Promise of Private Debt Burns Bright—With a Big If
Art by Nadja Zinnecker
The old saying is that every crisis creates an opportunity. That sums up the genesis of private debt, which owes its ascendancy to regulation-constrained big banks’ reluctance to lend to small- and mid-sized businesses and others not deemed sterling risks.
This non-bank credit has sprung forth to fill in the gap, left after Washington tightened loan standards for large lenders following the financial crisis. For small companies shut out of traditional credit, the advent of private lending is very welcome. The same goes for private equity firms looking to raise debt capital for smaller deals.
The list of Wall Street heavyweights getting involved in private credit, often by creating funds open to big clients, includes such luminaries as Ares, Apollo, Bain, Blackstone, and Goldman Sachs. Last month, Blackstone closed the largest real estate debt fund in history ($8 billion), some of the dollars earmarked for private transactions.
For pension plans and other institutional investors, private credit helps diversify their portfolios. So, earlier this month, the $262.5 billion California State Teachers’ Retirement System (CalSTRS) announced it was investing $1 billion in direct lending outfit Owl Rock Capital. Private debt activity takes many forms. Various family offices, for example, have lent money to Pizza Hut franchises.
Prospect of Plenty
To investors, unhappy over paltry fixed-income yields, private debt’s allure is that it can deliver 2 percentage points or more above corporate bonds. And sometimes private credit generates almost double-digit yields: The $42 billion Arizona State Retirement System, which has almost 15% of its assets in private debt, reported as of year-end 2019 that the strategy’s one-year return was 9.8%, and annually over five years, it garnered 10.4%.
Such results help explain why private debt has enjoyed a healthy expansion over the past decade, with assets under management (AUM) almost tripling in size, to $812 billion at 2019’s end, by the count of research house Preqin. Some 486 private debt funds are at work worldwide. Although their fundraising flagged in the beginning of 2020, owing to the pandemic, that largely has bounced back. As of mid-year, Preqin says, the number of investors committed to plugging in more than $300 million each to private credit was up 10%.
Private Debt Just Keeps Getting Bigger
Assets under management (in $billions)
Assets under management (in $billions)
812
739
667
604
551
474
472
400
371
332
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
812
739
667
604
551
474
472
400
371
332
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
812
739
667
604
551
474
472
400
371
332
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
812
739
667
604
551
474
472
400
371
332
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
Source: Preqin
Thornburg Investment Management, for instance, is raising money for what’s called the Bandelier Contingent Credit Fund, which will specialize in bonds of distressed companies. As of a June 15 filing, the fund had brought in about $24 million.
CEO Jason Brady said the firm hasn’t launched the fund yet because of the Federal Reserve’s extraordinary actions to backstop the credit markets. “We don’t see significant dislocation” at the moment, he said. Meanwhile, the firm has some $2.3 billion committed to this arena via a mutual fund, Thornburg Strategic Income, and a managed account undertaking called Thornburg Multisector Opportunistic Strategy.
Real estate is a bountiful destination for private lending. Securian Asset Management, a unit of the Securian insurance company, raises capital from private sources to invest in credit tenant leases—where it lends the money to construct a building. One such project is a distribution center for Amazon, with the online retailer’s 20-year lease serving as security. “We provide the capital and we own the real estate, which is our collateral,” said Mike Samuel, a Securian vice president.
Another plus for private debt is that the funds offering it have an abundance of “dry powder,” meaning unused capital that can be deployed to bolster them if trouble arises, or they find a good loan opportunity. By Preqin’s count, dry powder accounts for a third of AUM globally.
What Could Go Wrong
This pandemic-roiled economy has posed some headwinds for private debt, and although the obstacles have lessened considerably, the hope is that further economic weakness won’t crop up ahead as the pandemic rolls on.
The improvement from earlier this year is welcome. The default rate for private debt jumped in the second quarter, amid overall capital market turmoil, to 8.1% of loans outstanding, up from 5.9% on the previous period. As a consequence, there was some pain among private debt purveyors then.
One fund, affiliated with buyout titan KKR, got slammed in the first quarter by loans to a retail chain. FS KKR Capital reported that its portfolio had lost 11%, thanks in part to the $54 million in loans it had given 169-store Art Van Furniture, which filed for Chapter 11 in March. Around the same time, Hadrian’s Wall Secured Investments, which made loans to smaller British businesses, announced it was folding operations after “material” losses on investments in two biomass companies.
But for the third quarter, defaults eased back to 4.2%, according to the law firm Proskauer Rose, which tracks the asset class. Compared with junk bonds, which Moody's Investors Service says have an 8.5% US default rate, private debt looks to be less risky.
Private debt’s rebound “to the levels that we saw in the spring really speaks to the resilience we are seeing in the market,” said Stephen Boyko, co-chair of Proskauer’s private credit group. “After a few slow months, the market has come roaring back, and we expect it will continue through the fourth quarter.”
Nevertheless, a large downside to private debt is its lack of liquidity. Other significant asset classes don’t have that problem. Leveraged bank loans are bundled into collateralized loan obligations (CLOs), which large players can buy and sell. But if you need to bail out of a private loan, good luck.
What’s more, said Stuart Katz, CIO of Robertson Stephens Wealth Management, private loans are more difficult to be restructured if they default. Worse, too often the borrowers carry burdensome debt loads, with multiples like net debt that can range as high as five times earnings before interest, taxes, depreciation, and amortization (EBITDA). That can weigh heavily on a debt holder and endanger its business performance.
And many borrowers, Katz warned, don’t have capital structures that can cushion a company in times of stress, such as a solid equity component. “Fixed income is supposed to provide ballast” to a portfolio, he said. Thus, it’s wise for investors to ensure that the debt issuing funds they’re betting on have solid track records—and that the funds ensure borrowers are subject to strong covenants (restrictions of corporate behavior, such as on how much more debt is permissible).
Success Story
The Arizona pension program’s fine record demonstrates how private debt can be a serious advantage if done properly. The program created a stand-alone private credit operation in 2012. Arizona’s investment committee last year explained its penchant for private debt by writing that, due to low rates and narrower spreads for publicly traded debt, “We don’t believe that attractive investment opportunities exist in the public credit markets.”
With annual returns hovering around 10% for the past five years, the goal of extracting good performance from this asset class has been amply realized. “We want a 9% to 10% IRR for an extended period” from private credit, said Al Alaimo, senior fixed income portfolio manager for the plan, referring to internal rate of return. Private debt also provides “stable performance,” he added. One Arizona hallmark is its insistence on solid covenants for its loans
The state’s plan uses the S&P/LSTA Leveraged Loan index as its private-debt benchmark, plus 2.50 percentage points as “an illiquidity premium.” In other words, the asset class needs to generate that much more over the index because managers can’t simply unload these loans if they need the cash.
Arizona has beaten the bogey handily. In the first quarter, for instance, the benchmark was down 12.5% and the plan’s private debt holdings were off just 1%. Reason for the difference: Since the loans the plan holds aren’t liquid, these are buy-and-hold assets, and the only way for this category to lose would be if there were defaults.
At this juncture, though, Arizona’s private debt segment has only a 4% default rate. Alaimo indicated that the plan believes these loans will recover once the economy returns to normal.
For investors, Thornburg’s Brady said, “you can see why private debt is alluring.”
Related Stories:
CalSTRS Allocates $1 Billion to Direct Lending Firm Owl Rock Capital
Canada’s Public Sector Pension Manager Adds New Private Debt Chief
More Competition, Challenges for Direct Lending, Private Debt Market in 2017