Achieving target returns from private debt funds isn't easy
By Simone Westerhuis, Managing Director at LGB Investments – Investors’ continuous search for attractive returns and stable portfolio yields has been made only more challenging by the pandemic. With central bank stimulus measures dislocating bond markets and companies slashing dividends, investors are finding it harder than ever to implement effective income strategies.
Against this backdrop, private debt funds have become an increasingly important part of the market with investors attracted by the promise of healthy returns from lending to businesses that find bank finance and equity markets hard to access. Nevertheless, in a booming market of private debt fund providers, investors should make sure they choose those with the expertise to handle today’s highly complex credit landscape.
Monetary policy makes bonds unattractive, dividends still low
Government intervention and monetary stimulus programmes allowed equity markets to make a remarkable recovery since the lows of last February and March. However, these measures have led to the Bank of England holding interest rates at 0.1 per cent per annum indefinitely. Many investment platforms are already imposing negative interest rates, which the MPC mooted in its report on 4th February. Corporate bond yields are barely more attractive. Income seekers who count on dividend payments have also been hit. A total of 493 companies listed on the London Stock Exchange across a range of sectors, cancelled or cut dividend payments from January through to November, marking a 10.8 per cent increase compared with the period from 1 January to July 2020. The evolving nature of the pandemic and uncertainty as to how long a full vaccine rollout will take, reduces the likelihood that investors will be able to rely on consistent dividend income in the near term.
Increased demand for infrastructure and debt funds
Investors are therefore looking elsewhere, and we have seen the crisis spark several trends. According to a recent PwC survey, infrastructure and private debt will be among the winners of portfolio re-shuffles. The survey predicts that, given the need to refurbish roads, airports or finance renewable projects, assets in infrastructure funds could double to just over USD2 trillion by 2025.
This background, and the ongoing demand for loans among small and mid-tier corporates that is not being satisfied by the clearing banks, are making private debt much more appealing to businesses as well as investors in search of returns.
The need for expertise in today’s complex credit landscape
Some companies have attempted to set up in house teams to pursue alternative lending opportunities, yet this is not so straightforward. There are five main areas where credit funds run by investment specialists add value: finding or sourcing the right opportunities, negotiating and structuring terms, managing risk through diversification, monitoring and reporting, and intervention when things go wrong.
At least in the short term, the pandemic has disrupted the physical interaction between lenders and borrowers and between borrowers and their business counterparties. It has also made business investment and infrastructure projects more difficult as suppliers and contractors also have to manage their compliance with Covid measures. The pandemic has increased the challenge of adapting to the new customs requirements after Brexit. Managers of credit funds must decide to what extent they can conduct due diligence and make credit decisions on video conference calls. Monitoring and intervention are similarly affected.
The pandemic has also complicated the negotiation of terms. Many credit funds must achieve double digit IRRs from loans to achieve target returns net of credit losses and fees. This requires interest rates of 10 per cent or more and often the inclusion of an equity kicker. The availability of these terms reflected demand since the financial crisis from private equity funds to leverage their investments. Although expensive, debt provided by credit funds came at a cost that was perhaps half the expected returns of the PE funds. The increase in the volume of credit funds requires managers to propose such terms to companies that do not have a financial sponsor. This was already challenging before the pandemic, but government support measures such as CBILs loans and the fall in interest rates and bond yields have highlighted the high cost of loans offered by credit funds. If negotiations become difficult managers must decide between failing to deploy sufficient funds to achieve diversification and achieving lower returns.
In conclusion, no doubt many experienced and talented fund managers will be able to navigate their way through current difficulties, but investors should look beyond the attractive marketing documents. They must identify the expertise and differentiated features that support each product offering in order to make an informed investment decision.