Financing economic growth with private debt
This article appeared in our Investment Outlook for 2022 ‘Shooting the rapids’. Read it here
Despite concerns over a possible weakening of economic growth and intransigent price pressures, the broad picture at the end of 2021 was clear: Conditions in the G7 economies were improving thanks to large-scale fiscal and monetary stimulus which underpinned equity markets and kept interest rates low. As a result, equity valuations hit unattractive levels and bonds looked expensive.
Finding appeal among more investors
That mix has left private – unlisted – debt looking like a suitable alternative. For the same level of risk, it offers investors a liquidity premium relative to listed bonds. This explains the strong inflows into private debt – amounting to USD 120 billion in the first half of 2021 in Europe (source: Preqin).
A broader group of investors is now allocating to private debt. Insurers, attracted by its favourable treatment under Solvency 2 rules, have led the way. They are increasingly being joined by pension funds, sovereign wealth funds and even individual investors.
Many institutions have permanent allocation programmes at 10% or 20% of their portfolios, sometimes above 40%, with a balance between private equity, real assets and debt.
Demand for financing supports premiums
Of course, private debt does not escape the debate over the impact of excess liquidity on risk premiums. The amounts of dry powder are contributing to the pressure on credit margins. However, liquidity premiums have remained intact because demand for financing has also been rising.
Growth driven by an explosion in merger and acquisition activity has been fuelling the financing needs of European mid-capitalisation companies.
In addition, the need for infrastructure related to the energy and digital transitions are huge, particularly at the intersection of information technology and traditional infrastructure: Battery electricity storage, smart infrastructure (networks, cities, roads), and data processing and transmission.
Separately, Basel Committee rules are putting additional constraints on banks’ balance sheets. As a result, private debt has become part of a complementary financing model for banks – and investors – in Europe.
Please note that 'digital assets' are electronic files of data that can be owned and transferred by individuals, and used as a currency to make transactions, or as a way of storing intangible content — such as computerised artworks, video or contract documents. Cryptocurrencies, so-called asset-backed stablecoins and non-fungible tokens — certificates of ownership of original digital media — are all examples of digital assets.
Source: JP Morgan, Alternative Investments Outlook and Strategy, October 2021
The contribution of private debt to financing growth is in itself motivating investors. Increasingly, private debt involves respecting strict environmental, social and governance (ESG) criteria. Rightly so: financing the economy is good, financing tomorrow’s economy is even better!
Meeting ESG requirements requires significant resources and an approach tailored to each underlying asset. For our infrastructure and real estate loan portfolios, we measure the carbon and environmental impacts and, for example, the number of households gaining access to digital networks. For a small to medium-sized (SME) issuer, it involves assessing the awareness of a company’s executives of ESG themes and analysing the choices the company is making.
The search for diversification can be a further reason to invest in private debt. The risk of excessive valuations for the most sought-after assets drives investors to consider a wider range of assets.
This is why we believe it is important to have a multi-sector approach in infrastructure and real estate debt investing. We look at a broad range of companies, applying diverse strategies among SMEs and even more granular financing with mortgages.
Finally, the search for a fair compensation for the risk taken must be at the heart of any credit decision.
A classic ratio is the case selectivity rate. We have found that many apparently good credit opportunities can be put to the side if they do not offer a fair level of remuneration. That is why we integrate into our investment process a systematic calculation of the liquidity premium based on our analysis of listed peers.
We are convinced that by meeting these three prerequisites – sustainability, diversification and relative value – we can succeed in adding value and impact to portfolios through our management of allocations to private debt.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
Issue : David Bouchoucha, 02/02/2022