Why Private Capital is Suddenly Hot
This is Part 3 of Financial Advisor IQ’s five-part special report on fixed income. – by Ellen Sheng
In the span of a decade, the private debt market has grown to nearly $1 trillion in assets under management, up from $341 billion at the end of 2011, according to alternatives-focused research and data provider Preqin.
For advisors looking for yield in a low-interest rate environment, private debt is intriguing because it offers investors higher fixed-rate returns than public debt. Not only that, most loans are based on a floating index, such as Libor, so there is little-to-no interest rate sensitivity.
“The old normal watering holes for dividend income have either gone away or been cut in half,” says Jeremy Hill, chief investment officer at JB Capital. That has left investors trying to find ways to match fixed income portfolios with retirement obligations.
When investing in private debt, as compared to a traditional bond portfolio, investors must give up liquidity in exchange for a better return. Andrew Kapyrin, director of research at RegentAtlantic Capital explains that not all investors explicitly need liquidity from a traditional bond portfolio, relying on it instead to provide some stability.
Meanwhile, “there’s every reason to expect better results out of the private debt market in the immediate future,” Kapyrin says. And with the economy in position for expansion, inflation and growth for the next few years, he says it’s “a good time to enter the private debt market as a diversifier.”
The Wild West
Private lending proliferated in the wake of the 2008 global financial crisis. Facing increasing regulatory pressure, banks backed off from making loans to smaller companies. Consolidation in the banking sector also means there are fewer banks for companies to turn to. There were 8,000 Federal Deposit Insurance Corp.-insured banks prior to the financial crisis, compared to only 5,000 now, according to FDIC data. Meanwhile, private capital markets grew.
The downside of the fast growth? “It’s a little bit of Wild, Wild West. You don’t have as much regulation, you don’t have as much oversight,” says JB Capital’s Hill.
The fast-paced growth and looser lending standards have spurred concerns that losses could be coming. That risk is compounded by the lack of liquidity, with private loans often more difficult to trade, especially during periods of stress. Performance among private credit managers can vary greatly. The number of new entrants into the space should also give rise to caution, advisors say.
“Not all credit funds are equal, for a thousand different reasons,” says Hill. In such a “hyper-competitive” market, private credit vehicles need to stand out with a different nuance or something new, he adds.
“There are certainly some advantages and unique qualities of private debt. But you also have to recognize that there’s certain risks or limitations, primarily the lack of liquidity and transparency,” says Ian Seaver, head of fixed income and multi-asset research at Hartford Funds. Given the risks, investors in the space need to do even more due diligence, he says.
Finding quality
Despite the concerns, some types of private capital can be an attractive source of additional income and provide diversification to public markets. When looking at private markets, it’s important to go with a proven manager with expertise in the area.
Advisors shouldn’t try to go into individual deals because it’s too risky, but there are a number of middle-market lenders that provide pooled vehicles that are accessible to clients that have enough assets, says RegentAtlantic’s Kapyrin.
One of the first things Hill checks is how long the lender keeps something on their balance sheet. Many private credit funds are solely reliant on their relationship with private equity to build their business, JB Capital’s Hill warns.
“A lot of these credit guys are just chasing sponsors around,” he says. That’s a red flag, he says, because they’re not delivering value; they’re dependent on a third party to bring business and to deliver yield. Hill prefers for lenders to have a direct relationship with the borrower. Another factor to watch for is leverage — how much and what they’re doing with it, he says.
Advisors suggest examining the track record of the manager, just as with any investment, and checking the different layers of expenses. And even though private debt is less liquid, check that there is some long-term, enforceable plan to get cash out after a certain period of time, RegentAtlantic’s Kapyrin says. Most funds should state when they expect to return cash back; if it’s longer, the manager could face a penalty, he notes.