Guest Comment: Mark Jarosz's Primer on Private Debt

Today I have a guest comment on private debt from Mark Jarosz, a specialist in the field who was most recently with CPP Investments' Credit Investments team.

Before I get to his primer on private debt, Harriet Agnew of the Financial Times reports traditional asset managers race to expand private investment alternatives:

Last month, Franklin Templeton agreed to buy Alcentra, one of Europe’s largest credit managers, from BNY Mellon for up to $700mn. The deal marked the latest in a string of acquisitions in one of the hottest areas of the asset management industry: private assets.

Traditional asset management groups have been racing to expand their offerings in these alternative investments — a broad spectrum that includes private equity, private debt, infrastructure, real estate, venture capital, growth capital and natural resources.

For the fund managers, private assets are appealing because they typically command higher fees and lock up investors’ capital for several years. But robust client demand is also a tailwind, as investors seek to juice up their returns and diversify away from their core holdings in equities and bonds, now that the 60/40 balanced approach — previously a mainstay of investment portfolios — is facing some serious strain.

Amid a similar trend sweeping across the US, European groups including Amundi, Schroders, Fidelity International, Edmond de Rothschild Asset Management and Abrdn have flagged private assets as a key area for expansion. They are turning to acquisitions and aggressively hiring, resulting in a fierce talent war between mainstream asset managers, alternatives specialists, and pension funds that are trying to build expertise in-house.

The business case for the traditional houses is clear: they need to boost profitability and tap into new avenues of growth at a time when cheaper exchange traded funds are taking market share, and a downward pressure on fees is eating into their margins.

“Private assets are an area of high client demand,” says Georg Wunderlin. global head of private assets at Schroders, which last year bought a 75 per cent stake in renewable energy specialist Greencoat for £358mn, and vowed to double the size of Schroders Capital, its private capital business, to £86bn by the end of 2025. “It’s important in terms of asset allocation. Alternatives have stopped being alternative — they are core for our clients.”

Data provider Preqin predicts that the overall size of the private capital industry will grow from over $10tn last year to almost $18tn by 2026. Goldman Sachs forecasts that it could even grow to as much as $30tn by then, noting that the retail and wealth markets are key areas where fund managers could make inroads with private capital strategies.

For example, Fidelity International bought a minority stake in Moonfare, a digital investment platform for high quality private markets funds, and has signed a distribution partnership to allow banks, family offices and their advisers to access private markets funds on behalf of their clients.

On the institutional side, these strategies are well-suited to customisation for clients — such as liability matching or targeting non-financial goals for an investment, like social impact.

The opportunity set of potential investments within private capital has surged over the past decade or so.

Since the financial crisis, there has been a structural shift in how the economy is financing itself. “Large parts of the economy are now financed by the balance sheets of asset managers and private equity in a way that used to be financed by the banks,” says David Hunt, chief executive of investment management business PGIM. “This has resulted in huge opportunities in private assets for investment managers.”

Meanwhile, companies are staying private for longer, and the war in Ukraine has accelerated the urgency for the renewable energy transition, with huge opportunities for private capital to step in and help finance the shift.

Fund managers are also touting some private assets strategies as a hedge against rising inflation. “With inflation becoming a theme again, these strategies keep their pricing power,” says Christophe Caspar, chief executive officer, Edmond de Rothschild Asset Management. He pointed to real estate debt strategies that can increase their rents to keep up with rising interest rates, or infrastructure debt funds, where a part of the debt is linked to inflation, offering some protection for investors.

But sceptics caution that the push by mainstream asset managers into private assets is fraught with potential challenges.

It puts them into competition with private equity groups such as KKR, Blackstone and Apollo, which have long track records after building up vast, diversified businesses over decades. In a gold rush to make inroads in private assets, valuations have surged and traditional groups risk overpaying for deals or talent.

“We’re entering a stage where valuations and activity levels have been high,” says Andrew McCaffery, global chief investment officer at Fidelity International, which entered the private credit market last year and has been expanding the team. “This is more of a challenging world.”

Others point out that, culturally, mainstream asset managers are very different to private capital businesses, with different pay structures, timeframes and decision-making processes.

“Private assets are much less liquid and so, if you buy badly, you’re stuck with bad investments for much longer,” says Julia Hobart, a partner at consultant Oliver Wyman in London. “The ramifications of getting it wrong are much higher.”

I'm leading off with this article to show you how popular private debt as an asset class has become.

With traditional asset managers increasingly entering the sector, there is going to be more capital chasing deals and that can be good and bad. 

More competition is welcome but I tend to agree with skeptics who think the investment horizon of traditional asset managers isn't well suited for these type of private market investments. I also worry that valuations on deals will get a lot more stretched and inevitably, some traditional asset manager will suffer steep losses, maligning the entire industry.

Anyway, today I have an excellent guest comment on private debt from Mark Jarosz.

Mark is a private investments professional covering both private and structured credit across industries and the capital structure. He was most recently with CPP Investments' Credit Investments team and has experience with corporate bonds, leveraged loans, structured credit, CLO's & bank capital instruments. 

Mark reached out to me through my blog and after a few discussions, I was very impressed with his knowledge and experience and asked him if he'd be up to writing a primer on private debt and then follow up with another comment on strategies.

This is his first part on understanding private debt: 

WHAT IS PRIVATE DEBT?

Private debt is a form of lending provided by funds and is often referred to as direct (or private) lending because it is not issued or traded in the public markets and the debt is not provided by the regulated bank market. The massive growth in this asset class coincides with explosive growth in private equity, another major alternative funding source. Today, on average, roughly 80% of private credit capital comes from institutional investors.

Private debt has been viewed as a potential solution for institutional investors confronting low yields, heightened market volatility and rising interest rates. Investors are turning to alternative assets in search of high current income, low correlations with public markets and lower default risk than yield spreads would imply. Senior leveraged loans are among the fastest growing alternatives as banks reduced their exposure to middle market borrowers. With floating-rate coupons, leveraged loans offer the potential for increasing income with less price sensitivity as interest rates normalize.

Institutional investors remain underinvested in private debt given they lack familiarity with its attractive risk-return profile compared to traditional fixed-income assets. However, recent market trends are driving demand for private debt overall.

First, institutional investors are struggling to achieve targeted rates of return amid historically low yields on traditional fixed-income investments. Their capacity to increase risk in search of returns is limited by their liabilities and, for insurance companies by capital requirements.

Second, structural changes in bond markets, including decreased liquidity and rising asset correlations, are changing how investors think about liquidity and risk. Long-term investors are more willing to trade liquidity for additional yield (the “illiquidity premium”) and lower volatility to improve asset-liability matching.

Third, Banks have reduced lending to middle market companies in response to higher capital charges for middle market loans.  As a result, asset managers are lending to middle market companies that have offered investors both higher yield and lower default risk in exchange for illiquidity.

Private debt’s track record of better risk-adjusted returns and the range of yield and risk characteristics across different categories make it an attractive alternative to traditional fixed-income and equity investments. Potential advantages include:

• Yields significantly higher than offered by similarly rated public debt to compensate for illiquidity
• Lower default and loss rates historically, compared with public high-yield bonds due to strong covenants, management oversight and other safeguards
• Diversification benefits based on generally low correlations with traditional assets
• Lower interest-rate risk for leveraged loans using floating-rate structures with shorter duration

MIDDLE MARKET DIRECT LOANS

The vast majority of mid-market loans are broadly syndicated and issued by banks to companies with $50 million in EBITDA. Senior in the capital structure with first claim on the borrower’s assets, syndicated loans are distributed by banks to large groups of institutional investors. Since they are traded on secondary markets, syndicated loans are more liquid - resulting in lower yields and higher volatility, compared with direct loans. Differences in how direct loans are structured and issued have made this market attractive for investors.

Direct loans generally serve smaller companies with EBITDA ranging between $10 million and $50 million. Lenders in this market consist of small groups of generally up to 10 investors, known as “clubs”, that structure loan packages for a single borrower. Private “club” loans are generally held to maturity rather than traded, which has reduced their volatility. Like bank loans, direct loans are senior in the capital structure, but they also benefit from protections that help to reduce credit risk.

Key factors that account for the attractiveness of middle market direct loans:

• The illiquidity premium. Direct loans have enjoyed a return advantage because of the illiquidity premium. This extra yield compensates investors for holding loans that are not publicly traded and cannot be sold quickly. In addition, direct loans have offered better default and loss protection than syndicated loans. Issuers generally conduct strict due diligence, work closely with borrowers, and structure loans conservatively with less leverage, higher interest coverage, and tighter covenants.

• Banks pulling back created an opportunity in direct lending. Structural changes are generating demand for nonbank loans offering attractive investment characteristics. Although banks still dominate corporate lending, they are pulling back from the lower end of the middle market, reducing their exposure to these loans in response to industry consolidation and increased regulation. Facing uncertain financing, middle market companies are willing to pay higher interest rates for access to capital, allowing nonbank lenders to offer higher investment yields. At the same time, banks have shifted toward larger syndicated loans that are traded and subject to market volatility. In contrast, direct loans are generally held to maturity rather than traded, resulting in lower volatility.

• Private equity growth suggests continued demand for direct loans. Private equity deals and refinancing are expected to generate more than $1 trillion in new loan demand over the next several years. Regulatory limits on leveraged lending will prevent many banks from refinancing existing loans, forcing borrowers to turn to nonbank lenders.

PRIVATE DEBT’S POTENTIAL TO IMPROVE PORTFOLIO RISK-ADJUSTED RETURNS

Private debt offers institutional investors the potential to improve performance by diversifying the sources of return and risk associated with traditional asset classes. Private debt can offer incremental returns by providing exposure to additional risk premiums: illiquidity, manager skill in less efficient markets, and structural changes, such as the decline in bank lending. Direct loans, for example, can diversify portfolios by providing exposure to the illiquidity premium, reducing reliance on risk factors associated with traditional fixed-income or equity assets. Private debt with floating-rate structures offers the potential to improve yield and reduce interest rate risk as alternatives to fixed-rate corporate and high-yield debt.

Smaller middle market loans offered distinct advantages over larger, broadly syndicated loans and high-yield bonds:

• Despite lower default risk, middle market loans offered a higher current yield than broadly syndicated loans because they're relatively illiquid. 

• Middle market loans offered a significantly lower default rate compared with broadly syndicated loans and high-yield bonds respectively. In addition, middle market loans had lower loss rates and higher recovery rates than broadly syndicated loans due to more conservative structuring and other protections.

• Middle market loans offered higher risk adjusted returns based on Sharpe ratio than broadly syndicated loans and high-yield bonds.
  

Diversification

• Leveraged loans offered strong diversification benefits: negative correlations with global bonds and moderate correlations with stocks. Correlations with high-yield bonds were higher because both categories are below investment grade.

• Middle market loans had lower correlations with traditional asset classes than broadly syndicated loans and high-yield bonds.

 

MEZZANINE LOANS: HIGHER YIELD FOR JUNIOR DEBT

Mezzanine loans are a more specialized form of private debt usually invested as unsecured subordinated debt or second lien term debt and have unique advantages over other fixed income sectors. These loans typically are used in leveraged buyout transactions to fill the financing need between the sponsor’s equity capitalization and optimal senior debt levels. Mezzanine loans have offered higher yields reflecting their junior debt position, but their performance has implied less risk than spreads would suggest. To promote successful outcomes, private equity sponsors historically have provided financial, operational and governance support to their portfolio companies issuing debt. As a result, mezzanine debt has demonstrated better risk adjusted returns than other forms of private and public debt.

The private debt market can be divided into broad segments based on liquidity, seniority in the capital structure, loan size and floating or fixed rates. Yields vary depending on liquidity and credit risk: approximately 4% to 5% for broadly syndicated bank loans, 6% to 8% for middle market senior loans, and 9% or more for mezzanine, compared to 6% to 7% for public high-yield bonds. 

Since 2012, banks' share of corporate lending has again lost ground to non-bank sources of credit because of growing demand from yield-seeking investors, against the backdrop of prolonged low interest rates, as well as a rise in the number and scale of private equity sponsored enterprises. Investors hunting for yield are willing to assume greater credit and illiquidity risk, increasing the attractiveness of business development companies, CLOs and private credit funds. And over the past year, investor demand for floating-rate loan assets has grown along with expectations that interest rates will rise.

At the same time, banks have retreated from riskier lending segments such as leveraged finance, a trend reinforced by more restrictive Federal Reserve leveraged lending guidelines introduced in 2013. This has contributed to the steady climb in non-banks' share of corporate lending, which has accelerated over the last two years. And non-banks' share of corporate lending is now equal to around 63% of the $3.1 trillion market as of year-end 2021 or just under $2 trillion outstanding.

RISKS

Credit risk is important given most private debt categories are below investment grade, although the risk of a credit event can be lower than yield spreads would suggest. Default and loss rates can vary widely depending on the category, industry, and deal structure. Private debt requires thorough due diligence to understand risks relative to investment objectives.

Depending on the category, private debt’s credit risk can be lower than similarly rated public debt. While default rates have been lower for middle market loans, loss and recovery rates have tended to be significantly better for leveraged loans overall, compared to high-yield bonds. Private equity sponsorship also tends to reduce default and loss risks, given the sponsor’s incentive to provide financial and management support.

Illiquidity varies among private debt categories. Among leveraged loans, broadly syndicated loans are frequently traded and more liquid. Illiquidity increases for middle market loans, direct “club” loans and mezzanine debt because they are infrequently traded. Less liquid loans offer higher yields in the form of an “illiquidity premium” attractive to investors for whom liquidity is a lower priority.

Risks related to changes in prevailing interest rates vary depending on loan category. Leveraged loans have floating rates that vary based on changes in the underlying base rate allowing investors to earn higher coupons as rates rise. Their floating rates imply a lower duration and less risk of loan values being hurt by rising rates. In contrast, mezzanine debt carries fixed rates that subject the loan’s value to greater risk if rates rise.

I want to thank Mark for writing such a great comment going over the benefits and risks of private debt.

It's rare I get such institutional quality comments so when they come my way, I welcome the opportunity to publish them.

I also want to make it clear, Mark contacted me and these are his views, not those of CPP Investments' Credit Investments which he spoke very highly about. 

Lastly, I recommend you read Antares Capital's comment on private debt featuring insights from its CEO, Timothy Lyne. You can download this two-page report here and view it below:

I note this part:

Interestingly, in a May 2022 research paper from investment and research firm Cliffwater on the topic of lessons learned from US stagflation experienced in 1973-1982, the firm notes that, “Credit, apart from interest rate duration, was largely unaffected, perhaps because inflation deflates debt obligations.” Given private debt’s limited interest rate duration risk due to floating interest rates, the paper goes on to recommend a high 20% portfolio allocation to private debt in its “Stagflation Portfolio”—a portfolio designed to offer inflation protected asset allocation with high inflation beta and high expected risk-adjusted returns. It is notable that this 20% allocation to private debt is tied with US stocks for the highest allocation among various asset classes. Private debt demonstrated its resilience through the shock of COVID-19 in 2020-2021. Hopefully, a new stagflation stress test is not in the making, but if so, private debt may prove itself to yet again be an all-weather friend.

And note this on their outlook at the end:

Our pipeline of deals has picked up since its lows in January that had followed a blow-out year end 2021, but activity still modestly lags its year-ago pace. High volatility, falling stock markets in the face of war, and heighted economic uncertainty have no doubt rattled confidence for dealmaking. However, on the positive side, earnings results for companies in the S&P 500 have surprised on the upside in Q1 2022. Also, while an increasing percentage of forward guidance has become negative, with inflation a hot topic of concern, earnings are still forecast to grow almost 10% in 2022 as of mid-May, according to FactSet. Meanwhile, public market valuations are becoming more attractive, which could spill over into private markets where PE is looking to invest high levels of dry powder. Supply chains, which have been a source of pain, are increasingly becoming a source of PE investment opportunity. In short, we believe conditions look ripe for a renewed pick up in M&A activity should volatility abate. 

As far as attractiveness of private debt, we believe the asset class tends to shine best during times of uncertainty, owing to some of its key attributes such as lower volatility (e.g., versus broadly syndicated loans and high yield); limited downside risk at the top of the capital structure with low LTVs; floating interest rates that limit duration risk while offering higher yields should rates climb, and floors (typically) on the downside should rates fall; and significant yield premium at a comparable level of credit risk versus more liquid debt. 

Of course, performance can vary significantly among lenders, particularly during times of stress. We believe having: 1) strong originations and a very large, diversified portfolio of lead-managed incumbent opportunities that allows for selectivity among the best credits; 2) a first lien focus with strong PE sponsor support; 3) strong credit discipline, portfolio management, and experience through multiple cycles; and 4) a dedicated and experienced workout team to maximize recoveries—are all critical to favorable outcomes.

As I explained in my last market comment on bonds, I am worried that earnings estimates remain too high and as the US economy slows considerably in the second half of he year, an earnings recession looms.

Still, Antares Capital is one of the best mid-market direct lenders in the world, and their portfolio is well diversified and designed in a way to mitigate downside risks and deliver favorable outcomes.

There is a reason why CPP Investments bought Antares years ago, arguably its best investment ever, and why IMCO and other large institutional investors are invested with them. 

Anyway, hope you enjoyed reading this comment and let me once again thank Mark Jarosz for his tremendous insights in his primer.

I'm looking forward to reading his follow-up comment on strategies and execution. 

Below, Mark Attanasio, co-founder and managing partner at Crescent Capital and Milwaukee Brewers Owner, explains why he sees the best opportunity now in his 35 years in private credit and discusses expectations for Federal Reserve tapering and the market transition away from Libor. He speaks with Romaine Bostick at the Milken Institute's 2021 Global Conference in Los Angeles. 

This interview was done in 2021 but listen carefully to his comments at the end. 

Also, the Greenwich Economic Forum is at the leading edge of the private credit revolution. At the 2021 GEF, they assembled some of the leaders of this new alternative investment asset class to discuss private credit, its opportunities and risks. 

Panelists include Kipp deVeer, CEO, Ares Capital Corporation and Mark Lipschultz, Co-Founder, Blue Owl Capital and it is moderated by Jay Madia, Head of Risk Assets, AXIS Capital.