TOPICAL PERSPECTIVES

What is private market debt? KEY POINTS Private market debt offers a wide range of opportunities for longterm investors to gain additional yield and diversification. We currently see an attractive supply given the reduced role of traditional providers of non-publicly traded debt. Implementation is a major hurdle and requires specialist expertise.

Private market debt is the provision of non-publicly traded debt financing to small and mid-sized companies. Specific examples of these opportunities include asset-backed investments, direct lending, distressed investments and bank portfolio liquidations. In this article we discuss the opportunities available within private market debt and outline why we believe this asset class is well suited to institutional investors. Private market debt investments can take a number of forms: Lending alongside a bank or hedge fund – A loan by an institutional investor alongside an existing senior secured loan. Replacement of a bank – A single tranche with typically higher total commitment, higher leverage and additional covenants to reflect the challenges of lending to companies who struggle to obtain conventional bank financing. Subordinated lender – Mezzanine lending to corporations that tend to have an equity ‘kicker’, i.e. some degree of equity participation/incentive to boost the expected returns to the lender. Opportunities are available across a variety of industry and geographic segments. We focus on private market debt opportunities of intermediate term, typically with a two- to six-year holding period, which fall outside traditional asset classes but which often also do not fit neatly within the customary ‘hedge fund’ or ‘private equity’ classification. As a result, these opportunities are often overlooked by institutional investors.

FIGURE 19: INVESTING IN THE MIDDLE HEDGE FUND STRATEGIES

PRIVATE EQUITY STRATEGIES

0

2

6

10

YEARS

YEARS

YEARS

YEARS

INTERMEDIATE-TERM STRATEGIES For illustrative purposes only. Source: BlackRock.

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S T R AT E G I C P E R S P E C T I V E S

WHY IS IT TOPICAL? In the current market environment, we see an attractive supply of private market debt investments. This phenomenon results from acute supply and demand imbalances, caused by: Constrained balance sheets of traditional market participants (e.g. banks) Limited hedge fund capital in many strategy segments Regulatory restrictions such as the Volcker Rule and Basel III Investor constraints including asset allocation imbalances and liquidity preferences Many financial institutions are subject to a combination of these factors, and their responses have created opportunities for alternative capital providers. Global deleveraging has reduced the lending base for certain borrowers while many banks are terminating lending operations in non-core markets. This has resulted in opportunities for non-traditional lenders to capture an illiquidity premium by directly originating loans that are smaller and involve more complex collateral where strong structuring capabilities can help to isolate risks. High barriers to entry as a result of structuring complexity, infrastructure and resource needs serve as an additional source of premia that can be extracted by informed investors. Investors who can accept a degree of illiquidity are well placed to exploit the supply and demand mismatch in the market. Private market debt can allow investors to exploit these structural imbalances without being wedded to any one particular market or sector – instead, a skilled manager with a strong opportunity sourcing network in this asset class should be able to identify opportunities wherever they occur.

INCREASING POTENTIAL TO ADD VALUE

FIGURE 20: OPPORTUNITIES ACROSS THE CREDIT SPECTRUM PRIVATE MARKET DEBT Structured/asset backed credit Direct corporate lending Commercial real estate whole loans Distressed/ default debt Investment grade corporate debt

High yield bonds/ leveraged loans

Hybrid securities

TRADITIONAL INCREASING COMPLEXITY AND INEFFICIENCY DECREASING DEGREES OF INTER-ASSET CORRELATION AND MARKET BETA

Source: For illustrative purposes only. BlackRock.

WHAT IS PRIVATE MARKET DEBT?

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MARKET OVERVIEW IMPLEMENTATION CONSIDERATIONS Accessing suitable private debt assets is one of the biggest challenges in investing in this space. Three common routes for institutional investors are: Multi-client funds offered by managers with a particular speciality, e.g. in direct lending; Special purpose vehicles that are effectively bespoke funds for large investors, working in conjunction with a manager; Direct co-investment with a manager. The choice of implementation route depends on the constraints and requirements of an investor. Scale is a limiting factor on the second and third routes listed above, with smaller investments best suited to multiclient funds. Investors who are able to use the second or third routes benefit from the ability to create bespoke solutions that are not tied to any one particular industry or sector. Some asset managers offer ‘aggregator’ access whereby they create multi-client funds which themselves access the market in each of the methods listed.

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S T R AT E G I C P E R S P E C T I V E S

There is a wide range of opportunities in private market debt, ranging from energy investments to shipping. This contributes to the natural diversification within this asset class. We discuss the opportunities in some of the most currently attractive markets below. Within the global energy sector, a meaningful capital imbalance exists as demand for financing far outpaces the funding available from the traditional banking system. New technologies to access conventional resources (such as horizontal drilling for natural gas), aging infrastructure and geopolitical factors are leading to sustained, heightened demand for financing. In North America alone, the International Energy Agency projects that $7.5 trillion is needed by 2035. Loans collateralized by energy resources and infrastructure companies can present equity-like upside with the potential for downside protection. Opportunities also exist in the commercial real estate (CRE) market. There is a significant tranche of commercial real estate debt that matures between now and 2017, and traditional lenders have reduced CRE lending volumes, restricted maximum loan-to-value ratios, and generally tightened underwriting standards. Additional regulatory restrictions on commercial banks have made CRE lending less profitable. These factors leave a considerable funding gap in the market that create a better entry point for lending capital with the potential to earn above-average returns with reduced downside risk. We discussed mezzanine CRE debt in greater detail in the April edition of Strategic Perspectives. A distressed shipping sector, driven by decreasing fleet and shipyard utilization rates, low day rates and the disappearance of traditional sources of financing has created opportunities for less traditional providers to step in at attractive pricing. Over-levered corporate institutions, with large and midsize tanker fleet, have accumulated losses of more than $26 billion since 2009. This creates opportunities for non-traditional lenders to offer loan-to-own financing (i.e. loans giving the borrowers the option of future purchase). Portfolios can be supplemented with hard asset purchases – i.e. assets purchased at distressed pricing levels, usually via a joint venture with the operator, which creates upside optionality (assuming prices normalise) with the security of the intrinsic value of the asset.

AN EXTENSION OF ‘TRADITIONAL’ ALTERNATIVE ASSET CLASSES Private market debt can be an attractive asset class for institutional investors, and can offer targeted exposure to particular strategies, geographies or investment opportunities. They allow investors to further diversify their alternatives portfolios and obtain higher returns through both an illiquidity premium and a complexity premium – compensation for the high barriers to entry to this asset class. Given the idiosyncratic nature of investments, the more prevalent risks are often highly deal-specific rather than market-related, and so have a different risk profile to the majority of traditional investments.

Key challenges around investing in private debt include sourcing attractive deals, and the difficulties in managing and monitoring the risk being taken over time. Benefits

Risks

Risk mitigants

Different risk profile to traditional market assets and opportunity to capture an illiquidity premium and a complexity premium

Idiosyncratic deal-specific risks

Strong underwriting process

Difficulty in accessing opportunities

Deep sourcing network for opportunities

Stable cashflows protected by collateral

Liquidity

Investment horizon of between two and four years, considerably less that other alternative investments

Credit quality of issuer

Some institutional investors are well placed to take on liquidity risk Thorough investigation and critical assessment of debt issuer’s credit worthiness Diversification from other alternative investments

Exposure to market risks Ability to monitor and manage risk over time

If investments have equity market or interest rate sensitivity, a skilled investor can potentially establish an appropriate hedge Each deal’s sensitivity to various economic factors should be assessed as a part of the underwriting process in an effort to ensure that the deal provides an adequate level of return for the risk that is taken Consider a risk factor approach to monitoring private market assets

Source: BlackRock

WHAT IS PRIVATE MARKET DEBT?

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FOR MORE INFORMATION Please contact your usual BlackRock representative blackrock.com.au

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