With global growth improving, interest rates continued to increase in 2017, particularly in Canada and the United States. Many believe the U.S. Federal Reserve will raise rates three times in 2018, dragging the Bank of Canada along with it. On March 8, 2018, the 10-year benchmark bond sat at 2.37 per cent, which hardly represents a return for investors given the effects of inflation. So it isn’t surprising investors remain interested in private debt.
The continued environment of low interest rates over the past 10 years has supported private debt investment vehicles. Indeed, assets under management have increased significantly, rising to $638 billion in 2017 from $205 billion in 2007, according to a report published in January 2018 by Preqin Ltd.
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It also found that as of Dec. 31, 2017, dry powder (the amount yet to be invested) held by private debt funds stood at $236 billion. Almost half of that amount, $107 billion, related to funds raised in 2017 alone. And more than half of the funds raised last year were for direct lending vehicles: debt provided to complete private equity deals. The remaining money raised was for funds invested in venture debt, special situations, mezzanine debt and distressed debt.
So why are investors so keen on private debt? Between January 2000 and 2018, U.S. middle-market direct lending investments returned more than six per cent, net of fees, with an average annualized standard deviation of about five per cent, according to the Bloomberg Barclays and Standard & Poor’s indexes. The return is slightly higher than that of the S&P 500 over the same time period but came with less than half of the standard deviation. As importantly, the correlation between U.S. middle-market private credit and U.S. equities during this time period was 0.35 and just 0.2 when it came to investment-grade bonds, as measured by the Bloomberg Barclays U.S. corporate investment grade index.
Looking more broadly at the private debt market, between September 2004 and June 2016, the Cliffwater direct lending index returned 9.7 per cent — compared the Russell 3000 index’s return of 7.97 per cent — although with substantially lower volatility of 3.75 per cent versus 15.97 per cent, respectively. Median net internal rates of return for all private debt between 2008 and 2014 ranged between 8.2 per cent and 12 per cent, according to Preqin.
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It all sounds rosy, right? With so much money flowing in, competition among lenders of private equity-sponsored deals has led to a weakening of credit protections. The number of covenants or creditor protection clauses has fallen to an average of less than two in broadly syndicated loans. With a large number of first-time funds emerging over the last few years, some of them have management teams new to investing institutional private debt. Many long-time investors have expressed concern that these management teams haven’t yet experienced a full credit cycle and aren’t ready to weather the next one when it arrives (and they believe it will).
Investors are becoming a bit more cautious as well. First-time funds raised about $10.5 billion each year between 2013 and 2016. However, in 2017, commitments made by investors to first-time funds decreased to $7.8 billion. The number of first-time funds also decreased to 31 in 2017 from an average of 40 per year. In part, that’s due to the fact that many successful first-time funds have already raised their second fund. With large amounts of money raised and greater competition for deals, investors are tending towards experienced funds.
Those concerned about the situation are considering raising distressed funds to take advantage of the distressed investment opportunities they believe will present themselves. One manager has even gone as far as to predict the timing of such an event: 12 to 24 months. Fund managers and investors who were in a position to take advantage of the credit bubble in 2009 achieved outsized returns.
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So what does it all mean for investors? As with other private investment strategies, manager selection is key. Understanding how a manager sources its investments, the investment team’s skills, the pricing discipline it maintains, the amount of leverage it uses and the pace at which it deploys assets are some of the key items to assess. Depending on the strategy employed, investors may also wish to look at the manager’s ability to work out loans in the event of defaults.
Private debt remains an interesting asset class, but as with many other investments, not all strategies are created equal.