Doubling Down on Private Debt Amid the Pandemic?
Sovereign wealth and public pension funds are bolstering their funding of private debt, with close to $9 billion committed since the COVID-19 crisis as they hunt for yield and their ample liquidity allows them to take on more risk than banks.
Most recently, Saudi Arabia's Public Investment Fund said last week it had become an anchor investor in a new $300 million shariah credit fund. Queensland Investment Corp (QIC), an investment arm of the Australian state, last month became the latest state-owned investor to launch a private debt team.
Last year marked a tricky time for the asset class. Private- debt fundraising declined substantially and commitments to direct lending, the largest chunk of it, fell by more than half.
But as the uncertainty surrounding the pandemic lifts, activity is expected to pick up in 2021. State-owned investors with their deep pockets and long-term investment horizons are at the forefront.
"Now we are seeing real interest from sovereign and pension funds that wasn't there a couple of years ago," said Antoine Josserand, head of business development at pan-European private credit manager Pemberton Asset Management, which counts both types of investors as clients.
"It's a reflection of the fact that they recognize the merit in terms of diversification of their alternative asset bucket. Others, as part of their fixed-income portfolio, are trying to find the best relative value they can in the current negative rate environment."
With interest rates near zero in the pandemic's aftermath, many are tempted by the yield pick-up offered by private debt, with estimated returns over a 20-year period of close to 9%, more than U.S. equity or corporate high-yield benchmarks, according to PitchBook data.
"They are doing it because conventional asset classes are not giving the returns they have historically delivered," said Andy Cairns, head of corporate finance of First Abu Dhabi Bank, the biggest lender in the United Arab Emirates, home to state-owned investors Abu Dhabi Investment Authority (ADIA) and Mubadala Investment Co, both active in private debt.
Many funds choose external partners to manage their portfolios or invest alongside. Others, such as ADIA and now QIC, also have in-house specialists. QIC's team will look after the origination, analysis and management of private debt, initially in infrastructure assets.
The operations will act as a source of financial stimulus for sectors like infrastructure, real estate and companies rebuilding after COVID-19, QIC said.
The asset class has grown from 2% of portfolios in 2015 to 3.2% in 2020 among the top 10 state-owned investors, according to Global SWF, an industry data specialist. State-owned funds have allocated close to $9 billion to private debt since the pandemic, according to its data.
"Sovereign investors benefit from lower liability constraints that enable them to take on more liquidity risk than banks," Global SWF said.
Across all investors, fundraising for distressed debt and credit special situations, such as for growth capital and balance sheet restructurings, rose during 2020 to $37.3 billion, PitchBook data showed.
Qatar Investment Authority is generating strong returns on a multi-billion dollar bet it made on distressed debt, sources told Reuters last month.
So far, there has been little sign of investors being burned, with no wave of payment defaults after the COVID crisis. Still, mark-to-market values for private debt funds fell during the pandemic's immediate aftermath.
"Early indications point to a modest recovery in subsequent quarters, but the full extent of the damage to portfolios won't be known until later in 2021," Dylan Cox, a private capital analyst at PitchBook, wrote in a research report.
Interestingly, three weeks ago, PitchBook released its 2020 Annual Global Private Debt Report where it stated private debt is primed to bounce back in 2021 after a pandemic plunge:
The number of new private debt funds dropped to a nine-year low in 2020, while the amount of new capital raised sunk to its lowest point in five years. Some investors were wary of the market chaos caused by the COVID-19 pandemic. Others had coffers that were already well-stocked after a glut of major funds in recent years.
But last year's decline is more likely to be a blip than the beginning of a significant shift in the market, according to PitchBook's 2020 Annual Global Private Debt Report, sponsored by Tree Line Capital Partners. Among the other key takeaways:
A slump in direct lending fundraises played a key role in last year's decline, with new fund count falling more than 50%
Other major strategies, including distressed debt and special situations funds, saw annual increases in capital raised
Quarterly IRR for private debt funds was -6.2% in Q1, a sign of the toll taken by the pandemic on fund valuations
A quarterly IRR of -6.2% in Q1 2020 isn’t bad given what unfolded in markets last March.
I've already discussed pensions' love-hate relationship with private debt.
A full discussion of the asset class is beyond the scope of this post but I do recommend you read a short comment by Next Edge Capital on The Case for Private Lending.
In fact, here is the gist of that comment, first on the benefits and who invests in the asset class:
After I worked at PSP Investments, I worked a couple of years at the Business Development Bank of Canada (BDC), so I saw firsthand the risks and opportunities of private lending to Canada's small and medium sized businesses (the BDC is a complementary lender to banks and takes part in syndication deals too).
For regulatory and other reasons, big banks retrenched from direct lending and that created a void large private equity funds and pension funds filled.
And this is happening all over the world. For example, last summer, Bloomberg reported how KKR & Co., Asia’s largest private equity investor, said the region’s entrepreneurs are seeking more direct loans as the coronavirus pandemic dries up other avenues of funding.
Flush with liquidity, large private equity funds are only too happy to lend to cash starved businesses, for a nice yield, of course.
If anything goes wrong, they structure the loans in ways to make sure they and their investors are protected as much as possible.
Now, very large Canadian pensions invest with these large private equity funds doing direct lending and some of the really large ones, like CPP Investments and PSP Investments, have their own highly sophisticated private debt operations internally.
In fact, my sources tell me what David Scudellari and his team do at PSP Investments is extremely sophisticated and their private debt operations are second to none. Others tell me the same thing about John Graham and his team at CPP Investments, they really know the private debt markets extremely well.
In any case, all of Canada's large pensions are involved in one form or another in private debt and the reason is simple, record low bond rates are forcing them to take risks to make up for the yield shortfall from traditional fixed income securities, including high yield bonds which yield less than 4%, a record low.
Are there risks in direct lending? Of course there are, the economy can tank, borrowers can have trouble meeting their obligations but sophisticated teams working at Canada's large pensions know all this, they diversify their portfolios by regions and sectors.
In a post-pandemic world, the demand for direct lending is only going up, which is why you're seeing large sovereign wealth funds and pensions double down on private debt.
Now, to be sure, with all this money coming into the asset class, competition for deals is heating up and with that, prospective returns are diminishing.
Again, this is why those who run more sophisticated operations internally are much more solid than those who over-rely on external funds to meet their private debt targets.
Also, a couple of days ago, I covered AIMCo's 2021 long-term asset class forecast and they wrote this about private debt:
I think I'll wrap it up there, if you have anything to add, you can email me at LKolivakis@gmail.com.
Below, on "Bloomberg Money Undercover", Bloomberg's Lisa Abramowicz talks with Randy Schwimmer, head of capital markets at Churchill Asset Management. The firm, an affiliate of Nuveen, has $6.8 billion in committed capital under management as of December.
Mr. Schwimmer explains why private credit has nothing to do with systemic risk. Great insights, listen to what he says.