The use of alternative investments in investor portfolios has increased dramatically over the last decade. Record low-interest rates and high public market valuations have pushed Canadians toward private markets in increasing numbers because of their naturally higher yields and lower historical volatility.
One vertical of private markets, private debt, now has an ever-improving value proposition. While public markets see fixed-income valuations stretched near record highs, private debt continues to provide attractive yields and high margins of safety. As inflation fears heighten, the relative lack of interest rate sensitivity provides a solid measure of protection. The case for private debt has strengthened to the point where it has become a defensive driver of returns, acting as both an anchor and an engine. The asset class has many attractive characteristics:
- Low correlations with public market instruments,
- Strong risk-adjusted returns,
- Lower interest rate sensitivity than traditional fixed income, and
- Portfolio-level diversification.
Institutions have been diversifying into private markets over the last few decades, but the composition of investors is changing as savvy retail investors take up the charge. It is increasingly common to see portfolios include private debt as a core holding in Canadian fixed-income sleeves. With higher yields and lower loss rates than their public counterparts, private credit instruments serve as a cornerstone for traditional fixed-income sleeves.
Private credit is a loan extended to a non-public company.The Cliffwater Direct Lending Index (CDLI) and the Cliffwater Direct Lending Index-Senior (CDLI-S) are used to represent the private credit market.
Yield is calculated by taking the average yield of the loans within the respective index.
Average drawdown is calculated as the average of each years’ best performing quarter less the worst performing quarter.
Time period is 03/31/2011 – 03/31/2020.
Gaining exposure to the asset class is not as simple as it sounds. Deal flow is highly coveted, and the manager space is extremely competitive. On top of this, passive approaches are impractical. To gain access to the best originators, significant expertise, research, and manager diligence is required.
Manager Selection in Inefficient Markets: A Tale of Two Cities
Market inefficiency can be a great thing for active managers, providing ample room to add value to the investment process. Since private markets may be considered to be somewhat inefficient, strong management becomes an important differentiator.
From a direct lending perspective, many of the companies in the lower middle market lack the scale for public bond issuance and may be unwilling to facilitate cumbersome ongoing reporting requirements. Without a public issue, there is no consensus validation mechanism for what a loan would be worth to a third party.
While the market is primed for skilled managers to shine, a new issue arises: How do you assess a manager’s strength? Good managers provide significant value over poor managers but determining the quality of managers is no simple feat. Market inefficiencies can be a double-edged sword – leading to the best of times for the most skilled manager and worst of times for the rest. Since 2006, the spread between the best and worst managers based on vintage year averaged 11.4%.
Manager Dispersion by Vintage Year: Private Debt
Evaluating Asset Managers
Vetting managers is both an art and a science. The opaque nature of less regulated private funds creates several hurdles. For example, determining a manager’s edge and understanding the risks present in the underlying strategy requires an understanding of both lending fundamentals and empirical data in the relevant market segment. One common structure in the marketplace is an evergreen structure. From a convenience perspective, evergreens do not have a planned maturity and can re-invest investor capital once underlying investments mature.
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Differences in structure can lead to nuances in the due dilligence process. While there is tremendous variation within each grouping, these two types of offerings demand special attention.
Traditional funds that call capital and mature require investors to evaluate the manager’s previous vintages comprehensively. As capital is returned post-maturity, internal rates of return (IRRs) and multiple on invested capital (MOIC) figures are realized, which provide a wealth of information about the manager’s ability when analyzed in context and with experience. Attribution and measurement of previous performance can provide clarity around manager skill and execution capabilities.
Similarly, evergreen structures that offer day-one exposure to a pool of loans require ample vetting of mark-to-market practices to ensure prices reflect the reality of the loan book. Although a formal methodology does exist, there will be subtle differences because of the heterogenous nature of private funds.
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While due dilligence is generally extremely quantitative with respect to public market instruments, due dilligence in the private market sphere is more much qualitative and involved. On the operational side of the analysis, there needs to be consideration of the quality of service providers. Custodians, fund adminstrators and auditors play an integral role in the functioning of private funds. Calls to third-party fund administration to verify that assets exist, and how appraisals of net asset value are conducted, are steps in the process that are unique to private investment. Beyond service providers, evaluating risk management policies and procedures help determine how the fund is able to handle both market and idiosycratic stressors. Allocation decisions and commitment weights need to be decided after ample quantitative and qualitative due dilligence.
Managing a book of private debt funds also requires thoughtful consideration of the weights of various strategies against the current phase of the economic cycle. Defensive strategies, such as direct lending, may anchor a fund through a full cycle, while distressed credit provides higher torque in recoveries. Long lead times in making commitments add another degree of complexity, requiring investors to plan ahead and manage liquidity.
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Purpose Specialty Lending Trust
Making allocations directly to private managers is not the only option for exposure to private debt. Purpose Specialty Lending Trust (SPEC), Canada’s first global multimanager private debt fund, provides access to a curated pool of top managers. Purpose has relationships with some of the top managers in the world, has negotiated fee discounts, and has experience managing liquidity across multiple fund vintages. The fund targets an 8% after-fee annual return with no incentive fee, serving as an actively managed access point to a well-diversified pool of private fixed income.
Purpose Specialty Lending Trust: Managers
We believe the credit environment looks incredibly strong today, with 2021 becoming a tale of tailwinds (pun intended). Businesses remain flush with cash and eager to opportunistically take advantage of low rates to expand their core business. Consumers have as much dry powder as ever, with fiscal policy and lawmakers pushing out stimulative policies to protect their constituents.
Private lenders are built to take advantage of strong secular tailwinds, making this one of the best environments for the asset class in over a decade. While the asset class may be viewed as opportunistic, the low-volatility and defensive nature of private debt help build the case for a true cornerstone holding.
When constructing portfolios, the inclusion of thoughtfully selected alternative investments aids risk-adjusted performance and increases portfolio diversification. For those new to the asset class, as well as the faithful incumbents, its time to look beyond public markets for fixed-income exposure.
— Michael Scott, Investment Analyst
All data sourced to Bloomberg unless otherwise noted.
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