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Where to Turn for Yield? A Look at Private Debt

Strategies with flexible structures that offer the potential for both diversification and an attractive risk-return profile.

As the Federal Reserve has lowered rates to near zero for the foreseeable future, many investors are turning to private debt strategies to obtain yield, preserve capital or maximize returns. These strategies appeal to institutional and high-net-worth investors looking to rebalance portfolios, trim profits from equity and debt strategies that face market volatility and economic uncertainty, and placing those realized gains into strategies that offer diversification and yield. In addition, private credit is an attractive option to allocators who want to put cash to work in assets that aren’t volatile but generate strong risk-adjusted returns.

More investors have steered toward private debt in recent years, adding a new category to their asset mix. The asset class offers the potential for attractive yield and portfolio diversification given the ultra-low interest rate environment, current economic and market conditions.

A niche market 20 years ago, private debt assets and the number of funds continue to multiply, according to Preqin data. Through June 2019, private debt has swelled to $812 billion under management, with almost $300 billion in dry powder. Fundraising in 2019 crossed the $100 billion threshold for the fifth consecutive year and the 2020 Preqin Global Private Debt Report states “Looking ahead, investors are upbeat about their private debt portfolios. A significant 91% of investors we spoke to will either maintain or increase their allocation to private debt over the longer term.”

Private credit strategies range from conservative to aggressive, and different strategies are appropriate for different stages of the business cycle; though, senior-secured private debt can be regarded as an “all weather” strategy. Across strategies, the asset class posts returns of between 5 percent and 20+ percent.

Investment-Level Underwriting Targets (Gross IRR%)

Wary of Economic Jitters

Private debt, particularly the capital preservation strategies, holds appeal in the current economic environment. As the search for yield intensifies allocating to private credit may provide desired income and be a stabilizer. Investors can choose among strategies with different risk-reward profiles to fit their interpretation of the market’s and economy’s direction. Allocators have many choices in private debt to consider.

Some mid-market strategies within niche parts of the sector have proven appealing; these can deliver equity-like returns without volatility as several strategies exhibit low correlation to other risk assets. Many of the more prominent private credit strategies can be broken

down into capital-preservation, return-maximizing and opportunistic/niche categories, according to a Cambridge Associates report on the asset class.

Senior Secure Private Debt can be regarded as an All-Weather Strategy

... senior secured real estate strategies offer a high-yield with regular distributions. These appeal to advisors who require quarterly distributions to supplement income for retired clients ...

Capital Preservation Strategies

  • Senior Debt is highest in the capital structure, making it the first loan to be repaid if the borrower defaults, and is typically backed by collateral. Senior debt can be viewed as a public company private debt issuance. Returns come from current cash pay coupon.

  • Mezzanine Debt is an unsecured position that falls between senior debt and equity in the capital structure, generating returns between those of senior debt and equity. Mezzanine debt is frequently used to finance buyouts and acquisitions. Interest can be in the form of periodic cash payments or Payable-in-Kind (PIK) interest, whereby the principal amount owed increases (per the stated coupon rate) and is paid out at the end of the period.

Return-Maximizing Strategies

  • Distressed Debt, which can be non-performing notes or companies that are on the verge of bankruptcy. Investors buy reduced-priced debt and seek a take-out with par refinancing or a settlement that generates returns. This strategy can be used to create a liquidity event where the business raises money through financing, and without selling, thereby allowing business owners to retain control. Returns can be similar to private equity returns.

  • Subordinated Debt is riskier debt that’s repaid after senior creditors are paid in full. Subordinated debt is also used as a means for allowing owners to retain control of their firms. Managers often generate higher returns from fees, interest and penalties.

Opportunistic/Niche Strategies

These strategies run the gamut, covering sectors that include aviation, real estate, insurance, etc. Credit investors seek out these corners of the market to generate returns where liquidity is low and the upside potential is high. Executing in these strategies requires specialized expertise to identify, assess and properly structure the best opportunities.

  • Rediscount: issuers offer debt multiple times at increasing discounts to par and pay full par value at maturity.

  • Life Settlement: a secondary market for life insurance policies where investors buy another’s policy or into a pool of policies for a one-time cash expense, taking on obligations and beneficiary rights.

  • Catastrophe Bonds: high-yield, insurance-linked debt that raises money for insurance companies for specific natural disasters, letting investors receive higher interest rates.

  • Aviation Finance: issuance of debt to provide capital to airline and leasing companies to buy aircraft, from which investors receive fixed payments.

In another example of a niche strategy, senior secured real estate lending can provide equity-like returns without equity-like volatility. A commercial real estate income fund can serve as a nice defensive ballast in client portfolios for advisors who are wary of allocating money to equities at the current levels. Additionally, senior secured real estate strategies offer a high-yield with regular distributions. These appeal to advisors who require quarterly distributions to supplement income for retired clients, or who have conservative investment profiles that don’t allow for sizable equities allocations.

Where Private Credit Strategies Typically Play in the Capital Stack

Different Investors Looking for Diversification

The various segments of private debt offer a range of styles and risk/reward profiles. This part of the debt sector can be used as a diversifier or in place of equities when cash is generated from a liquidity event, such as the sale of a business or a large asset, and must be invested. Allocators who are nervous about adding more to the stock market or to traditional fixed income investments are trimming back their equity and bond exposures as they rebalance portfolios and are also turning to private debt.

Among the largest investor groups, private and public funds comprise 27 percent of investors in private credit, according to Preqin. Institutions such as foundations, endowments and insurance companies represent 20 percent of total assets; wealth managers, family offices and fund of fund managers make up another 31 percent.

The private debt market will continue to expand in an environment of ultra-low interest rates and growing concern about the economy and markets. As the hunt for yield continues, private debt offers a viable and appealing alternative. In this space, investors will find an array of strategies with flexible structures that offer the potential for both diversification and an attractive risk-return profile.

Special Thanks to our Contributor

Laura Catalino

Senior Vice President, Investor Relations at M360 Advisors

(949) 528-3610

M360 Advisors invests in niche segments of private credit and manages a vertically integrated credit strategy that targets short duration commercial mortgage assets secured in first lien position by income-producing properties. The firm’s objective is to preserve invested capital and achieve attractive and sustainable risk-adjusted returns relative to traditional fixed income investments, while also providing reasonable liquidity to investors. M360 Advisors oversees the entire value chain internally – from sourcing loans all the way through to portfolio management.

By focusing exclusively on secured investments that are senior in the capital structure, we are able to deliver to our clients a rare combination of stable, uncorrelated returns with significant collateral protection.

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