Asset owners are aiming to get in on anticipated opportunities in private debt and credit in light of what they see as a worldwide need for loans and relief from the high-priced public and private equity markets.
Private debt investments are not easily “bucketed” into existing asset allocations because they can have characteristics of more than one asset class. Indeed, some investors have created a new allocation to “opportunistic credit” for these investments, which can range from direct lending and mezzanine to distressed debt.
Institutional investors are investing in the private debt strategy in a big way. Capital raised for direct lending funds was up 29% in the first quarter, after reaching an all-time high last year, with 45 funds closing on $29.1 billion in 2014, according to London-based alternative investment research firm Preqin. Private debt funds raised $16 billion in the first quarter, up from $12 billion in the first quarter of 2014, moving the average size of a private debt fund to $941 million from $528 million in the respective quarters. As of April 17, private debt managers have raised 25 private debt funds this year with a combined $20 billion in capital.
Some asset owners are bumping up their allocations to private debt strategies. The $34.7 billion Arizona State Retirement System, Phoenix, is increasing its credit allocation to 10% from 3% to get exposure “to private markets where capital availability is needed,” according to minutes of its March 27 meeting. Private debt is part of the retirement system's 25% fixed-income allocation.
Adding to the buzz is General Electric Co.'s decision to sell its commercial lending business, which would be a huge win for private debt investors. The move is seen as another example of regulated lenders getting out of the commercial lending business as a result of federal regulations, leading leveraged loans to slump. All these factors point to plenty of room for the capital being raised for private debt.
Indeed, 50% of investors in private debt intend to commit more capital to the sector in 2015 than they had in 2014, with only 13% of investors planning to commit less capital, a Preqin survey shows.
Direct lending and other private debt strategies are now more established. Many private debtmanagers are working on their second funds, which is giving investors comfort to invest after seeing returns from their first funds. For example, on April 16, KKR & Co. LP closed on $1.5 billion for its second direct lending fund, which was oversubscribed and is three times the size of its first such fund.
12.1% net IRR
KKR's first direct lending fund earned a 12.1% net internal rate of return as of June 30, according to agenda materials for a meeting of the South Carolina Retirement System Investment Commission, Columbia, which invests for the $29.9 billion South Carolina Public Employee Benefit Association. RSIC is an investor in KKR's second direct lending fund.
Direct lending is a small part of the New York-based firm's $26.9 billion credit business, which also includes mezzanine and a distressed credit and rescue capital strategy called special situations. KKR is also raising a new special situations fund, which has more than $700 million in commitments.
“Direct lending is becoming a much more mainstream asset class,” said Erik Falk, member and global head of private credit in the New York office of KKR. “The initial attraction to the asset class was the incremental return vs. what was available in other fixed-income products. ... The new interest is the result of compelling risk-adjusted and absolute returns they see in the asset class.”
KKR isn't the only firm to close on a megafund this year. Other funds are concentrating mainly on mezzanine and direct lending, including Goldman Sachs Group (GS) Inc.'s merchant banking division's mezzanine fund, the $8 billion GS Mezzanine Partners VI; Ares Management LP's $3.19 billion European Loan Program; and the $1 billion Morgan Stanley (MS) Credit Partners II.
Some investors also are concerned about the impact of an interest rate increase on their fixed-income portfolios, which is another reason why the private debt strategy is so popular, said Theodore Koenig, president and CEO of Chicago-based middle market private debt manager Monroe Capital LLC.
“What happens to fixed income when interest rates rise? Investors would get hurt,” Mr. Koenig said. “Institutional investors want to trade (invest) into floating rate, which is private debt.”
Most asset owners invest in private debt and credit as part of a fixed-income allocation. The next most popular choice is to invest in private debt and credit as part of a general opportunistic or an opportunistic fixed-income allocation. The third choice is to invest in private debt as part of a private markets allocation that could also include private equity, mezzanine and infrastructure, Mr. Falk said.
But for many asset owners, there is still a push-pull between the private equity staff and the fixed-income group as to where private debt belongs, consultants said. Private debt might have less risk than private equity, but is likely to provide lower returns than private equity. However, private debt's illiquidity means it doesn't fit squarely in a fixed income portfolio.
The $14.5 billion New Mexico Public Employees Retirement Association, Santa Fe, invests in private debt in both its private equity and not-quite-1-year-old opportunistic fixed-income allocation, said Jonathan Grabel, chief investment officer. The fund has a 7% private equity allocation and a 5% allocation to what fund executives call “fixed-income plus.”
Private debt is attractive “to the extent that private equity is overheated and larger funds are being raised, many with a one-and-done close,” Mr. Grabel said. ”Debt that supports private equity deals may be less risky. If (general partners) are overpaying, that may not impact the debt.”
Officials at New Mexico PERA recently have been investing in niche private debt strategies, including committing up to $65 million in February to Athyrium Opportunities Fund II, a health-care focused credit fund managed by Athyrium Capital Management LP.
“We're identifying more niche opportunities within private equity and private debt,” Mr. Grabel said. “We want to put money to work prudently.”
New Mexico PERA might issue an RFP in the next two months for a multisector opportunistic credit manager that could run as much as $400 million. The matter is expected to go before the investment committee in late April, he said.
Not restricting
Overall New Mexico PERA officials are not restricting their search to strategies that provide debt for investments in companies. They also are cutting across the private asset portfolio to invest inreal estate and real asset debt as well.
New Mexico PERA is not the only asset owner to invest in private debt as part of its private equity portfolio.
Alaska Retirement Management Board, Juneau, which oversees more than $26 billion in retirement assets, in December committed up to $200 million to KKR's second direct lending fund as a “fixed income replacement” even though it will be part of the sovereign wealth fund's private equity portfolio, said minutes for its Dec. 4-5 board meeting. The board has a 9% private equity target allocation.
Available investment strategies are not monolithic but vary greatly across industries and investment size. Investors are also interested in strategies that take advantage of events in the market, with energy being a big theme, Mr. Falk said.
For example, in December the $12.6 billion Orange County Employees Retirement System, Santa Ana, Calif., launched a search for either a private equity or credit manager to take advantage of the dislocation in the energy markets caused by the falling price of oil.
This article originally appeared in the April 20, 2015 print issue as, "Private debt