National Standard has opted for Private Debt as an asset class for delivering its impact investing objectives as opposed to Private Equity. This follows National Standard’s research on the global Private Debt markets where we gained significant insights into the development of the global Private Debt market since 2008. Private Debt refers to non-bank lenders providing capital mainly to small- and medium-sized companies in the form of a loan rather than equity, with loans ranging from direct lending to specialised lending into distressed assets. Private Debt is also utilised in other asset classes that include infrastructure and real estate. It has, however, not been a common asset class prior to the 2008 global financial crises as banks dominated the lending space.

One research report in 2019 goes deeper into defining Private Debt, noting that it has only recently been considered an asset class in its own right and that the term covers a range of different investment styles and strategies. The report defines the term ‘private debt’ as typically applied to debt investments that are not financed by banks and are not issued or traded in an open market, while the word ‘private’ refers to the investment instrument itself and not necessarily the borrower i.e., public companies can borrow through private debt just as private companies can. Private debt falls into a broader category termed ‘alternative debt’ or ‘alternative credit’, and is used interchangeably with ‘direct lending’, ‘private lending’ and ‘private credit’. Within the private debt market, investors lend to investee entities – be they corporate groups, subsidiaries, or special purpose vehicles established to finance specific projects or assets – in the same way that banks lend to such entities. Private debt investments are typically used to finance business growth, provide working capital, or fund infrastructure or real estate development.

History

In giving the history on the rise of Private Debt, one research report in 2015 noted that the 2008 credit crisis led to bank lending shrinking as banks were forced to repair their balance sheets, and with the Basel II and Basel III international banking regulations tightening both capital requirements and liquidity requirements for banks. This was witnessed across the globe. Mid-market companies needed fresh capital that they could no longer secure from banks to refinance their existing loans and raise new capital to fund their business growth. This gave rise to Private Debt markets as institutional investors were able to step in, attracted by Private Debt’s returns that have the potential to outperform some equity and fixed income indices, and the low correlation with other asset classes. As a diversification play, Private Debt is perceived as having superior protection compared to traditional bonds and equity-like returns.

Tim Hames, Director General of the British Venture Capital Association gave the following statement in September 2015 in his analysis of one research report:

“The changing strategies of traditional institutional lenders in the wake of the global recession continues to act as a drag on business expansion plans. This has spurred rapid growth and increased interest in alternative forms of lending, with demand from SMEs matched by a strong appetite from institutional investors faced with continuing low yields from traditional fixed interest vehicles.

The increase in both supply and demand is having a significant impact on how alternative lending funds are being used. In recent years not only has there been an influx of new entrants, but there is also now a far greater diversity of investment strategies. It is a dynamic area and one where interest has accelerated dramatically in recent years and is only going to increase as more assets come onto the market. Next to private equity, private debt is expected to deliver the highest returns over the next three years, thus taking it into newly emerging asset allocation models.”

Another research report by Preqin in 2020 noted that Private Debt allocations are favoured by multi-asset investors due to the potential for both stable cash flows and uncorrelated returns. Amid equity market volatility and with an uncertain period ahead for many sectors within private markets due to the Covid 19 pandemic, Private Debt investments can anchor an investment portfolio.

A further research in 2015 noted that, with returns remaining historically low across asset classes, institutional investors will continue to hunt for yield, with Private Debt expected to gain more traction among investors with longer time horizons who want to exploit the illiquidity premium associated with Private Debt. This falls squarely within the appetite of pension funds and insurance companies who are typically long term investors. Asset classes like Private Debt that were once considered peripheral will most likely continue to gain momentum as the global macro-economic environment changes. With increased regulations, Banks can no longer provide the levels of lending they did before the 2008 global financial crisis, and the new bank regulations introduced post the global financial crises would mean that the rush towards Private Debt is structural and is unlikely to reverse.

Rationale

In summary, the following key factors will continue to present Private Debt as an attractive asset class for long term institutional investors like pension funds and insurance companies:

• • Inflation beating risk-adjusted returns uncorrelated with other asset classes like equities and fixed interest investments

• • Enhanced structural protections due to the detailed due diligence that is undertaken when issuing a loan. Before a loan is made, a detailed due diligence process is undertaken, various scenarios are envisioned and tested to evaluate how the company might perform in differing market conditions, and if it would still be able to meet all of its financial obligations. This facilitates informed decision-making. The loans then issued have a final maturity date, a contractual return and a tailored set of terms and charge over the assets of the company that protects investors in the loan from the risk of loss in priority to other unsecured investors.

• • Relative appeal over high yield bonds due to changes in mainstream bond investing over the past few years in some global markets, where there has been reduced liquidity in some secondary bond markets with no corresponding liquidity premium added to compensate for the illiquidity.

• • Relative appeal over high yield bonds due to changes in some public capital markets where there has been a shift in issuance from floating to fixed-rate bonds, favoring issuers when rates rise, with investors shifting to Private Debt markets that still offer floating rate returns.

• • Private Debt offering equity-like returns, where some research analysis of median Private Debt returns showed that they benchmark well against equities. In a rising interest rate environment, for example, the floating rate returns from private debt are protected, whereas a fixed rate bond return is exposed to this risk. The equity kickers that are often attached to private debt investments then provide further equity upside for investors.

• • Private debt as a cross-over asset, providing bond-like features and equity-like returns, is particularly compelling during equity bear markets where:

• • • • buy-and-hold investing may struggle as equities may be outperformed by bonds over a long period

• • • • actual returns may diverge markedly from expected returns for most asset classes

• • • • diversification may become less effective, as the correlation between historically lowly correlated asset classes may continue to rise, which may promote innovations in institutional investors’ approach to asset allocation in pursuit of broader diversification, especially where asset-liability matching is required, as in the case of inflation-linked annuity portfolios, in which case Private Debt may be preferred as a surrogate asset for equities from a return perspective and for bonds from a hedging perspective.

A further 2019 report stated the supply and demand factors contributing to the Private Debt market’s continued growth globally, dominated by Europe and the US, reaching about US$887 billion assets under management in June 2020 (from US$638 billion in June 2017):

Supply factors:

• • Banks have reduced lending (particularly to smaller private companies) to meet regulatory capital requirements by deleveraging, thereby limiting sources of capital.
  • In turn, that has made direct lending more attractive to investors, as yields may be higher than public debt and flexible terms may allow interest payments to be index-linked.

Demand factors:

• • Investors are seeking to increase yield in an ultra-low interest rate world.
  • Investors are seeking diversification from traditional asset classes.
  • Investors are seeking floating interest rates to protect against rising rates.
  • A recovering global economy has driven considerable demand from companies to finance and/or refinance loans to enable growth.