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PAGE 3 | Alternative Income for an Unpredictable World: Understanding Private Debt Funds

Why are Private Debt Funds Worth Considering Today?

Private debt funds of all kinds have garnered widespread interest from a broad spectrum of investors and investment managers in recent years. A very recent example is Apollo Global Management’s announcement of a new $12 billion vehicle to issue large corporate loans with the backing of the sovereign wealth fund of Abu Dhabi as its lead investor.1 Also, Blackstone closed an $8 billion real estate debt fund in September 2020. Direct lending of the kind pursued by private debt funds was so attractive to CalPERS, the nation’s largest pension fund with about $400 billion in assets, that it requested authority to change state laws in California to allow the pension fund to compete directly in this market.2 (Subsequently, the state lawmakers who sponsored the required bill decided to withdraw this bill, and CalPERS announced that it will still pursue private direct lending, but only using third party managers.3)

Below are some of the reasons that investors find private debt funds to be compelling alternatives to traditional asset classes today.

Low interest rates and returns in traditional investments.

At the end of the second quarter of 2020, 10-year government Treasuries offered a yield of just 0.64%. Moving out to a 30-year maturity increases the yield but it is still only 1.37%, a similar yield to municipal bonds. For investment grade corporate bonds, the yield was below 3.0%. While investors could obtain higher yields with energy-focused Master Limited Partnerships (MLPs), Business Development Companies (BDCs) or High-Yield (i.e. “junk”) bonds, such asset classes involve significant economic risk.

1 Apollo Launches Platform to Make Big Loans 

https://www.wsj.com/articles/apollo-launches-platform-to-make-big-loans-11594031400

2 Source: https://www.ocregister.com/2020/07/09/why-calpers-the-countrys-largest-pension-fund-is-getting-into-banking/

3 Source: https://www.bizjournals.com/sacramento/news/2020/08/19/calpers-direct-lending-confidentiality.html

Moreover, financial planners and wealth managers have growing concerns that equity markets are poised to deliver subpar returns after a bull market that lasted more than a decade. As one example, a model created by Prof. Robert Shiller of Yale University predicts that stocks will generate a 0.9% annualized return over the next decade, which is of even greater concern when one considers that stocks also have higher levels of volatility than most other asset classes.

High volatility in public markets increases the value of non-correlated asset classes.

During times of elevated stock market volatility, alternative investments tend to attract greater interest. Not only can they generate positive absolute returns across economic cycles, but they also tend to deliver smoother returns. And layering in such investments into a traditional stock-and-bond portfolio can generate superior risk-adjusted returns. 

Hedge Fund Research, Inc. (HFR) looked at various markets over a 20-year stretch ending in 2014, a time which included the first five years of the recent bull market. In that time, stocks rose by an average of 0.79% per month while alternative investments (such as real estate) posted a 0.70% monthly gain. More to the point, alternatives delivered respectable long-term gains with much lower volatility. Over the 83 down months in the 20-year period, stocks fell an average of 3.87%. Alternative investments fell by just 1.07%, according to HFR. Said another way, the stock market’s wild swings in that 20-year cycle produced a standard deviation of 15.5% according to Invesco, while alternatives had a standard deviation of 5.7%.

4 Source: https://www.horizonactuarial.com/uploads/3/0/4/9/30499196/rpt_cma_survey_2020_v0716.pdf

Looking ahead, private debt funds may deliver more robust returns than equities and many other asset classes on an absolute non risk-adjusted basis. In a survey of 39 investment advisors including Vanguard, Goldman Sachs, JP Morgan, BlackRock and others4, Horizon Actuarial Services found that private debt should be expected to generate a 7.75% annualized return over the next 10 years, compared to 6.16% for large cap stocks. (That’s a notably better outlook for stocks than the earlier-noted Shiller model). 

It’s important to note that in the Horizon survey, stock market returns are expected to come with an expected standard deviation of 16.2%, compared to an expected standard deviation of 12.1% for private debt. In our view, as noted elsewhere in this report, the volatility of returns for many real estate private debt funds (as measured by standard deviation), has turned out to be substantially lower than that forecast. Simply put, private debt returns have proven to be quite consistent over time. 

Expectations for private debt returns also compare favorably to long-term corporate debt. Strategists in the Horizon survey project a 2.6% annual return for high-grade debt in that time frame, and a 4.9% return for high-yield (i.e. “junk”) debt in that time. Private debt also compares favorably to those other asset classes over a 20-year time horizon, according to the survey respondents. 

One final note about that survey: participants project that U.S. large cap stocks and private debt have a 57% correlation of returns, suggesting a sufficient degree of non-correlation to provide enhanced risk-adjusted returns in portfolios.5

Small balance bridge and renovation loans for real estate investors are well-suited to the goals of many private debt fund investors.

Most investors avoid private debt funds, helping to elevate returns.

Investment returns are suppressed by too much capital pursuing any given opportunity. Conversely, returns remain more robust when capital flows to a particular opportunity are restricted. Some niches may face sustained restricted capital flows for a variety of reasons. Each of these reasons will be discussed in greater detail later in this white paper. In the authors' view, private debt funds remain mysterious to many investors, curtailing capital flows and increasing risk-ajusted returns, all other factors being equal. 

SIDEBAR ARTICLE

How One Larger RIA Uses Private Debt Funds

ayne Anderson Rudnick Investment Management (KAR) is a $37 billion RIA that has come to utilize private debt funds for client portfolios. The firm seeks exposure to real estate “up and down the capital stack,” according to Allen Kim, KAR’s Director of Research & Investment Solutions. That means access to both real estate equity and debt, and even within debt, exposure to investment vehicles that have a range of risk and yield profiles.

With real estate debt, KAR prefers funds that have a large level of safety, which has been their experience with private debt funds. Kim concedes that RIAs have a series of misperceptions about private debt funds, which can only be dispelled through due diligence. One example is company risk. Many operators of private debt funds are smaller firms, and it’s important to ensure that management has a strong and long track record and suitable risk controls in place. In the four years that KAR has been investing in private debt funds, the results “have exceeded our expectations.” says Kim. 

A key misperception for RIAs is that private debt funds carry the risk of defaulted loans and the need to work them out. In practice, the relatively low loan-to-value ratios in place means that such a scenario has happened only rarely. 

“People hear that the funds are involved with real estate development, which sounds risky,” says Kim. “But the proper level of due diligence helps them to understand that such perceived risks are often times unfounded.”

For its clients, KAR will allocate a certain percentage of a portfolio to private debt funds. Kim says they aren’t well-suited to clients that are extremely risk-averse. And even for the clients that are more risk tolerant, portfolio allocations to private debt funds will be limited to a certain (though unspecified) percentage.

 
 
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