This article was written and published by Chris Rich, Staff Writer at KangaNews (October/November 2020 edition)

Private debt is a catch-all term for a number of private financing formats including institutional corporate loan placements, leveraged finance, structured finance – especially in mezzanine format – property debt and project finance. Historically, most of this type of funding has been provided by the local major banks supplemented by international banks, with just a small slice available to asset managers.

Given its breadth and diversity, it is impossible accurately to estimate the scale of the market – let alone different lenders’ market share within it. But there are signs of more debt becoming available to investors outside the banking sector. For instance, regulatory changes in the securitisation market have made it harder for banks to hold the full capital structure of warehouse facilities provided to nonbank lenders, creating an opportunity for specialist investors to gain mezzanine exposure even before borrowers approach the capital market.

On the demand side, the hunt for yield is prompting interest in fixed-income strategies that focus on higher-yielding securities. In 2020, Australia took its final steps to catch up with the rest of the world as an ultra-low cash-rate environment.

The Reserve Bank of Australia (RBA) cut the cash-rate to 0.25 per cent in the early stages of the COVID-19 pandemic. Most analysts expect a further “micro-cut” to 0.1 per cent and even the possibility of negative rates at some stage in 2021 – despite RBA protestations that this approach has not delivered desired results when implemented elsewhere.

Australia’s interest rate had already fallen significantly prior to the onset of COVID-19. The RBA cut the cash-rate to 1.25 per cent from 1.5 per cent in June last year – after spending almost three years at the higher rate – before dropping to 0.75 per cent in October.

Bob Sahota, founder and chief investment officer at Revolution Asset Management in Sydney, says the private-debt space continues to offer appealing absolute-return opportunities in the new environment. “From March onwards, we have been able to demonstrate that we can get the same type of deal done in the market as a pre-pandemic transaction – meaning the same level of credit risk, spread and illiquidity – but be rewarded with 1-1.5 per cent of additional yield in the COVID-19 affected market,” he tells KangaNews.

This backdrop may be helping specialist investors clear one of the biggest hurdles to entry to their sector. Private debt is typically illiquid, which makes it a tough fit for end investors that require – or are legally required to be offered – daily liquidity. But with rates at an all-time low and credit spreads tight, private-debt managers report investors of all stripes are taking the steps required to gain access to their sector despite the liquidity constraints.

“We think investors are taking the next step, which is strategically understanding fixed-income products in the alternative debt space. This process, which was already ongoing, has been made more profound in the last 12 months with the rates environment,” says Robert Camilleri, Melbourne-based founder and investment manager at Realm Investment House.

Metrics Credit Partners is among the beneficiaries. It offers a range of strategies, lends to investment- and sub investment-grade corporates and has the ability to participate through the entire capital structure from senior-unsecured debt through to equity.

Institutional investor interest has increased across this spectrum of products, according to Andrew Lockhart, managing partner at Metrics in Sydney. “We have won new superannuation-fund clients over the past six months and have received an increase in capital allocation from existing superannuation clients, insurance companies, universities, charities, foundations and others that have all been looking for alternative ways to drive yield,” he says.

Banking Environment 

Some of Australia’s private-debt investors are long-established names in the sector. For instance, along with several other asset classes, Moelis Australia manages just more than A$1 billion (US$718.1 million) in the private-debt space with a focus on providing secured loans to mid-market corporates and SMEs.

Chris Wyke, Sydney-based joint chief executive at Moelis Australia, says many of the factors that led the asset manager to pursue opportunities in private debt in the early 2010s remain in place today. “In the lead up to the financial crisis the major banks dominated the lending market in Australia, and this led to regulators seeing the need to open up the market in a smooth and controlled manner post-financial-crisis. This has been a global trend,” he explains.

Wyke points to the fallout from the banking royal commission and increased regulatory capital requirements as significant factors mitigating banks’ capacity to lend in some areas of interest to specialist debt funds.

Some borrowers may fall out of the banks’ realm entirely while in other cases funds may be able to invest alongside banks to top up capacity or provide liquidity in specific parts of the capital stack. Securitisation again illustrates this latter outcome, as funds now frequently provide a – smaller, but higher-yielding – mezzanine slice alongside banks as the senior lender in warehouses.

Specialist fund managers say this process was already well underway ahead of COVID-19. “Our credit funds are focused on areas we believe present opportunities for solid risk-adjusted returns – and these are primarily areas where the banks are no longer undertaking lending activities. It is a fertile way to go about growing loan portfolios,” Wyke adds.

On the other hand, the bank sector is suffuse with liquidity in the latter months of 2020 and the RBA’s term funding facility (TFF) is widely expected to maintain this status quo for an extended period. All else being equal, this should make the banks more willing and able to lend to any borrower sector. Facilitating credit provision across the economy is certainly the RBA’s goal.

The pandemic certainly did not prompt a liquidity crisis. Indeed, one of the largest differences between COVID-19 and the financial crisis has been the availability of capital to corporates – from domestic and, for the most part, international lenders.

Wyke believes this is already changing, though. “In the early days of COVID-19, the banks were extremely accommodative of borrowers due to the sheer number of client applications being thrown at them. I think they are now re-evaluating that accommodation,” he says.

While the TFF and strong deposit inflows have enhanced the major banks’ ability to lend, specialist investors are quick to point out that the pandemic has not undone the heightened regulatory scrutiny placed on the banking sector after the last crisis.

“APRA [the Australian Prudential Regulation Authority]’s regulations around banks’ activities will remain in place. They can capitalise on some pockets of credit thanks to their competitive funding advantage but there is still a large landscape out there for asset managers like us to thrive,” Wyke argues.

"Our credit funds are focused on areas we believe present opportunities for solid risk-adjusted returns – and these are primarily areas where the banks are no longer undertaking lending activities."

Chris Wyke, Joint CEO at Moelis Australia

The environment has certainly not been enough to deter greater interest in private debt, including from some more mainstream players. For instance, in September Revolution announced that it had signed a co-investment relationship and consequent new mandate to manage Australian and New Zealand private debt with QIC.

Phil Miall, Brisbane-based director, credit at QIC, agrees that the opportunity set is not drying up despite the changing environment. “Banks still have to hold greater capital levels so their return on capital is less. Bank appetite for sub-investment-grade loans in particular is likely to be affected, which creates an opportunity for institutional investors to fill the supply gap and provide capital at attractive yield.”

This is not a phenomenon unique to Australia, either. In particular, a number of Australia-based specialist funds are looking at opportunities in New Zealand – which is experiencing similar banking-sector dynamics.

Revolution, for instance, has 25 per cent of its assets invested in New Zealand. Sahota says: “Much like the Australian experience, there is an increasing trend toward private-credit investment in the New Zealand market as institutional and wholesale investors seek out reliable and defensive income against a backdrop of poor global growth, low inflation and falling yield.”

Liquidity Management

The reality of the return environment is making debt investors of all types contemplate breaking new ground to find yield. In the high-grade space, this often involves moving further out in duration to take advantage of a relatively steep Australian dollar curve. In credit, many investors are prepared to compromise long-held requirements on liquidity.

Sahota tells KangaNews institutional-investor interest in the private-debt space has come a long way in a short time as a result. “When we started – two-and-a-half years ago – there was a lot of push back about the illiquidity of our asset class compared with offshore. But as rates have collapsed globally, fund managers are being forced to look at the defensive part of their allocation in a lot more detail,” he says.

Liquidity in private debt may also not be as shallow as it is often perceived, says Luke Gersbach, Sydney-based senior portfolio manager at Mirae Asset Global Investments. “If you need to get out of positions, you can. Equally, there are opportunities to increase positions. The illiquidity premium offered by private debt is one of the attractions and it is one of the yield enhancers we are trying to harvest.”

In this case, scale can help. Lockhart tells KangaNews: “Turnover is substantial when you run an operation the size of ours, and we certainly don’t have any liquidity obligations to investors in our various funds that could not be adhered to.”

Starting with its first wholesale investor fund in 2013, with one investor and A$75 million of assets under management, Metrics now oversees in excess of A$5.5 billion with about A$4 billion sourced from Australian institutional funds. The firm originates transactions and lends directly to Australian and New Zealand companies via a range of products.

Lockhart believes investors’ reassessment of allocations to traditional fixed-income asset classes picked up in intensity following the volatility of March and April. In particular, he suggests that institutional funds invested in public-market securities have not been able to get the liquidity they sought and experienced dislocation in traded prices as volatility abounded.

“The market is less liquid than investors were expecting – they are being charged substantial costs on exit,” Lockhart says. “This has led many to reconsider some of their investment positions because they have not performed as they should have in periods of stress.”

Sahota says the illiquidity that hit public markets in March and April changed the way typical fixed-income fund managers view illiquidity in the private-debt space, with the COVID-19 overlay making the illiquidity premium an attractive proposition.

In effect, the argument goes, confronted with illiquidity across their portfolios many investors are warming to the idea that they might as well be paid an illiquidity premium in the private-debt space for at least some of their assets under management.

This is not just an institutional-investor story. Specialist funds say retail interest in their strategies is growing, too – and some have made distribution moves to take advantage.

Heightened risk environment

At the same time, the pandemic and the heightened credit-risk environment bring an increased focus on credit quality. Lockhart says some of the inflows to Metrics have moved out of property-related equity and into the debt part of the capital structure, seeking solid return with added security and less asset-price volatility.

Sahota adds that at this point in the cycle there is growing recognition of the benefit of being secured at the top of the capital stack versus unsecured debt or equity. This was already the case coming into the COVID-19 dislocation, though. “We found that this discussion has really started to gain traction as the coordination of central banks around the world has reduced interest rates – in some cases into negative territory,” Sahota says.

Private-debt practitioners describe COVID-19 as a classic case of a risk event creating challenges and opportunities. Sahota reveals that the secondary market has been a productive pipeline for Revolution, while at the same time the risk environment has led to a renewed focus on structural quality in the new-issuance space. “The upfront fees are higher and the overall margins we have been able to get are better on a risk-adjusted return basis because of the current environment,” he comments.

Moelis Australia maintained a comfortable cash position until recent months, Wyke says, when micro- and macroeconomic data began to improve. It has now ramped up lending in structured finance as well as pre-sale construction of residential properties. By contrast, the firm remains cautious on anything consumer-related.

The devastating impact of the pandemic on some economic sectors is not without impact in the private-debt space. As Wyke’s rundown implies, lending to the property sector is a significant component of the private-debt market – and this sector was one of the hardest hit by the COVID-19 crisis, at least outside the residential space.

Gersbach says Mirae has become more selective about the sectors it will look at. “We don’t knock something out purely because of its sector but we have not looked at anything in the property space for most of the year. Pre-COVID-19 this was from a pricing and competitiveness standpoint but now we have largely dismissed property and retail transactions outright,” he says.

There are still opportunities. A steady stream of transactions in sectors that have experienced significantly less impact from COVID-19 has been a decisive factor in moving away from property, Gersbach adds. “The health and technology sectors have provided private-debt investors with the most opportunities, proving their resilience through the crisis,” he reveals.

Steering away from procyclical industries has been key to the success of Revolution’s strategy. “Through the crisis we have focused on healthcare, consumer staples, infrastructure and mission-critical software companies,” Sahota comments. “We have provided, along with other lenders, the senior-secured debt for acquisitions where borrowers could demonstrate they have performed well through the cycle.”