private debt draws investors with higher yields and favourable risk premiums

Investors stand to realise higher returns from private debt compared to those from equities, and with less risk

Source: BusinessLive

By: Dino Zuccollo

Investing in alternative assets emerged as a prolific trend globally in 2022 as investors searched for yield amid market volatility, a global equity sell-off and rising inflation.

While alternatives enjoyed mainstream adoption globally after the 2008-2009 financial crisis, these investments largely remained on the fringes of portfolio allocations in SA. During this period fund managers had to work proactively to pull investors towards alternative assets and attract fund flows.

However, the challenging macroeconomic conditions that emerged in early 2022 prompted local investors to reassess their options, pushing many towards alternative investments in their hunt for lower volatility, better returns and cash yields beyond those provided by traditional asset classes such as equities, fixed income and bonds.

In addition, alternative investments in private market assets managed by experienced investment teams offer additional benefits, such as diversification, lower correlations to listed equivalents and tax efficiencies.

According to the Westbrooke Alternative Asset Management’s Investing in Alternatives 2022 Wealth Partner Survey, private debt, structured products and hedge funds emerged as the most popular alternatives last year, followed by private equity and venture capital.

Interestingly, 61% of respondents indicated that they plan to increase their allocation to alternatives in future, with the largest proportion (28%) allocating up to 20% of their portfolios to these investments and 16% indicating that they would allocate 30% or more. The majority (55%) focused 60% or more of their alternative investment allocations to offshore markets.

Amid these rising allocations to alternative investments, private debt continues to attract record investment flows based on its increasingly compelling value proposition in the current environment. In fact, private debt funding is one of the fastest-growing alternative investment asset class globally, trailing only private equity and venture capital in terms of volume.

Westbrooke invested about R2.1bn of group and client capital across 61 transactions since January 2022, with more than half — R1.2bn — invested in private debt. Also known as private credit or direct lending, private debt funds provide private loans to small to medium-sized companies via various mechanisms, typically at higher interest rates with shorter, privately negotiated repayment periods compared with traditional vanilla financing options.

Various factors have contributed to the growth in private market lending, most notably an asymmetry between risk and return that is arguably skewed in the investor’s favour amid prevailing market conditions. Consequently, investors stand to realise higher returns from private debt compared with those from equities, and with less risk.

Another important factor relates to the soft macroeconomic environment, which has prompted above-average deal flow in certain jurisdictions as traditional funders take a more cautious approach in certain markets. For instance, the UK market has experienced a significant pullback from banks. These traditional institutions are taking a more cautious and risk-averse approach due to the strong overhang from the Coronavirus Business Interruption Loan Scheme (CBILS).

Banks need to secure positions to avoid losses on CBILS loans, which are only partially backed by the government, as well as other loans. And with businesses struggling in the post-Brexit economy, banks are not writing much new debt. However, businesses need to find more free cash flow to service debt, which has created greater scope for private lenders. In this environment, private debt providers have moved from price taker to price maker, which is creating opportunities for better returns.

In SA, the traditional banking sector is highly competitive but more risk-averse, so does not play in certain markets and requires more involved credit approval processes. This market dynamic creates space for private debt providers to play in areas where banks like lending to lenders or serving established mid-market businesses. Private debt providers are also ideally positioned to serve businesses requiring more innovative and quicker capital solutions.

The attraction of private debt for investors is a mix of inflation-beating returns and more reliable income streams, coupled with the ability to mitigate risks through direct security, a lack of mark-to-market volatility and investment protection with more favourable risk premiums, which has become paramount in the volatile investment environment.

When private debt providers understand the complexities at play and perform their due diligence when assessing borrower-specific risks and quantifying market risks, the potential emerges to move at speed to secure loans and achieve similar returns compared with equity without the same risk.

Compared with traditional loans, the shorter loan repayment terms on private debt — typically 18-24 months — add to the risk-adjusted return profile by reducing lock-in and improving liquidity. Moreover, by taking a partnership approach and closely monitoring loan covenants to identify early warning signs of stress, we are able to further reduce risk exposure by working with borrowers to restructure debt or find other solutions to ensure repayment, rather than simply pulling the plug.

Private debt providers have the scope to participate in the middle funding layer in financing deals by providing second charge or mezzanine funding, which opens opportunities to blend private debt and equity as a form of hybrid capital. This allows private debt providers to play in a protected space within the capital stack with enforcement rights on the secured debt, with additional upside from an equity co-investment, a profit share agreement or a warrant for the privilege of providing the mezzanine debt that essentially unlocks the transaction.

Given the current market conditions, which are characterised by sustained market volatility, and with inflation likely to persist well into 2023, private debt providers won’t struggle to find opportunities.