Private debt: Investors’ solution to low returns?

12 October 2020

Source: MoneyWeb    By: Adriaan Kruger

Lending directly to companies yields attractive returns, but there are reasons for that.

Investing in private debt has become one of the world’s largest and fastest growing alternative asset classes and private debt has secured a place as a core part of fixed income portfolios in the current low interest rate environment, according to a British fund manager specialising in alternative assets.

Westbrooke Alternative Asset Management believes this growth is fuelled by current low interest rates and high share valuations that leave little upside from current levels.

Dino Zuccollo, head of distribution at Westbrooke, says governments around the globe have cut interest rates to zero to assist economic recovery following the Covid-19 pandemic. “At the same time, equity valuations have run hard as free money has become available.

“In this environment, private debt offers similar historic returns to equity investments, but can be structured to offer additional security to the investor, ” says zuccollo.

“This security can be in the form of direct security against a tangible asset.”

He says investors can secure a higher return by investing in private debt, resulting in an asymmetric risk/return profile.

Private debt explained

Simply put, private debt is where a loan is made by a non-bank lender and therefore falls into the broader category of ‘alternative debt’ or ‘alternative credit’.

The term private debt is used interchangeably with ‘direct lending’, ‘private lending’ and ‘private credit’.

Private debt investments are typically used as bridging finance for property transactions, funding real estate development, financing business growth, providing working capital, and to fund infrastructure.

Westbrooke says private investors such as high net worth individuals, family funds and institutions view private debt investments as an opportunity to enhance returns within a fixed income portfolio.

“It generates predictable, protected, hard-currency cash yields,” says Richard Asherson, principle of Westbrooke Alternative Asset Management UK.

Reasons

There are several reasons for the higher returns generated by private debt investments, including:

  • An illiquidity premium, as borrowers have to offer higher rates to compensate lenders who are required to invest for a prescribed period of time (since the debt is not listed on an exchange and investors cannot easily liquidate their investments);
  • A structural or complexity premium, because deals are often bespoke and require specific structuring;
  • An off-market (disinformation) premium due to a lack of an efficient market that effectively prices debt; and
  • The smaller size of the loans demands a premium as banks prefer to lend bigger amounts to big companies, resulting in a shortage of capital available for medium-sized loans to smaller and medium concerns.

Asherson says that compared with listed debt instruments, private loans typically benefit from more robust security packages because they hold direct asset security as opposed to a general claim against the issuer in the cash of listed debt.

“Private debt is often able to generate higher returns as a result of its inherent complexity and unlisted nature. However, private loans are illiquid and require investors to invest capital for a certain period during which they are unable to access their money, whereas listed debt instruments can be bought and sold on listed exchanges,” says Asherson.

Growing demand

He says loan activity to small- and medium-sized companies in the UK increased by more than 15% in the first half of 2020. “While some of this increase has been funded by the UK’s Coronavirus Business Interruption Loan Scheme, private debt funds have been pivotal in funding this demand.”

To date, Westbrooke has invested more than £100 million (R2.1 billion) across 35 private loans in the UK and Europe.

Westbrooke was founded in 2004 and invests and manages investments in alternative assets in multiple geographies on behalf of its shareholders and investors. This includes investments in private equity, venture capital, private debt, hybrid equity and real estate.

Since establishing its UK office, Westbrooke has provided debt funding to businesses across several sectors in the UK and EU, with a predominant focus on the lower mid-market, a traditionally underserved market segment that has seen an increased appetite for funding in recent months following the outbreak of Covid-19.

Transactions to date include debt facilities to support the UK’s second largest independent provider of mobile device protection solutions, a London-based independent nurseries group expanding across south-east England, as well as a number of real-estate-backed transactions, primarily focused on acquisitions and shorter-term bridges, says Asherson.

While private debt investments are available to SA investors, they would need to adhere to South African Reserve Bank (Sarb) regulations.

Thus a local investor would have to externalise their cash using their annual discretionary exchange control allowances and invest directly in hard currency offshore. Sarb approval would be required above a certain threshold.

“Alternatively, one can invest locally in rands through a local feeder vehicle, such as a company or endowment trust which has the capability to invest offshore.”

Zuccollo says Westbrooke expects further growth in private debt as an asset class, but indicates that it is not for everybody.

“The rise of private debt as an asset class is still in its infancy. Sophisticated investors across the globe have steadily increased their allocation to this fixed income alternative as part of a well-balanced, diversified investment portfolio.

“However, quality private debt funds can be difficult to access, especially where South Africans are looking to invest in offshore markets.

“We suggest that investors seek out well-established asset managers who have deep local networks and infrastructure and a track record of performance to help clients navigate gaining exposure to the asset class.”

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