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Industry Voices

Commentary: Private debt is still attractive, but beware of risks

U.S. private debt markets have swelled in recent years. If interest rates and inflation remain low, we expect market volume and demand will continue to be robust in 2019. But lurking beneath the surface of this asset class are some risks that could come back to bite investors in the next recession.

Private debt is still an attractive asset class to long-term investors, if done with care. It diversifies portfolios away from concentrations in the public debt markets and provides incremental yields. For example, it is common to see yields of 7% to 8% in middle-market debt, compared to yields of 3.5% to 4% in investment-grade public bonds. In many cases, covenants may also provide private debt investors greater control and protection than in the investment-grade public debt markets.

However, investments with an attractive risk-return ratio are becoming harder to find. We've seen a slowdown of private debt supply in Canada and Europe and expect a constriction in the supply of U.S. private debt this year. At the same time, the quality of these deals has deteriorated. We were funding 1 out of 5 of the investment-grade private debt transactions that passed an initial screening process in the first quarter of 2018; by the fourth quarter 2018 that ratio had decreased to 1 in every 13 transactions.

Investors are increasingly fighting over a limited number of deals. Part of the problem is that alternative investment firms had $3.15 trillion in dry powder for private debt investments as of June 18, according to a Preqin report. Having raised all this capital, they needed to deploy it to receive their fees, which has led to a compression in spreads and the loosening of covenants.

As an investor of institutional assets, there are deals in the market that make me anxious. Last year, many middle market borrowers took advantage of market conditions to refinance debt on much more attractive terms for the borrower. For example, we participated in a direct loan to a logistics company priced at 350 basis points over the London interbank offered rate. The company later refinanced the loan with another lender, who was willing to do it for 275 basis points over LIBOR and also allowed for significantly increased leverage, relaxed covenants and eased security requirements for subsidiary companies. That's a great deal for the company, but the lender is underwriting that additional risk for diminished returns.

There are two problems with these types of deals. First, relaxing financial covenants limits the investor's opportunities to take action to remediate a problem before it escalates. When a default occurs without covenants, the situation is likely to deteriorate further and losses will be relatively higher. Second, investors are not seeking higher yields to reflect that increased risk.

This is not an isolated case. In project finance, investors are accepting projections that use aggressive assumptions to suggest that the project has a strong debt service profile. In reality, the actual performance is likely to result in higher than the projected leverage and a less resilient structure.

In conservative loan structures for single-tenant real estate properties, the loan would be fully repaid over the term of the tenant's lease. However, seeking incremental yields, some lenders are accepting structures where less than the entire loan is repaid during the term of the lease. This poses additional risks to lenders, as the unpaid portion of the debt will need to be refinanced when the lease expires, which will be impacted by whether the tenant renews the lease, as well as real estate values and rental rates at that time. That incremental risk effectively includes a "bet" on future real estate market conditions.

The broader systemic issue driving this behavior is that investment managers are motivated by their fee structure to invest capital. So rather than leave money on the table, they are often loosening covenants and underwriting standards to deploy capital into private debt at any cost.

By comparison, investors who are not motivated by a fee structure, like banks, insurance companies and other institutional investors directly investing for their balance sheets, are largely sticking to their discipline in terms of underwriting and pricing deals in private debt. At Sun Life, we co-invest the balance sheet alongside third-party assets under management.

This is all going to play out in the next credit crisis. Investors who do not stay disciplined on covenants and underwriting will suffer higher losses in the next downturn. Those investment managers risk losing clients and, ultimately, the fees from their AUM.

Once that happens, either the investment manager will have to sell its assets and close up shop, or it'll be acquired by another fund manager with stronger performance. We expect to see a series of consolidations in the investment management space in the next two to three years as a result.

We are now late stage in the credit cycle, with our forecasts indicating a global recession in 2020. For an appropriate risk-return investment approach, investors in the private debt market should be biased toward deals with a higher credit quality. More significantly, they should also avoid anything where the covenants have been loosened beyond what is prudent, or where returns do not adequately reflect the underlying risk. To allow an investor to be selective, it is important to have a strong pipeline of deals to get a sense of quality in the market. If an investor screens, say, 800 viable private debt transactions, it may only invest in 20% of those opportunities.

Investors who retain their discipline in a frothy market and have capital to deploy will ultimately be rewarded when the dam finally breaks. That's when they should be pumping up their deal activity in the private debt sector, because those assets will be at the best price for the entire cycle.

Candy Shaw is senior managing director and head of private fixed income at Sun Life Investment Management in Toronto. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.