Private Debt Bubble
For years, prudent institutional investment practice dictated that bonds and gilts were reliable means securing a decent return without running unnecessary risk. Whilst bond yields weren’t ever going to make an insurer rich, they would ensure that outflows of cash to the annuity holder would be met.
Then came the joys of the global financial crisis followed by a “temporary” reduction in rates by central bankers looking to stem the bleeding from the world economy. Eventually the panic passed, the economies began to recover, yet central bankers, indebted governments and markets alike became addicted to the cheap money created by low rates and quantitative easing. Months and then years passed with the global economy stuck on the life support machine of low interest rates.
Years of ultra-low interest rates have distorted markets significantly, challenging the very foundations of pension scheme and insurance investment philosophy. Regulatory regimes that focus on capital adequacy have added fuel to the fire as capital charges reduce the viability of many other asset classes. Gradually the institutional world accepted the fact that the income return offered by many bond markets simply wouldn’t meet the promises made…….
Enter private debt.
Once the reserve of contrarian, value oriented Private Equity investors, over the last few years, institutional investors have slowly and possibly reluctantly woken up to the idea that the toll bridge in southern Europe, social housing in rural England, or financing of the earth moving equipment for that South American mine, might actually provide a steady fixed return on their money. Gradually, even the more conservative institutional investors began to recognize that private debt could be an asset class that can deliver the risk-adjusted fixed-income return that the bond market was failing to provide.
The challenge with any asset class is that market forces dominate. Despite the rigorous analysis that’s used to assess the appropriate price for any asset, it is ultimately determined by what someone is prepared to pay. Private Debt is no exception to this. When interest rates are at historically normal levels, there are only a small and brave band of investors even in a position to fund the weird and wonderful that is private debt. When interest rates are at a 300 year low, a considerable number of sophisticated institutional investor are chasing such deals, meaning many Billions are entering this market.
The Looming Bubble?
This means that the Private Debt market, will be (if it isn’t already) subject to significant price inflation. The higher the price paid for the most recent cobalt mine transaction, the easier it is to justify paying at least that next time round. And why not? After all, the numbers still add up and it beats holding gilts. If we are not already witnessing a private debt boom, its hard to see how is this avoidable with the flood on institutional money entering this market.
At some point, rates will rise. The illiquid nature of many private debt investments means that long time horizons and at least a nod to historical norms is healthy and advisable if not essential. As pension schemes mature and seek to sell off their investments, rates may have returned to more historically normal levels. Might insurers at this point be more interested in parking their money in liquid bond markets that give a “good enough” return. Then there is the spectre of regulatory change. Perhaps future regulations post-Brexit will incentivize institutional investors to invest in UK PLC by investing in equities. Or perhaps a post-Brexit Corbynist government will impose rent caps and build so much social housing that the return on the private build-to-rent simply no longer adds up. In 30 years time, those institutional investors who competed hard and maybe paid a smidgen over market price for that UK real estate investments might be left high and dry when the low yield tides ebbs back to historical norms.
The Answer
So what’s the answer? Should you stay out of this asset class, stick with bonds and watch your insurance business slowly die? The answer, as with any article produced by Plenum, must lie in hiring the right people! Institutional investors need to engage in this market but must stay ahead of the herd by hiring the very best originators.
With scarcity of assets being cited as the biggest barrier to the boom of the pension buyout market, only those with the ability to source the weird and wonderful on a global basis will avoid falling victim to this looming private debt bubble and ensure their investments stack up regardless. Those who employ a half hearted attempt, using a mid-level individual to compete only in the busy UK market, are far more likely to be left without a chair when the music stops.
With an established network in the private debt space, including originators with global coverage, talk to Plenum to ensure you stay ahead of the herd.
Author:
TC Jefferson
To discuss this market in more detail and see how Plenum’s network in the space can be of use please contact:
TC Jefferson tcjefferson@theplenumgroup.com 020 70784895