Private debt offers attractive returns but an allocation constrained by the performance test
Investor demand and a large influx of M&A deals have historically driven the growth of the private debt market, especially when global interest rates were low. The asset class is expected to grow 10.8% annually to an all-time high of US$2.3 trillion ($3.55 trillion) in 2027, nearly double 2021’s volume of US$1.2 trillion. US dollars according to data company Preqin.
“There has been a lot of investor interest in this asset class, especially when rates were falling as it created a higher yielding strategy,” said Young Jo Bae, asset consultant at JANA.
“The most attractive thing is that private debt offers equity-like returns with significantly lower volatility. The higher returns are due to illiquidity and complexity premiums. In today’s market, these loans generate around 10-11% cash return.
Market growth started around 2013 following the global financial crisis and the stricter capital adequacy rules imposed by Basel III.
“Over the past two or three years, there has also been an increase in product launches by managers, primarily due to active M&A activity that required a lot of funding in the leveraged buyout space,” she said.
Private credit generally consists of variable rate loans that can protect investors in the current interest rate environment.
“The universe of private debt is mainly composed of variable rate loans. The nature of lending makes it one of the few asset classes that could see yields rise in a rising interest rate environment,” said Elizabeth Kumaru, head of corporate private assets at Australian Retirement Trust (ART ).
The $230 billion super fund has a 5% allocation to private credit with the majority in the US due to the sheer size of the market.
The selection of managers and credits as well as the construction of the portfolio are essential given the complexity of the product and the market.
Global fund manager Neuberger Berman’s private debt strategy focuses on senior and unitranche loans to private equity firms in North America with EBITDA between US$20 million and US$250 million.
The firm avoids cyclical industries, capital-intensive industries, and unpredictable industries such as retail, restaurants, energy, leisure, and most consumer businesses.
“We look for recession-resilient industries that are growing faster than US GDP, and then within those industries we look for market-leading companies that have very high free cash flow,” said Susan Kasser, manager. of portfolio of Neuberger Berman Private Debt.
The firm currently manages $13.1 billion of private debt across more than 130 companies, with up to $500 million committed per investment. The company recently closed an $8.1 billion private debt fund — its fourth — in June.
Portfolio diversification is also key, said Kumaru of ART. “Having a highly diversified portfolio prevents a single underperforming position from derailing overall portfolio results,” she said.
Performance testing constraints
Notwithstanding the investment proposition, the Your Future, Your Super performance test imposes limits on the ability of certain super funds to allocate capital to this asset class due to tracking error. Under the performance test, the private credit has a benchmark rate of 50% fixed interest rate plus 50% equity benchmark.
This product sits at the extreme end of benchmark risks in terms of duration, liquidity, and fees, JANA’s Bae explained. “If the super fund has enough headroom against the performance test, it could be a very good medium-term allocation,” she said.
“But if the fund does not have enough headroom against the performance test, it is unlikely to withstand the volatility that this asset class can cause.”
Funds like ART that have enough headroom against the test believe that the risk justifies the return. “This means that from a Your Future Your Super performance perspective, we have less confidence in our ability to outperform the benchmark over shorter time horizons due to stock market volatility, but ART considers these strategies offer attractive risk-adjusted returns that have the ability to outperform the YFYS benchmark over the cycle,” Kumaru said.
Deterioration of macro conditions
The private credit market should hold up reasonably well despite deteriorating credit conditions and an expected rise in default rates.
“If interest rates go up too much, you’re obviously going to see an increasing number of defaults. But still, you’re going to be higher in the capital structure and as long as you’re in the right companies with the right balance sheets and the ability to handle the current environment, performance should remain robust,” Kumaru said.
Many of these financings come with covenants to protect investors in the event of a downturn. In Neuberger Berman’s portfolio, 80% of loans have these covenants, resulting in an annualized default rate of 0.04% and an annualized loss rate of 0.02% according to Kasser.
Private debt asset selection is also key, and this is where Neuberger can get a leg up on the competition as a diversified asset manager.
The firm is a sponsor of 600 private equity funds and this close relationship with private equity sponsors provides deal flow for Neuberger Berman’s private lending business.
“This competitive advantage makes [our] life so much easier because [we] don’t have to balance deal flow and selectivity. You know you’re going to have a ton of deal flow so you can be as selective as you want,” Kasser said.
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