Appetite from the private capital community for private debt investment opportunities has been strong in recent years, as volatility in public markets, coupled with low interest rates, prompted investors to look for yield and find ways to further diversify their portfolios. But now that interest rates have shot up again, how hungry are private investors in the current climate?
We’re certainly seeing a marked shift in their perspective on private debt strategies. After years in which cash deposits and other cash-like instruments yielded next to nothing, today investors can get around 5% interest on their money with zero risk. That’s causing them to do one of two things (or both).
Rising expectations
On the one hand, private capital is pivoting towards capital-generating strategies such as private equity, as they target long-term capital growth (and gains).
On the other, those that are looking at private credit opportunities have far higher expectations around returns. Understandably, many feel that if they are going to move money out of the safe haven of 5%-yielding cash deposits, they want to be compensated accordingly. Moreover, they are looking for that illiquidity premium for locking their capital up in medium-to-long term strategies.
This is pushing returns expectations up to 15% or so for the more straightforward lending opportunities - around 5% higher than when interest rates were still low. For opportunities with an equity risk element or a mezzanine feel to them, investors are typically looking at returns north of the 20% mark.
We are seeing significant demand for strategies that offer some equity upside as part of the way their deals are structured, on top of the headline interest rate. Having that equity ‘kicker’ attached to the loan note is more appealing than ever for private investors right now.
Unconventional opportunities
These kinds of high-returning opportunities are out there. For example, while mainstream lenders and conventional debt funds are still lending on the more plain vanilla deals, they have a lower tolerance for less orthodox opportunities. This could include PE-sponsored mezzanine opportunities or cashflow lending where there is no security in the assets but where the lending dynamics are nonetheless attractive to other investors prepared to consider more unconventional options.
We’re also seeing opportunities emerge in the commercial property market, where incumbent senior lenders – who have hitherto been happy to lend at a loan-to-value (LTV) of 60% and upwards - are no longer comfortable lending at this level. Therefore, property owners who need to refinance are increasingly looking at doing so with a combination of senior lending plus a mezzanine strip on top, making it an appealing prospect for private capital.
When it comes to private debt funds, one area that is proving particularly popular with the private capital community in the current climate is the distressed and special situations credit market. These strategies play well to the current challenging economic conditions, so there is real scope to generate good returns – with the right manager. It takes specialist expertise and long experience to make this complex strategy work. Therefore, investors must be wary of newcomers jumping on the bandwagon. More than ever, track record matters.
Fixed versus floating rates
Historically, private capital has preferred fixed rate credit funds because investors like the predictability of knowing what their returns will be over the long term. But when interest rates are on the up, this approach can start to look less appealing. Some investors who have committed to funds at lower rates may be starting to question that wisdom.
However, floating rates are not necessarily a better call. There’s the obvious caveat that rates might go down as well as up – but even if they remain high, there’s still the risk factor. Portfolio businesses on floating rates are likely to come under much more stress as interest rates rise, putting them at greater risk of default or even threatening their very viability.
The idea that investors may want to exit fixed-rate funds for a (potentially) better deal in a floating rate fund also highlights the importance of investing in closed-ended vehicles. In open-ended funds, a trickle of investors rushing for the exit could become a flood, potentially putting the stability of the fund in danger. By contrast, managers of closed-ended funds have the time to see out their long term strategy because they are insulated from the ‘herd mentality’. They don’t need to take any hasty decisions triggered by the vagaries of the market – and private capital likes that.
A clear investment rationale
So far, so sensible, but this brings us back round to the earlier point which is that if investors are going to lock up their capital for years, and not just stick cash in the bank, there needs to be a clear investment rationale for doing so. Private capital’s demand dynamics have changed, and while private debt remains an area of interest, investors are looking for more bang for their buck to make it worth their while. And they can get it, provided they know where to look.