Herd behaviour: Horses galloping free in rural Utah, USA. Photo: George Clerk via iStock
Asset managers have a habit of moving in packs. When there is money to be made and assets to gather, the investment management community has a track record of displaying significant herd mentality.
And there is no clearer sign of this than its fondness for launching new funds. Every few years a new hot topic arrives – whether it be liability-driven investment, smart beta or ESG – which piques the interest of investment companies. The upshot is the market is then flooded with new funds all vying for the attention of end-investors.
This time around that hot topic appears to be private debt, essentially credit extended by non-bank lenders, with asset managers falling over themselves to bring new products to the market.
Since the onset of the global financial crisis the private debt market has mushroomed. As banks curtailed their lending during the worst of the crisis in order to try and mend their own balance sheets, a vacuum was created that non-bank lenders neatly occupied.
The result has been sizable growth of the private debt market, with assets jumping from less than $45bn (£35.6bn) at the end of 2000 to more than $1.5trn, according to the latest figures from data provider Preqin.
This rise has not been lost on asset managers. In the last few weeks alone a number of investment companies have launched private debt funds, including Goldman Sachs Asset Management, M&G, Nordea Asset Management and Legal & General Investment Management (LGIM), with many more sitting on the sidelines waiting to press the button on their own launches.
Matching supply with demand
The big question, however, is whether there is enough demand from end-investors to match the supply? According to one senior executive at a consultancy that advises pension funds on their investments, who asked to remain anonymous, the answer is no.
"It is hard to say but, no, I don't think so," they said. "Yes, private debt offers something different, and it can be a good diversifier, but it is quite difficult to explain."
Robin Powell, a campaigner for what he calls positive change in global investing and the author of the blog, The Evidence-Based Investor, is more forthright.
"Asset managers will sell whatever they can, and particularly products that generate high fees. The fashion for private debt funds is just another example of this.
"As so often happens, it's primarily the industry that's stoking demand for private credit funds rather than investors. The vast majority of investors don't understand what private debt is, let alone the risks involved."
What is private debt?
So, what exactly is private debt? Perhaps the first thing to address is that it has many names and is also known as private credit, alternative lending and shadow lending, among others. But, in essence, private debt, regardless of its moniker, is where credit is provided by non-bank lenders, typically to small and medium-sized private companies.
Private debt funds can adopt a number of different strategies to do this but the main one is via direct lending, where non-bank lenders provide loans, usually senior secured debt with a floating rate coupon. The floating rate aspect has the added benefit of stopping inflation cutting into investors' returns.
While the returns from the asset class can be higher than that of more mainstream investments, so can the risks, with the biggest being company defaults, which can spike during economic downturns. Another is the illiquidity of the asset class. Once credit is extended it can take a long time to get that money back, making the asset class more suitable for investors willing to lock their money away for longer periods. Not something that should put off pension funds, however.
The quality of companies being lent to is another hurdle for the asset class, according to Create Research chief executive Amin Rajan.
"Yes, there is demand there from investors," he says. "But mainly for the part that is less risky: the senior tranche. Nearly a quarter of the allocated – but uninvested – assets in private debt remain as ‘dry powder'. This is indicative of the limited opportunity set that prevails currently." In short, he believes the less risky part of the market has already been gobbled up by early investors.
He also believes the current appeal for private credit is reduced by the decent yields on conventional fixed income assets – such as investment grade bonds and high-yield credit – "due to higher interest rates since 2021". But he adds: "The asset class is set to grow while banks sit on the sidelines."
Indeed, the recent wobble in the US banking market has perhaps added to their cautiousness. In March last year Silicon Valley Bank, a regional lender with more than $200bn of assets, collapsed over a period of two days following a run on the bank, becoming the biggest bank failure since the 2008 financial crisis. Two days later Signature Bank, the nation's 29th-largest lender, went under. And just days after that the contagion appeared to spread to Europe, with the already troubled Swiss bank Credit Suisse bought out by local rival UBS for CHF3bn (£2.61bn) in a deal approved by Swiss regulators without shareholder approval. As a result, many banks began once again licking their wounds and further reined in their lending to smaller companies and those perceived to be riskier borrowers.
Matthew Taylor, head of alternative debt at LGIM, which launched its first short-term alternative finance fund in 2021, says: "Bank retrenchment over recent years has opened up the opportunity to institutional investors, such as pension funds. And we believe the strategy will be of interest for a variety of reasons."
And returning to the point of the asset class being difficult to explain, Taylor adds: "It is a nascent asset class for many institutional investors and therefore we have found a certain amount of education is needed to help potential investors fully understand the risks associated with such an investment."
But, he continues, "we see a key part of our role as supporting clients to understand the strategies in which they are potentially investing – we are always happy to offer educational sessions to prospective investors".
It is the unknowns, however, that might also put investors off, despite the promise of increased education. The asset class is in its early stages and, with the exception of the Covid-19 pandemic, it has yet to be properly tested.
Rajan says: "Private credit is a young asset class. It hasn't had a mid-life crisis like hedge funds did during the last decade. The default rate has been very low in the benign economic environment since the 2008 crisis, helped by central banks' easy money policies. The true test will come if the net inflows remain as robust as they have been when the next recession arrives."
Showing promise
In the meantime, the asset class continues to show promise as features such as speed and flexibility proves beneficial to borrowers. The sticking point is whether more investors will arrive in the numbers they have and whether or not that is even being considered by asset managers in their never-ending bid to win more assets.
Powell is not shy about what he thinks: "Product providers typically exhibit herding behaviour and FOMO, or fear of missing out, when launching and marketing products. They've clearly seen a commercial opportunity in offering private credit funds at this particular stage in the economic cycle, and no firm wants to be the last to jump on board," he says.
Chris Newlands is a freelance journalist who has previously worked as an editor at the Financial Times, inews.co.uk and Financial News
