What lays beneath – Zenith pragmatic on private debt

Financial advisers and their clients should not lose sight of the fact that private debt is an illiquid, sub-investment grade asset class with default risk, according to research and ratings house, Zenith Investment Partners.

In an analysis of the growing popularity of private debt, Zenith’s head of alterntives and global fixed income, Rodney Sebire said private debt is unusual, and consistent headline returns could hide the risks that lie beneath the surface.

“Paradoxically, two managers could end up delivering similar return outcomes, but with varying risk profiles and default sensitivities. As the impact of higher interest rates and declining consumer spending continues to impact corporate profitability, we are approaching an inflexion point,” he said.

“The spotlight will be placed on private debt managers and the robustness of their lending processes. Investors may soon learn that private debt returns are in fact, a ‘two-way street’.”

The analysis said that navigating the private debt universe could prove a minefield for advisers given the different lending types and associated risks in circumstances where managers employed a range of strategies with some specialising in senior secured lending while others invested in junior or mezzanine loans or a combination of both.

“The ability to compare performance across managers is difficult given the private, bilateral nature of corporate lending and the differences between individual loans, covenants and security packages. A manager with an impeccable track record of no ‘technical’ defaults may pass the first review, but this may not reveal the number of loan restructures, payment deferrals or covenant relief provided to borrowers.

“In stable environments, returns from private debt are predictable, delivering consistent monthly returns with limited capital volatility. However, in challenging environments, the type of lending, quality of underwriting, level of covenant protections and security packages quickly separates good managers from those with relaxed standards.”

The analysis said that Including a private debt fund in a client’s portfolio is complex it involves identifying the expected risk/return, performance in negative equity environments, and alignment to the client’s growth or defensive allocation.

“The reliability of cash distributions and regular access to capital are key considerations. What if a manager were to freeze redemptions, would this create asset allocation imbalances and broader liquidity challenges?”

“Fees and costs have always been a murky topic, with many funds not subject to the RG97 fee disclosure regime. The payment or collection of fees across managers varies significantly, including the types of fees charged and the beneficiary of those fees. Managers may retain a portion of the borrower-paid margins or penalty interest.”

“In many instances, the costs of a private debt fund exceed 2% p.a., subject to the type of lending and a manager’s approach to sharing lending fees with investors. This remains a key focus area for Zenith and an area where we are yet to gain complete comfort (apart from a small number of institutional quality managers that we have on our Approved Product List (APL)), noting that the universe has yet to achieve uniformity in terms of disclosure practices.”