Private debt: moving into the mainstream?

As 2021 draws to a close there are many reasons for investors to feel anxious. Increased chatter about stagflation has underlined uncertainty over the macroeconomic backdrop and the outlook for monetary policy. Additionally, valuations across public investment markets remain on the high side, largely due to the unprecedented stimulus unleashed to defend economies from the pandemic. For investors hunting for higher yields, are the options becoming limited?

Private debt could offer an attractive alternative. Once considered a niche form of investment, assets are flowing into this space and private debt is projected to increase 11.4% annually, with total assets nearing USD1.5 trillion by the end of 2025, from USD848 billion at the end of 20201. So why is this asset class suddenly moving into the mainstream and should more investors consider allocating to it?

A post-GFC investment innovation
Private debt is an umbrella term that covers the provision or acquisition of debt to companies or projects not available on public markets. Historically, this was the domain of banks, but the tightening of banking regulations in the aftermath of the Global Financial Crisis, prompted many banks to leave this market, opening the door to a swathe of non-bank lenders.

In an environment where traditional asset classes offer very little by way of yields (bonds) or are priced at all time highs (equities), private debt has a solid track record of delivering stable income streams, diversification and modest drawdowns over the long term. Moreover, private debt assets tend to offer floating rather than fixed interest rates, meaning investors are primarily taking credit risk rather than interest rate risk, which could offer some desirable protection in a rising interest rate environment.

Even so, this area of investment is typically less liquid than conventional assets, therefore the notion of long-term investing is key and prospective investors will need a longer investment horizon.

Real diversification potential
Amid the globalisation of capital, public markets no longer offer the same level of diversification as they did in the past. However, private debt spans a diverse number of industries and sectors, including real assets, such as infrastructure projects and real estate.

In addition, post pandemic, more companies are likely to seek funding from the private market as government support eases, establishing a fresh set of opportunities that should persist for some time. These include:

  • Companies in sectors that were hit hard by the global shutdown and whose business models will need to be re-evaluated in a post-pandemic world – such as aviation.
  • Companies in sectors that have been affected deeply, but that operate in markets with solid fundamentals and can be expected to bounce back strongly once economies have fully re-opened – for instance, tourism or the events industry.
  • Companies in sectors that have been resilient throughout the crisis or have even benefited to some extent, from the pandemic – for example, healthcare, IT and telecom.
Investing across the capital structure
Within private debt, diversification does not have to be limited to industries and geographies. Diverse opportunities can also be captured across the risk/return spectrum.

When investing in loans, it is worth investigating which part of the capital structure is the most attractive on a risk/return basis. For example, when considering a corporate or an infrastructure project it is not necessary to solely focus on senior debt financing. Junior debt can often offer attractive yields at a level of risk that can be compelling on a relative value basis.

Yet, even though being open-minded about the capital structure can present differing opportunities, it remains critical to maintain high standards of due diligence, focusing on the risk an individual company is exposed to, as well as the strength of its balance sheet.

An evolving risk backdrop
While there is an increasing universe of private debt opportunities, it is essential to be discerning. Infrastructure debt may appear to have safe haven-like status, but the outlook for some sectors – such as airports and transport – remains challenging.
The level of risk has also increased in areas such as commercial real estate, where some segments were significantly impacted, and arguably transformed, by the pandemic (hotels and retail assets) while others – such as logistics – have thrived. Additionally, the reflationary environment is changing the risk outlook and it is important to take an array of business risks – such as a company’s exposure to commodity prices – into consideration. Even though default rates have mostly remained around historic lows for the last decade, the more challenging economic backdrop means it is increasingly important to monitor certain criteria such as a borrower’s existing leverage, growth prospects and profitability.

As with all areas of investment, working with experienced investors who can identify the best borrowers and keep credit risk at manageable levels is essential.

Identifying sustainability risks
Against a backdrop of growing regulatory requirements and investor demand for responsible investments, sustainability can and should be factored into private debt.

Whether it’s a company, real estate asset or an infrastructure project spanning several decades, sustainability factors are going to impact the borrower’s ability to reimburse debt, therefore the need for them to have a solid environmental, social and governance (ESG) profile and strategy is paramount and should be an integral part of any borrower assessment.

Taking a step further, it is possible to measure the net environmental contribution of a project, or corporate strategy, and compare that with the broader universe to determine whether the overall impact will be positive or negative. Analysis of CO2 emissions and whether there is alignment with the Paris agreement can also be factors to consider when assessing the quality of an investment opportunity and can help highlight unsuitable investments.

Be selective: not all opportunities are equal
Private debt may have been under the radar for many, but the requirement for yield in an increasingly uncertain and unstable economic environment should see more and more investors turn to this area for attractive and resilient long-term returns.

The pandemic has increased the number of solid companies that are turning to non-bank lenders to overcome both temporary and more structural challenges and therefore the range of opportunities should increase to match the rise in demand. Yet, it remains critical to ensure the best borrowers are identified and credit risk is kept at manageable levels.

At BNP Paribas Asset Management, our experienced team investigates all the factors affecting each sub-sector to ensure they can identify the most resilient sectors and uncover the best quality opportunities. Additionally, by using sustainability as a core security selection tool, they seek to avoid unsuitable investments and enhance returns over the long term.

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