Liquidity key as investors back private credit, experts say
Asset owners are concerned about another sovereign debt crisis and are weighing their liquidity needs as they prepare for periods of market stress. But investors continue to show interest in private credit, despite concerns over default risk (Jason Alden/Bloomberg)
Asset owners remain on guard against the risk of another sovereign debt crisis and are weighing their liquidity needs as they prepare for periods of market stress, industry experts say. However, investors continue to show interest in private credit, despite concerns over default risk.
Peter Smith, investment director at TPT Investment Management — the fiduciary management service of the £11.6bn TPT Retirement Solutions — told the recent Edelman Smithfield Investor Summit in London that investors would need to ensure they had the necessary liquidity to manage short-term changes in bond markets.
"I think most of the [defined benefit] market is still scarred by 2022, in terms of the significant rise in yields," Smith said.
"It wasn't necessarily the level they reached; it was the pace at which they got there. So do [investors] have enough liquidity to manage that yield move?"
An overwhelming majority of institutional investors globally are wary of the risks posed by rapidly rising bond yields. In its November Investor Pulse survey of 300 investors, Edelman Smithfield found that 97 per cent expect that a sovereign debt crisis is likely in a developed market economy in the next three years. Nearly two-thirds (63 per cent) say this is very likely.
Investors consider default risk
While investors have expressed doubts over sovereign debt, interest in private debt strategies has risen, particularly among asset owners with ample liquidity in their portfolios who are well placed to make investments on an opportunistic basis.
Smith explained that the market upheaval seen during the Covid-19 pandemic provided a "brilliant time" to be a lender for investors, but they would "obviously need to have the liquidity to move the portfolio around in a relatively short period of time".
More broadly, he added, TPT is well-suited to private market strategies given its long-term investment horizon, with pension liabilities stretching 50 to 100 years into the future. As a long-term investor, TPT is "prime placed" to offer liquidity to borrowers in periods of market stress, he said.
According to MandateWire data, net inflows into private debt strategies recovered in the fourth quarter of last year after a fall in Q3, with £741.1mn allocated to the asset class, up from £88.9mn. However, this was still down on the £1.6bn private debt inflows tracked in Q2.
“Market upheaval, as seen during the pandemic, can provide a “brilliant time” to be a lender for investors, but they “obviously need to have the liquidity to move the portfolio around in a relatively short period of time””
In December, MandateWire reported that the DKr255bn (£29.8bn) Danish pension insurer Industriens Pension had ploughed £257.1mn into a credit fund run by Goldman Sachs Asset Management, geared towards lending to mid-sized private equity-backed businesses.
The same month, we wrote that the £304mn University of Birmingham Pension and Assurance Scheme would increase its allocation to a private credit fund run by Partners Group, following another of the asset manager's funds entering its distributions phase.
In a January briefing on private markets published by Aberdeen Investments, European sentiment around private credit remains "strong", buoyed by structural changes including tighter bank lending, which has "created strong demand for private credit, particularly in Europe where direct lending has seen a significant uptick".
The asset manager forecasts returns of between 8 per cent and 12 per cent for direct lending strategies over a five-year period, and between 6 per cent and 8 per cent for investment-grade private credit.
Other investors have had to reassess their liquidity needs during the past year.
Speaking at the Edelman Smithfield summit, Niall O'Sullivan, global solutions chief investment officer at Mercer, said that a number of US endowments and foundations have "suddenly found themselves wondering exactly what their liquidity needs are", which has "[created] some interesting opportunities to be a liquidity provider".
US universities including Harvard faced financial strains last year after their federal funding was cut by President Donald Trump's administration.
Private credit remains untested in a downturn
But for those investors who "have the liquidity to use", O'Sullivan added that "making sure they can continue to use [it] is a real theme".
He said private credit has been a "very interesting" asset class, noting that it had "not seen a proper credit event really since the [global financial crash]" in spite of some "humps and bumps around Covid", which were mitigated by regulators.
While private credit has seen low realised losses and limited defaults since 2008, regulators have warned that the asset class is yet to be tested in a major downturn.
In December, the Bank of England undertook a stress-testing exercise to examine the role of private market finance (including private equity and credit) in the UK economy and how those active in private markets may respond to a "to a severe but plausible global downturn".
The study, which will be completed this year and reported on in 2027, will involve a mix of large asset managers and banks providing credit in private market funds, as well as institutional investors.
While the rate of credit defaults currently remains low, four-fifths of investors (81 per cent) in Edelman Smithfield's November survey agreed that the abundance of capital flowing into the asset class would mean managers "will need to compromise on deal quality or terms", which would then increase the risk of defaults in the future.
O'Sullivan told the crowd that the private credit managers who would most likely be resilient in a market slowdown would be those that were performing "a little bit worse at the moment, because they're going to keep that [protection] and risk [as] part of their process, and not compromise on covenants".
In an era of more expensive credit, manager skill is also becoming more important in private equity, O'Sullivan added, given higher debt levels and starting valuations.
Instead, he said, managers were "going to have to have operating excellence to turn the company into something better".