In the wake of the COVID-19 pandemic, one of the most common responses by governments across the globe has been to slash interest rates. In South Africa, our repo rate has been reduced to a historic low of 3.5%, equating to a prime lending rate of 7.0%. Internationally, interest rates in many of the world`s largest and strongest economies are now close to zero, or in some cases negative.

One of the downsides to the reduction in interest rates has been a vastly reduced return on the fixed income products that often form a key element of traditional investor portfolios. These portfolios often also include an allocation to equities, many of which have trimmed (or completely cut) the payment of dividends, so as to build cash buffers in response to the pandemic.

The combination of these factors has left many investors in an unenviable cash-flow squeeze. It is in this context that the private debt industry has emerged from the global investment periphery, to become one of the world’s largest and fastest growing alternative asset classes.

At Westbrooke Alternative Asset Management, we have invested more than R3bn across over 100 private debt transactions since 2016 in South Africa, the UK and Europe. Given the levels of global economic uncertainty and volatility, there are instances where private debt returns have offered similar historic returns to equity investments but with vastly improved security packages (e.g. direct security against a tangible asset). This generates an asymmetric risk/return profile for clients and can ultimately assist in solving the cash-flow squeeze conundrum.

Simply explained, private debt is where a loan is made by a non-bank lender and therefore falls into the broader category of ‘alternative debt’ or ‘alternative credit’. The term private debt is used interchangeably with ‘direct lending’, ‘private lending’ and ‘private credit’.

Private debt investments are used for a multitude of purposes, including to bridge property transactions, real estate development, finance business growth, provide working capital and fund infrastructure.

Compared with traditional fixed income, private debt can provide investors with higher yields, portfolio diversification and lower portfolio volatility.

At a high level, the higher returns generated by private debt investments are not always due to an increase in risk, and can be explained by:

  • an illiquidity premium (private loans earn higher returns because they are not listed and investors are therefore required to invest for a prescribed period)
  • a structural/complexity premium (deals are often bespoke and require structuring)
  • an off-market/disinformation premium (due to a lack of an efficient market in the space)
  • the size of loans (as banks have moved resources to larger loans, the mid-market is under serviced and accessibility to cheaper capital is limited).

Although the rise of private debt as an asset class is still in its infancy (especially in South Africa), there are a few access points for sophisticated investors to gain exposure through local alternative asset managers.

While private debt investments may form the foundation for many yield enhancement strategies, alternative asset managers may also be capable of including additional structuring mechanisms in portfolios that ultimately enhance yield. One such mechanism is Section I2J of the South African Income Tax Act, for example. Through Section 121, clients are able to deduct their full investment against their taxable income in the year they invest, thereby reducing their initial net investment amount by up to 45%. As many Section 12J investment strategies pay an annual dividend, the Section 12J tax break has the impact of almost doubling the net yield received by clients.

In respect of all alternative investment strategies, investors should seek out well-established managers who have deep local and international networks, resources, infrastructure and a track record of performance in providing clients with exposure to these compelling and uncorrelated asset classes.

By: Dino Zuccollo   Source: Money Marketing