Institutional investors struggling to find value in crowded private debt market

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It has become more challenging for institutional asset owners to find compelling opportunities in private debt, according to new research from Willis Towers Watson which examines the key principles that investors should follow in order to invest most effectively in the sector.

According to the report, “Finding value in private debt”, adoption of private debt has become more widespread amongst asset owners since the company published its 2015 paper, “Illiquid credit – playing the role of a (good) bank”, with assets allocated to credit strategies more than tripling between 2007-2017. However, Willis Towers Watson believes that investors are placing too much focus on mid-market corporate direct lending, thereby missing out on opportunities in less competitive parts of the market which could offer greater return outcomes.

Chris Redmond, Global Head of Credit & Diversifying Strategies at Willis Towers Watson, said:

The private debt market has grown substantially in a relatively short space of time and continues to do so in an increasingly diverse manner. As the market widens, its complexities become more difficult to understand, with the majority of institutional investors continuing to concentrate their activities on mid-market corporate direct lending. The result is large capital flows into a squeezed portion of the market, creating downward pressure on returns and upward pressure on risk.

With this portion of the market demonstrating signs of deterioration in future return potential, Willis Towers Watson believes that investors must make sure that they continue to direct capital towards areas offering the best risk-adjusted returns.

According to the research, regulation continues to inhibit historically dominant lenders in several sectors, with the most attractive returns most likely to be found where the impact of policy is at its most extreme.

In the research paper, Willis Towers Watson believes there is a tendency for managers to focus on ideas that can be quickly raised, are scalable and profitable to run, which ultimately results in flocking towards very similar opportunities.

In reality, we find that smaller, niche strategies which are harder to scale and so typically offered by specialist managers are often the most compelling, particularly when faced with higher valuations such as those we see in most credit markets today. Investors who are willing to pair with specialist lending teams in specific geographies and assets are ultimately going to derive the greatest benefit in the long-term,” added Redmond.

Similarly, investors’ willingness to embrace complexity and revisiting asset classes tainted by prior poor performance are also likely to be well rewarded.

It is important to understand the market fundamentals for the assets you are lending against. Understandably, many investors are unwilling to be a first-mover into markets that have experienced historical performance issues,” commented Redmond.

US residential mortgages are a great example of this. It’s a sector that we believe has demonstrated improved fundamentals whilst delivering excellent performance, both on an absolute and risk-adjusted basis.

Redmond concluded:

In recent years meaningful investor capital has flowed into the private debt market, making it more challenging to find value today. However, we feel there are compelling opportunities to be found if investors remain selective, with good value for risk taken for those investors willing and able to go the extra mile and unearth interesting opportunities. As such, in our paper we look to try to provide some guidance as to the sorts of characteristics we look for in investments we recommend.

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