This article appeared in our 2022 investment outlook’Shoot the rapids‘. Read it here
Despite concerns about a possible weakening of economic growth and uncompromising price pressures, the overall picture at the end of 2021 was clear: conditions in G7 economies were improving thanks to fiscal and monetary stimulus at scale that have supported stock markets and kept interest rates low. As a result, equity valuations rose to unattractive levels and bonds looked expensive.
Find appeal with more investors
This mix has left private – unlisted – debt emerging as a suitable alternative. For the same level of risk, it offers investors a liquidity premium compared to listed bonds. This explains the strong inflows into private debt – amounting to 120 billion dollars in the first half of 2021 in Europe (source: Preqin).
A broader group of investors are now turning to private debt. Insurers, won over by its favorable treatment under Solvency 2 rules, have paved the way. They are increasingly being joined by pension funds, sovereign wealth funds and even individual investors.
Many institutions have permanent allocation programs at 10% or 20% of their portfolios, sometimes above 40%, with a balance between investment capital, real assets and debt.
Funding demand supports premiums
Of course, private debt is not immune to the debate on the impact of excess liquidity on risk premia. The quantities of dry powder are contributing to the pressure on credit lines. However, liquidity premia remained intact as funding demand also increased.
Growth driven by an explosion in mergers and acquisitions fueled the financing needs of European mid-cap companies.
In addition, the infrastructure needs related to the energy and digital transitions are enormous, especially at the intersection of information technologies and traditional infrastructures: Battery electricity storage, smart infrastructures (grids, cities, roads), and data processing and transmission.
Furthermore, the rules of the Basel Committee impose additional constraints on banks’ balance sheets. As a result, private debt has become part of a complementary funding model for banks – and investors – in Europe.
Please note that “digital assets” are electronic files of data that may be owned and transferred by individuals, and used as currency to conduct transactions, or as a means of storing intangible content, such as computerized works of art, videos or contract documents. Cryptocurrencies, so-called asset-backed stablecoins, and non-fungible tokens – certificates of ownership of the 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 for investors. Increasingly, private debt involves strict compliance 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 adapted to each underlying asset. For our infrastructure and real estate loan portfolios, we measure carbon and environmental impacts and, for example, the number of households accessing digital networks. For a small to medium-sized (SME) issuer, this involves assessing the awareness of a company’s managers of ESG themes and analyzing the choices made by the company.
The search for diversification may be an additional reason to invest in private debt. The risk of overvaluation of the most sought-after assets pushes investors to consider a wider range of assets.
This is why we think it is important to have a multi-sector approach in investing in infrastructure and real estate debt. We look at a wide range of businesses, applying various strategies among SMEs and even more granular financing with mortgages.
Finally, the search for a fair compensation because the risk taken must be at the heart of any credit decision.
A classic ratio is the case selectivity rate. We’ve found that many seemingly good credit opportunities can be turned away if they don’t offer a fair level of compensation. This is why we include in our investment process a systematic calculation of the liquidity premium based on our analysis of listed peers.
We are convinced that by fulfilling these three prerequisites of sustainability, diversification and relative value, we can succeed in adding value and impact to portfolios through our management of private debt allocations.
All opinions expressed herein 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 have different views and make different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.
Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as 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 developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.