most Private Credit funds having shortened investment periods compared to other private market investments (two years on average for private credit vs. five years for private equity), recycling of payoffs and coupons is less common resulting in more distributions to investors sooner. Furthermore, regular distributions from coupons, origination/exit fees, and prepayment penalties enhance distributions and compensate investors for their illiquidity.
5. Private credit and debt sectors tend to have a low correlation with public markets, creating opportunities for portfolio diversification
Given low correlations with public markets the inclusion of private credit and debt investments inside a portfolio can enhance overall portfolio construction and potentially reduce risk. Lagged mark-to-market of debt investments helps to smooth out intra-quarter/month volatility, while strong underwriting and hands-on investment teams work with private business owners as partners, helping maintain the overall credit quality of investments.
Opportunities today in Private Credit
Amid government stimulus, monetary policy, and low rates, it is a difficult environment for investors to seek differentiated returns. While government support (both fiscal and monetary) has helped drive the epic bull market post-2008, it has come at the cost of differentiation. Within portfolios today public equity markets are exhibiting staggering returns, especially in the US, but the ability to diversify the sources of risk/return are at all-time lows.
At the same time fixed income investments, which typically have provided diversification of risk from equity markets, face return headwinds from the low rate environment, the looming removal of easy monetary policy, and the potential for rate hikes. And on the risk-side, a consequence of Fed support for equity / fixed income markets has been highly correlated cross-asset returns.
Private debt investing offers opportunities to create value within an investors portfolio. With attractive loss rates, engaged lenders, regular distributions, and the potential for enhanced return through equity warrants, they present a compelling investment option.
Like any other private market investment underwriting, due diligence and proper analysis of risk is important. For investors that are qualified and able to withstand the illiquidity Private Credit provides a unique way to enhance yield, total return, and portfolio divarication. We encourage investors to to discuss the topic with their advisors to see if Private credit makes sense for them in their own portfolios.
ENDNOTES
Disclosures
This commentary reflects the personal opinions, viewpoints and analyses of the author providing such comments, and should not be regarded as a description of advisory services provided by Defiant Capital Group or performance returns of any Defiant Capital Group client. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Defiant Capital Group manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary.
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.