Portfolio approach to private debt strategies

With the expansion and proliferation of private debt strategies in Australia, investors can adopt a portfolio approach to investing in this asset class while diversifying across various economic risk factors, according to Foresight Analytics’ whitepaper titled “‘Australian Private Debt Market Review – Opportunities and Risks for Investors”.

Foresight Analytics analyst, Rodney Lay, stressed that many private debt sub-segments required domain expertise and established networks, which lenders’ with cheaper sources of capital often lacked.

“As a result, the supply and demand of financial capital in many of these segments remain imbalanced, providing opportunities for specialist debt managers to extract outsized risk-adjusted returns,” he said.

According to the firm’s founding Director, Jay Kumar, investors in private debt also received a yield premium over traditional fixed income investments with similar risk or economic exposure.

“‘Part of the excess yield is an “illiquidity premium” due to the non-traded nature of these assets,” he said.

“Another component of the yield premium is the “complexity premia, ” which is effectively compensation for structuring a private debt deal with non-standard origination, underwriting and pricing terms.”

The third and most material contributor to the yield premium was the “scarcity premium”, which reflected the scarcity of debt supply in specific segments of the market.

“In addition to these drivers, the idiosyncratic skillset of a debt manager in sourcing deals, underwriting, pricing, structuring, portfolio management, recycling capital and risk management can add material alpha to the base return,” Kumar added.

Also, many institutional investors have adopted the private debt asset class as a core part of their defensive portfolio, as higher yields and risk-adjusted returns compared to traditional fixed investments have resulted in greater institutional allocations.’

According to Foresight’s whitepaper, other benefits offered by private debt asset class include:

• Portfolio diversification due to idiosyncratic terms;
• Reduced volatility due to mark-to-model valuations;
• Inflation hedge due to short duration reset (floating-rate structure);
• Income dominated total return;
• Defensive and resilient capital protection;
• Expanding opportunity set for domestic and global private debt strategies; and
• Availability of specialist managers across private debt sub-segments.’