Private Debt: Safe Alpha in Tough Times
Coverage of the 2012 Investment Innovation Conference.
BY Donald W. Bangay | December 26, 2012
The investment grade private placement debt market is a reliable source of safe alpha because it has a long history of delivering a higher rate of return than public market bonds. It is also easy to understand and less risky than investment grade public market corporate bonds. Private placement debt is a low profile traditional asset class that operates in the mid-market between bank loans and public market bonds. Although the private debt market has a long history as a reliable source of yield pick-up over public market bonds, there is very little published research on it, mainly because of the lack of publicly available information.
A key to success in the private debt market is active relationship-based investment management. Private debt market managers maintain direct contact with borrowers from the inception of the investment until it is fully repaid and they actively perform all the functions that are usually managed by intermediaries in the public bond market. This requires investment management skills that are more fundamental than those generally employed in public market bond investing. This significantly reduces risk due to greater control over the structuring, management and administration of the investments.
Investing in the private debt market is primarily a manufacturing process. By comparison, public market bond investing is mainly process of selecting investment exposures from an inventory of pre-packaged debt securities.
The manufacturing process involves several steps, including pro-active direct origination of investment opportunities, fundamental credit analysis (often on businesses that do not have any publicly available information), negotiation of the structure, terms and conditions of the investment (often custom designing the loan to deal with the unique situation of the borrower), and, with the assistance of legal counsel, documenting the transaction to ensure the terms and conditions of the investment are fully and accurately captured.
Post-closing the investment manager pro-actively monitors the ongoing creditworthiness of the borrower and directly administers the investment. The direct relationship, timely receipt of information on the borrower's activities and short lines of communication reduce credit risk by ensuring early intervention in the event of credit deterioration.
Although it is infrequent in the investment grade private debt market, adjustments to the terms of an investment may be required from time to time. This can be due to a positive event (e.g. a growth enhancing capital spending program) or as a result of a negative event (e.g. a cash flow strain that limits the ability to make debt service payments). In either case, the private placement debt manager has the in-house analytical, negotiation and documentation skills and resources to deal with the changes and thus minimize risk.
The alpha from the private debt market comes from a combination of two identifiable and measureable sources: a higher interest rate and lower loan losses than public market bonds, plus active relationship based investment management. The higher interest rate comes from an illiquidity premium and/or a uniqueness premium. This illiquidity premium recognizes that private debt is a buy and hold investment that is intended to be held to maturity and that there is no active secondary market for private debt.
However, there is structural liquidity as there is a contractual maturity date for the debt, many of the investments have amortization schedules that partially or fully repay the debt during the term of the loan and interest and principal payments are often monthly. As a result, the ongoing cash flow from a private debt portfolio is higher and smoother than that of a public market bond portfolio.
The uniqueness premium obtains a higher interest rate from borrowers who have unusual or complex borrowing requirements. Because this type of borrower has difficulty obtaining financing, they are more focused on the availability of the funds than the cost of funds. While additional time, effort and skill is required to assess the creditworthiness of these borrowers, the payoff for investors is often a higher interest rate for less credit risk than for easier to understand borrowers.
Loan losses are much lower in the private debt market than in the public bond market. The stronger covenants in private placement debt combined with the ongoing direct relationship with the borrowers results in early intervention in the event of credit deterioration. At the same time, in-house skills and resources and a commitment to minimize losses results in higher recovery rates. In the public market, bond investors usually do not have the skills and resources to deal with defaulted loans and are required by investment policy to sell defaulted or downgrade bond exposures resulting in low recovery rates. Consequently, investors in the private debt market not only benefit from a material yield pick-up over public market bonds but, with the passage of time, the yield pick-up widens due to lower loan losses.
In conclusion, the investment grade private placement debt market is a safe, sustainable and easy to understand source of meaningful yield pick-up over the public bond market. It increases the rate of return on fixed income portfolios, provides stable and predictable cash flow and is a highly valuable asset class for implementing an LDI strategy.
Donald W. Bangay is Chief investment officer, Integrated Private Debt Corp.