The unprecedented market turbulence sparked by the COVID-19 outbreak last year struck both public and private markets, yet several private market sectors demonstrated remarkable resilience amid the challenges of the ongoing pandemic. Institutional investors continued to see private markets as a means of generating their target returns in a low-yield environment, and the overall transaction flow by year-end was strong. To find out which sectors are holding up well, which ones remain challenged, and where investors should expect to see opportunities next, Pensions & Investments spoke with Eric Lloyd, global head of private assets at Barings; Scott Baskind, head of global private credit and chief investment officer at Invesco; and Theodore Koenig, president and chief executive officer at Monroe Capital.
Pensions & Investments: As developed markets emerge from the COVID-19 pandemic, one of the remarkable takeaways is the resiliency of private capital, even amid the initial volatility in both public and private markets. Could you share your experience with how the private markets performed?
THEODORE KOENIG: You mentioned resiliency. We’ve certainly seen that, but we’ve also seen consistency in private credit and that inspired a sense of certainty among global investors. As a result, borrowers came into the private markets for capital at a time when there was very little certainty in the public markets.
Once the deals were getting done on a consistent basis, business leaders and investors could see that the private markets worked better than the public markets. You didn’t have to do “best-efforts” syndicates or look at market pricings the day before. World events didn’t affect whether deals closed or not.
Large companies got used to the fact that they could do private market deals without an overabundance of disclosure of terms, conditions and covenants. That interest is continuing. We’re looking at billions of dollars of deals now that are held on a co-investment, co-lending basis by private market lenders. It just speaks to the size, development and efficiency of these markets.
ERIC LLOYD: Private markets generally held up very well through the crisis, performing largely in line with what many investors may have expected. That said, performance varied widely across asset class, sector and company. Within real estate, for example, industrial and logistics properties performed extremely well. On the other hand, areas like retail — which was already facing challenges due to the structural shift away from brick-and-mortar storefronts — were hit particularly hard. Other sectors, like office, still present a fair amount of uncertainty.
Through the ups and downs, one thing that has become increasingly clear over the past year is the importance of real relationships and partnerships, not only with private equity sponsors and portfolio companies, but also with investors. We were proactive in communicating challenges and sharing our outlook, which not only allowed investors to know how an asset was performing within their portfolio, but it gave us insight into their broader portfolio challenges. Ultimately, we were able to work with our partners in a more constructive way, underscoring the value of clear communication, transparent partnerships and strong relationships.
SCOTT BASKIND: I’ll focus on the private credit space, within private markets. The pandemic in the first quarter of 2020 obviously brought on not only a health crisis, but also a liquidity and economic crisis across risk-based assets. It also created significant opportunities across risk assets in general and within the private credit arena.
Those opportunities were presented in a few different ways. One was in those sectors initially impacted the most by the ongoing shutdown of economies, namely travel and leisure, and then the broader credit markets traded off in sympathy. But very quickly, the rebound in those sectors began occurring by the mid- to the end of the second quarter, led by higher-quality assets in general, and then followed by the rest of the private credit space.
In 2021, private credit has performed quite well. The opportunity set remains attractive across the different elements of private credit, whether it’s on the more liquid end, in the syndicated bank loan space, or the less liquid end, in direct lending and special situations, which remain a very interesting opportunity for investors.
CURRENT PERSPECTIVES ON PRIVATE MARKETS
P&I: Let’s drill down further into the private debt sleeve of the alternatives space. What are the takeaways on what worked and what didn’t as portfolios repositioned to meet challenges as they arose? How will they shape future investment activity?
KOENIG: Strong underwriting worked well. That meant looking at a series of downside “what-if” scenarios to consider base-case and worst-case situations: What if business slowed? What if you lose customers? What if you lose margin? What if supply chains get interrupted? All those things happened during COVID.
Another thing that worked was equity support from sponsors. A lot of in-person businesses, such as physician practices and dentist offices, restaurants, entertainment companies and fitness centers, all of which had to close for extended periods of time, were able to survive when sponsors stepped up and provided liquidity. For businesses where the sponsors didn’t step in, they were taken over by lenders and creditors. A lot of these cyclical industries got hurt. They’re just starting to come back, and it will be through 2022 before we see any real positive growth.
Diversification clearly worked well. Credit diversification is your friend. The wider the portfolio, the less the concentration of risk.
BASKIND: [What has worked] is the ability to not only build strategies from an asset allocation perspective and manage them within the different verticals, but also to combine the different asset classes. It’s about creating portfolios that are dynamic across a full cycle. The ability to actively manage that asset allocation within a portfolio strategy is incredibly powerful for the partnership between an investor and a manager with expertise across different marketplaces, whether it’s bank loans, distressed assets and special situations, direct lending, collateralized loan obligation securities or other opportunities.
[Investors] want a manager who can add value not only from a bottom-up standpoint, but also at the macro level of asset allocation. There’s value in partnering with someone who has the ability to shift from liquid assets to illiquid assets and then back in the opposite direction through a full cycle.
P&I: Given the importance of diversification — in both private equity and private credit — where should institutional investors look for diversification today, and why?
LLOYD: We saw the importance of diversification over the last year, as managers with the right portfolio composition and good diversification fared much better, overall, than those that were overly concentrated in a particular industry or asset.
As we think about diversification and consider areas of potential opportunity today, one area that comes to mind is infrastructure. If we see a material infrastructure bill passed in the United States, for instance, it will likely generate a fair amount of interest in the asset class. Aside from traditional infrastructure, there is also digital infrastructure, which might create a different opportunity set. We’ve also seen some interesting opportunities in residential real estate, such as build-to-rent or single-family real estate, both on the equity and debt sides.
In private equity, we’re more focused on the middle-market and emerging-manager space. Compared to the really large private equity funds, emerging-manager vehicles tend to be smaller and more nimble, and typically are less correlated with public markets.
BASKIND: Within the world of private credit, we believe it’s important to not only think about diversification within the context of a particular investment strategy but also to consider the opportunity to assemble a portfolio of complementary strategies within private credit via asset allocation.
There are different avenues to look for alpha-generating opportunities within a strategy. One is at the security-selection level. We would suggest that over the last year, the opportunity to drive alpha is at elevated levels versus historical periods, particularly post-financial crisis and pre-pandemic. That’s quite exciting, and it holds across all ratings and risk spectrums, within both liquid assets and illiquid assets, and in lending to companies from an origination perspective at elevated spreads.
The second avenue is asset allocation — having a particular view on a go-forward perspective in terms of risk-return and maintaining a volatility-adjusted framework that allows for a dynamic approach. So, it’s moving from loans to direct lending, to special situations and distressed assets, and then as the cycle moves to a more stable environment, taking the opportunity to invest in other types of assets.
P&I: With the challenges of 2020, there was also a chance for private markets to be opportunistic. How were you able to capitalize on these opportunistic strategies?
KOENIG: One of the areas where we were able to capitalize is within our opportunistic private credit strategy, which is focused on more asset-backed situations. We have built a strong business in this area. It is a great space because it is counter-cyclical and allows us to spread the portfolio over private equity-backed loans supporting leveraged buyouts and non-sponsored cash flow facilities for middle market companies, as well as loans that have significant asset protection.
We also were able to take advantage of the idiosyncratic speedbump generated by the pandemic to provide increased liquidity and rescue capital to good companies. In both areas, we were able to generate premium pricing and structures and, thus, a better overall risk-reward for our investors.
P&I: What other opportunities are you watching in the private markets space, and what are the tailwinds driving them?
LLOYD: We’ve started investing more in real assets that may offer some protection in an inflationary environment. We’re also looking at continuation funds, since some investors have good assets in their portfolios that they don’t want to monetize in this environment. So we’re looking at ways to create a continuation vehicle for those particular assets as they come out of a private equity fund.
Another area we’re watching is office repositioning. As the office environment changes, there will be some interesting opportunities to see what demand will look like going forward. For instance, who will be able to take existing office space, repackage or reposition it in a value-add way, and also tie in environment, social and governance components? Companies want to have buildings that really speak to their values and their culture.
We’re also looking at a potential rebound in the hotel sector, which should benefit from supportive tailwinds as the economy continues to open and travel patterns start to normalize. Leisure seems to be driving the rebound for now, but as corporate travel picks up, we expect to see other parts of the hotel sector follow suit. From an investment perspective, it ultimately comes down to your time horizon on a particular asset.
There are a number of macro trends that are also creating tailwinds. We see that, for instance, in digital infrastructure, with investment in fiber towers, e-commerce infrastructure, logistics and intermodal transportation. We also see it in clean-and-green investments, such as on- and off-shore wind, solar, battery storage and carbon-capture technology.
KOENIG: Cloud storage and data has been a strong business over the past five years. Software and technology also continue to be very strong from a lending and an investing standpoint. We have gone from valuing these companies on an EBITDA [earnings before interest, taxes, depreciation and amortization] multiple basis to [valuing them on] a multiple of revenue, underscoring the growth.
We’re also seeing opportunity in healthcare and a chance to capitalize on the changes in how it’s being delivered. Five years ago, nobody would have thought that telemedicine had a shot. Today, we’re seeing it everywhere.
These are sectors where you really need specialists. You need deep knowledge of these industries, in terms of underwriting, because the market is shifting so much and the rules are changing. In software, you need to understand the recurring nature of the revenue. In healthcare, especially, there are government-reimbursement rates, trend lines, margins, product innovation and insurance company pushback.
BASKIND: Some industrial and cyclical sectors have had tremendous tailwinds. There’s cyclicality around the auto space that has led to very strong performance, and energy has also outperformed. One of the strongest sectors in the credit space is oil, as a result of the dramatic increase of the commodity price of oil. That inflection point in terms of creating value in the energy, oil and gas sectors has been quite opportune.