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With private debt well-positioned to navigate the difficult market headwinds, institutions – including hedge funds and traditional managers – are moving into the asset class.
Post-pandemic hedge fund performance has been solid, with the industry delivering strong returns against a backdrop of struggling global equities and bonds. In 2021, the industry produced returns of 10.3% which prompted a surge of investor inflows, with AuM rising to above $4.01 trillion1. Although hedge funds generated positive performance last year, managers are conscious that 2022/3 will not be without challenges. Fueled by COVID-19 and now the Russia-Ukraine war, hedge funds will need to navigate the perils of inflation and recessionary risk. As a result, a growing number of hedge funds are diversifying into new strategies – such as private debt – which are well-positioned to withstand some of these difficult market headwinds.
A similar story is happening in the traditional asset management world, where a combination of tough macro conditions; increasing costs; and growing competition from passives is heaping pressure on the industry. In response, some firms are launching private debt strategies as a means by which to overcome these issues . In addition to the diversification benefits, private debt can also help traditional fund managers differentiate themselves from some of their peers.
According to Preqin, the private debt industry has grown on average by 13.5% annually over the last decade, with the sector projected to enjoy a CAGR (compounded annual growth rate) of 17.4% between 2022 and 2026, in what should make it the second largest private capital asset class – after private equity – by 2023. Right now, Preqin says the private debt industry manages $1.21 trillion (as of October 2021), but it anticipates AUM will double to $2.69 trillion by 2026.
These managers are likely to attract interest from investors, many of whom are seeking out counter-cyclical opportunities. Preqin notes that 36% of investors are attracted to private debt because it provides them with a reliable income stream, while 37% cited the asset class’ high risk adjusted returns as the most compelling reason to allocate.
Accordingly, many firms are launching private debt vehicles to widen their sources of returns and broaden their underlying investor demographics. But why is private debt so compelling for asset managers?
In a low interest rate environment, the junk bond market is normally an enticing place for corporates to borrow, but it is becoming markedly less so as inflation picks up and the Federal Reserve looks to tighten rates. In response, companies are increasingly turning to private debt for financing. The same rings true for leveraged buyouts (LBOs) as private debt managers underwrite ever larger transactions, a practice which has historically been dominated by investment banks.
There are other opportunities for private debt too. Ever since the global financial crisis and subsequent eurozone sovereign debt crisis, banks globally have been trying to offload problem loans from their balance sheets. Overall, banks – up until March 2020 – had successfully removed NPLs (non-performing loans) from their books, many of which are being acquired by private debt. Manager appetite for NPLs is driven primarily by performance, with some assets potentially yielding double-digit returns at a time when alpha is hard to come by.2 Research by Ashurst in 2018 revealed that most investors reckoned Greek NPLs, for example, would net them internal rates of return (IRR) of between 10%-15%.
While COVID-19 resulted in a number of NPL sales being put on temporary hiatus, the market has since recovered. According to Clifford Chance, activity in Europe is buoyant, mainly thanks to the various government guarantee schemes3. It continues that the most prolific jurisdictions for NPL activity are currently Italy and Greece, with Italian NPL sales accounting for EUR 38.9 billion, or 60% of all sales in Europe.4 As such, NPLs could prove attractive for private debt managers.
With more asset managers adopting private capital-type structures and investment styles, managers must ensure their internal operations can cope with the various changes. Unlike a conventional trading strategy, private debt instruments such as NPLs command specific expertise, especially in the field of credit analysis.
It also requires funds managers to invest in new technology systems capable of handling complex and highly bespoke asset classes such as NPLs. Moreover, better automation and a transition away from manual-based processing will be integral if firms are to oversee and suitably manage the risk of NPLs in their portfolios. As an alternative, some managers may opt to outsource these middle and back-office activities to trusted third parties with a strong track record of supporting multiple asset classes and financial instrument types with automated custom workflows.
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