Pictet Asset Management head of private debt Andreas Klein says “mainstream” private credit investments have probably run their course as buyout activity decreases and global regulators up their oversight of the booming asset class. Instead, investors should consider “micro-niches” such as the lower-mid-market, litigation and biosciences financing, he argues, but warns these emerging corners of the market come with hidden and unique risks attached.
Buyout volume as a percentage of S&P market capitalisation is at the lowest level ever recorded, Pictet Asset Management head of private debt Andreas Klein told the Fiduciary Investors Symposium.
The statistic suggests a dearth of demand for capital, which, coupled with “excess dry powder” from enthusiastic institutional investors, provides some evidence for the topical assertion that cracks are starting to appear in the veneer of the private credit boom, Klein said.
“There are definitely some headlines and … media coverage about the heat within the market and some of that is definitely justified,” he told the symposium hosted by Top1000Funds.com at the University of Toronto, Canada, last week. “You have this imbalance between supply and demand. And consequently, it’s obvious what happens, there’s a pressure on returns.”
Global private credit assets are estimated to have doubled in just a few years to surge past $2 trillion, according to the IMF, which has warned the market presents a potential “vulnerability” for the financial system.
Klein said the penetration of private credit as a capital source for borrowers continues to increase, due to myriad macro and geopolitical factors especially the retreat of banks from certain lending markets due to balance sheet mismanagement (think Silicon Valley Bank, First Republic and Credit Suisse) and higher regulatory standards, alongside lower public issuance.
But he outlined Pictet’s thesis that this “golden age of private credit” is “unlikely to stick around”, even though the high default cycle some had anticipated in the post-pandemic era never really eventuated, giving some false hope to the market.
Micro-niches over mainstream
“There’s certainly some elements of concern going on,” Klein said. “Now, do we still think that there’s value to be had in the private credit markets? I obviously wouldn’t be sitting here if we didn’t think so. It’s just you need to think about credit from a different perspective.
“The mainstream solutions have probably run [their] course. Yet, the vast, vast majority of assets going into the private credit space is into mainstream funds. So where can you still find value?”
He argued that the opportunity for pensions and sovereigns lies in “micro-niche” markets and strategies. “We like the lower-mid market, for example, we think it’s a much more insulated market,” he said. “We think the supply and demand dynamics within the lower-mid market are much more balanced. Structurally, there are more small corporates than there are large corporates and hence the borrower universe is much wider.
“In 2008-2009 it was deposit money that regulators were focused on – now it’s really pension money that regulators are focused on.” – Pictet Asset Management head of private debt, Andreas Klein
“Furthermore, the idiosyncratic risks that you find within a heterogenous market environment allows you to structure around that risk and drive incremental yield whilst protecting yourself against that. And we’ve seen that the lower mid market has been much much more resilient than the larger cap in terms of margin preservation.”
Other micro-niches singled out included litigation debt finance, biosciences finance and significant risk transfer, which usually involve the transfer of credit risks from banks to investors, often using synthetic securitisation.
“These are just areas that you can think of that are uncorrelated that have potentially diversification elements and bring resilience into the wider portfolio,” he said. “It comes down to manager capability for origination, particularly on proprietary origination, being able to find these assets that have these specific characteristics within micro-niches that are protected.”
‘Orange flags’ and ‘shadow banks’
Asked whether government regulation posed a threat to the market by potentially limiting the appetite of asset managers to take up the lending mantle forfeited by banks, Klein said more regulation was not only likely, but welcome.
“I think there’s a lot of underlying systemic risks within this ‘shadow banking’ market,” he said. He warned of a number of prevalent “orange flags” investors should look out for.
“There’s a lot of hidden leverage, whether that is at fund level [or] leverage within the underlying assets; [there is a] significant increase in the number of continuation vehicles for private equity vehicles [and an] emergence of ‘hold co.’ financing or NAV financing to provide liquidity to underlying LPs. These to me are all signs of orange flags that mask a larger underlying issue.
Net zero requires transformational changes and significant investment. This guide aids industry leaders in implementing net-zero investing. It offers practical guidance that stresses the importance of mindset shifts and highlights strategies for success.
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By Roger Urwin, FSIP
For investors with long careers in managing fixed income portfolios, 2022 was “a real shock”, according to APG Asset Management managing director of global fixed income Ann-Marie Griffith.
Griffith manages a €200 billion ($217 billion) fixed income portfolio, roughly 50 per cent in developed market government bonds, about 30 per cent in credit and the balance in emerging markets.
She told the Top1000funds.com Fiduciary Investors Symposium in Toronto that for a considerable period of time, treasuries were viewed as a natural hedge, but in 2022, “that hedge completely broke down and was probably one of the more significant loss drivers across fixed income portfolios”.
“The positive correlations caught many people offside in terms of the balanced portfolio 60/40 mix, but certainly within fixed income portfolios as well,” she said.
“And what I mean by hedges, generally, when you’re long credit risk, whether it’s corporate risk or structured credit risk, you can offset some of that risk with a bit of treasury hedges, because for a long period of time, they were quite negatively correlated,” Griffith said.
But the turnaround in 2022 has led to some rethinking inside Europe’s largest pension investor about “how long and how persistent the correlation between treasuries and underlying fixed income investments will remain positive”.
“And then the inverted yield curve obviously plays a little bit of a role here as well,” Griffith said.
“The cost of hedging across the yield curve can be quite different and also brings into question the traditional ways of looking at risk management within fixed income.”
The three S’s
Griffith told the symposium that “there’s quite a lot riding on when that positive correlation breaks down”.
“And if it’s intermittent, how agile can you be, how tactical can you be in adjusting your hedges so your hedges don’t undermine your actual investments in your portfolio?” she said.
“Hopefully, we’re not going from 5 to 10 per cent in terms of interest rates, but there is some question about how persistent these higher rates will be, and if in fact the Fed – it is actually the Fed and other central banks around the world – have done enough.
“You’ve seen the US economy be incredibly resilient in the face of these higher rates. One would expect that to have slowed things down quite drastically, but that was not the case. So there’s a lot of thinking going on a lot of challenging assumptions and again, making things more resilient and preparing for what, what might come.”
The bond rally of March 2020 was the kind of reaction to be expected in a period of crisis when risk assets sell off, said Maryland State Retirement and Pension System chief investment officer Andrew Palmer.
However, then “the bond market broke, and the Fed had to step in”, Palmer said. He believes from a structural perspective, that bonds still provide that hedge, but they may not provide it over short, intermediate periods of time”.
“And it may take extraordinary efforts by the Fed,” he said.
“So, I have got three Ss to talk about. Structure is the first; so the structure is different. The size is different, that’s the second S. And then the third one is sustainability.
“And my basic point is, I think we have to think differently than just looking in the rearview mirror and saying, ‘This is how they performed in the past’. Even if you go back to 1980, there was a positive correlation then. But I think you could think it has some different attributes to really pay attention to and try to incorporate into your portfolio construction going forward.”
Palmer said that the fund is currently rethinking how it approaches fixed income management.
“I’m thinking about things; doesn’t mean [I am] changing anything,” Palmer said.
“At the moment, we’re thinking [it] through. We have a one-year process we’re kicking off with our board on asset allocation. We’ve had a long duration portfolio, which has been sort of a pretty much of a drag over the last three years.
“I do believe that going forward, it’s actually got a lot more portfolio utility than it has had in the past. The cost of insurance is cheaper you’re getting it doesn’t cost you a lot to have it.
“I still believe in the role of it, I just think maybe for the implementation or through more stress testing and those types of things, I think we have to be a bit more dynamic in how we manage it.”
The symposium heard that paying attention to geographical diversification could become a more prominent aspect of fixed income management.
That’s one thing we’re going to look more closely at,” Palmer said.
“We’ve been very US focused. One, because it wasn’t very attractive to go elsewhere, with negative rates and much of the world, and our liabilities are all in dollar; but I do believe we’ll, we’ll be looking at non-dollar allocations to sort of build in some more diversification on the bond side.”
Regime shift
MFS Investment Management fixed income portfolio manager Ward Brown said if the post-2022 stock-bond correlation proves to be more than transient, “that has some big implications for portfolio construction”.
When interest rates are raised by central banks to curb inflation driven by demand, it generally indicates a growing underlying economy. But when rates are raised to tame inflation caused by supply constraints, the underlying economic fundamentals can be quite different.
“What’s critical for thinking about this positive correlation is whether or not those demand shocks are going to continue driving inflation, or whether it’s going to be something else,” he said.
“What else could cause inflation to be higher and move inflation around? Well, one obvious answer is supply shocks.
“That’s a situation where inflation goes higher, but growth doesn’t move. In fact, growth might go lower. So in that circumstance, you’re going to get this positive correlation.”
But growth isn’t responding, Brown said.
“And so equities and any long-duration asset is going to be very sensitive to interest rates,” he said.
“They’ve got two things driving those assets: growth and the discount rate. If growth isn’t doing anything, then they’re just going to respond to the discount rate. No higher growth, but central banks are raising rates. That’s how you get this positive correlation: raising rates, bond yields go down, and long-duration assets go down as well.
“That’s important to think about when you’re saying, Well, we’re going to get persistence, because one argument that we’re going to have this positive correlation persisting is that we’re going to have continued supply shocks in the future, and they’re going to dominate over demand shocks.”
Brown said investors also need to consider whether central banks around the world might move away from inflation-targeting strategies, which he said grew out of the supply shocks of the 1970s (the OPEC oil crisis) but also when the Fed moved away from the Gold Standard.
“When people say, well, we’re going to be in this high inflationary environment that’s not going to be correlated with growth’, they have some sense that we’re going back to the 1970s,” he said.
“But I think that’s not very likely, as long as these inflation-targeting regimes stay in place. And whether they stay in place is a is a political prediction.”
Brown said he predicts that the positive correlation between stocks and bonds “probably does not persist in the way people are thinking of the 1970s”.
“It may be more incremented, because we may have large supply shocks going forward for a number of reasons,” he said.
“But they are probably going to be transitory, and we’ll go back between positive and negatively correlated regimes.”
The stars aligned in the 2010s when a series of structural conditions stacked up favourably for global investors. Coming out of a decade defined by two major crises – the dotcom bubble and the GFC – the 2010s saw cheap valuations and a depressed economy needing to heal.
Low inflation, increasing globalisation, pro-business policy and steady economic growth have together helped the average 70/30 developed world stock-bond portfolio to return 8.5 per cent in 2010s, outperforming the previous five decades, according to analysis by Bridgewater Associates.
However, co-chief investment officer of the world’s largest hedge fund, Karen Karniol-Tambour, warned that these perfect conditions will be hard to replicate in the 2020s, and it’s high time that investors start building portfolio resilience.
“I think, for any CIO sitting with the allocation that they have, what you definitely can’t do is be confident that you will get the 2010s again,” she told the Fiduciary Investors Symposium at the University of Toronto earlier this week.
“[They need to think] ‘I don’t want to have a portfolio that is reliant on getting the amazing 2010s to repeat itself – what I want is something that’s a little more resilient to a range of options, knowing that the world has shifted in a way where a range of options might occur.”
Resiliency can be defined with several characteristics, she said, including narrower range of outcomes, lower tail-risk outcomes, less likelihood of sustained period of underperformance and higher average return across the environments.
In practice, Karniol-Tambour said investors can use “incremental decisions” such as shifting existing asset allocation, the types of exposures they hold within a particular asset class, or allocating to strategies that can hedge the tail risks.
However, the biggest challenge in building resilience, she said, is for investors to remember that a part of their portfolio will need to be explicitly assessed relative to how the rest of the portfolio performed, rather than as standalone performance.
It matters a lot to make it clear to that resilience-building part of the investment team that the plan is for them “to have a more consistent return or to only perform well when things are going poorly” in the rest of the portfolio, she said.
“You’re not telling the person [responsible] that ‘you did a bad job’. You’re saying that was the plan.
“If you don’t govern it that way, then the person who manages that bottom asset is going to say ‘wait a minute, we just had a great growth year, and I had this very low return relative to the rest of the portfolio, I better change my strategy to not have that happen to me again’.”
Understanding, not avoiding risks
Chief investment officer of the C$25 billion ($18 billion) pension OPTrust, James Davis, echoed the sentiment and said it’s governance can be a huge challenge when the objective is building resilience.
“Resilience is not about avoiding risks, it’s about understanding them, and it’s about managing them,” he said.
“We define risk not as volatility or return. We define it in terms of the probability of becoming under-funded. The reality is that the risk-free rate is not high enough that we could just invest in risk free assets and earn the returns we need to pay pensions, so we have to take risks.
“We’re not trying to grow that funded status, just try to keep it stable.
“We do rigorous due diligence in all of our deals, and in our fund and direct investing. We treat risk as a scarce resource. We don’t incentivise excessive risk-taking.”
Getting the board to understand this objective can take rigorous communications sometimes, Davis said, but that needs to be done.
“It’s amazing how our board gets distracted by returns, and the media feeds into that.
“At the end of the day, we can have a very good stable, potentially even improving funded status and have a negative rate of return. Think bonds that hedge your liabilities, then bonds have a bad year and yields went up.
“Then our board is like ‘well, you say you did good, but did you really do good?’
“Boards in general, our board as well, are line item focused. This is one of the things you try to overcome by going to a total portfolio approach, but it’s hard to break that habit.”
Karniol-Tambour said that at the end of the day, the first step to building resilience is to create shared understanding of the investment end goal within an organisation and its investment team.
“Being able to really have that shared understanding of why over the long-term resilience is so valuable, especially be able to demonstrate mathematically how damaging it is to have ups and downs [in returns].
“People who think themselves as long term investors – given that we have requirements along the way to make payments – not being able to compound and having big ups and downs makes a big difference.
“So creating that shared understanding, and then being able to have that understanding pushed through to the actual activities people are doing, to the actual choices they’re making [is important].”
The investment path to net zero may not always be clear for asset owners. With the lack of a dedicated asset class and shifting risk profiles for energy transition-critical assets, the Fiduciary Investors Symposium in Toronto heard that investors need to be flexible and ready to creatively make room in their portfolios when the right opportunities arise.
For example, even infrastructure can be perceived as a riskier asset class when it is tied to new energy technologies, said Rossitsa Stoyanova, investment chief of Canada’s Investment Management Corporation of Ontario (IMCO). The fund invests C$77.5 billion on behalf of its public sector clients.
“We’re used to looking at infrastructure as clipping the coupon – there’s assets, they have a contract, and they just throw cash,” she told the symposium in Toronto.
“And the infrastructure of the future is not that, because it doesn’t exist yet – like renewables, batteries or green data centres, you have to build them.
“It might be perceived as taking higher risk, because we’re developing new infrastructure that eventually will become the infrastructure that is clipping coupons – for now, it’s not. But I think that’s the only way to do it.”
IMCO doesn’t have a specific allocation to sustainable investments, but Stoyanova said it has the expectation that “every asset class in the portfolio will be sustainable at some point”.
In cases where a sustainable asset doesn’t fit neatly into traditional asset classes, Stoyanova said IMCO is usually able to leverage its broad mandate and do things like splitting the investment into two sub portfolios.
For example, the fund’s investment in electric vehicle battery company Northvolt draws from the EV expertise of the infrastructure team, as well as on structuring and pre-IPO knowledge from the public equities team, Stoyanova said. It can take some explaining to the board, but the result is worth it.
“Sustainability brings the teams together. They work together, they find opportunities, and then we’ve committed to find a place for those opportunities,” she said.
“They’re not easy to approve, especially sometimes [these investments] are a challenge for boards to understand. I mean we’ve gotten there, but it’s not a cakewalk.”
Chief strategy officer of global infrastructure asset manager IFM Investors, Luba Nikulina, told investors not to lose sight of the fact that “net zero is not really an investment target, it’s an emission target”.
“The reality is, if you own assets that are critical for the functioning of the society, and these assets are really difficult to decarbonise, then net zero target becomes, in some instances, impossible,” she said.
“So what do you do in this context? I think actually, in the whole industry, my observation is that we are on a learning curve.
“Instead of just being the slaves to this target on carbon emissions, and say ‘I will do anything possible to reduce carbon intensity’, they [our team] start thinking about transition planning.
“This is where you really step into it as an investor, rather than an ecologist and ask ‘do I have the technology to decarbonise?’.”
Answering that question can require some creative thinking. For example, IFM Investors has partnered with several research universities in Italy to study a wireless technology that will allow EVs to be charged on the road as they drive, hence addressing EVs’ range problem and toll road assets’ decarbonisation.
Peter Martin Larsen, senior managing director and head of private markets in Canada’s University Pension Plan also spoke of the inclination and need to transform existing assets into more sustainable operations over time.
“Touching on the long-term view here, if I buy a data centre today, I would rather sell a green data centre in 15 years than a data centre that is not green,” he said.
“Coming from Denmark, we invested directly in offshore wind 15 years ago. ESG was not even a term [then], but it was a good commercial investment.
“For us, it’s really fundamentally believing that sustainability is commercially the right thing to do, so it’s 100% about risk return.”