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Why private debt is trending in wealth

The quest for yield in uncertain economic times is increasingly leading investors to the attractive world of SME funding, writes Simone Westerhuis

The search for yield has been the dominant theme for both institutional and private investors in recent years. Faced with faltering returns on public markets, institutions were the first to move into alternative asset classes but have been quickly followed by HNWs and family offices. Among alternative investments, private debt is very popular, with family offices now committing some 11 per cent of their funds to this asset class. Debt funds that lend directly to businesses via a range of funding instruments are increasingly in demand. Of course private investors who target this broad area need to assess the risks, but private debt is a sensible element of an overall asset allocation strategy and can generate attractive returns.

Globally there are over 300 private debt funds, with the UK being home to more than a third (133) of these vehicles. They offer a range of strategies, such as mezzanine, distressed debt, venture debt, special situations as well as conventional direct lending to well-established businesses. The direct lending funds are increasingly popular with around 130 such funds globally. According to Prequin, the proportion of investors targeting direct lending funds over the next 12 months has increased from 36 per cent in Q1 2016 to 42 per cent in Q1 2017, and in Q2 2017 such funds were seeking close to $50 billion in capital to match funding demand.

The popularity of extending credit directly to businesses revolves around a number of factors. As an alternative asset class it offers diversification benefits, steady cash flow, it is a substitute for traditional fixed-income exposures and the assets typically offer lower volatility. Also, while big companies have been able to tap the corporate bond markets to compensate for any reluctance by banks to lend, most SMEs do not have this option. As a result, direct lending instruments to growth businesses can offer robust returns relative to public markets where benchmark yields have been lowered by monetary policy.

Peer-to-peer lending, retail bonds on the LSE and credit funds have helped to make private investors aware of opportunities to lend to companies, to take advantage of the limited scope of bank funding and to achieve attractive interest rates. However, they are cautious about the quality of companies that they lend to, the intermediaries or platforms that manage the loans. In our experience, the typical case study of a private investor in this area involves an initial limited allocation followed by increasing investments as they become familiar with the counter-parties to the transactions. When they receive interest and redemption payments, their confidence grows and they become predisposed to lend again to borrowers who demonstrate a strong credit record.

A variant of direct lending, in which LGB has been a pioneer, is structured loan notes issued by SMEs and growth businesses under the terms of a programme involving common loan documentation that enables repeated issuance. The notes are secured, fixed-rate, medium-term debt securities. They carry robust security, have seniority in a borrower’s capital structure and offer regular investment opportunities to those seeking a sector-diverse portfolio. The notes pay a frequent, fixed cash yield offering investment returns of around 6-10 per cent per annum and a maturity ranging from six months to five years. The interest rate of an issue reflects investor demand and the credit standing of the issuer. Issues are often listed on a recognised stock exchange to benefit from the Quoted Eurobond Exemption from withholding tax on interest.

Our investors have the opportunity to attend investor presentations by companies and form their own investment views or they can simply make an asset allocation to the area and ask us to manage a diverse portfolio of such transactions to reduce risk. So far we have arranged some £44 million of issuance and we estimate demand from our network of around 350 private investing clients at around £100 million.

HNWs considering investing in direct lending to SMEs, whether through structured loan notes or other instruments, should of course recognise that the differential between the returns of private credit transactions and bank deposit rates do imply credit risk, that private debt has yet to be tested in an economic downturn and that by definition there is no formal secondary market for lending instruments. However, properly assessed and used as part of an overall asset allocation strategy, private debt and direct lending to businesses can offer HNWs and family offices an attractive option to help balance their portfolios and address their search for yield in what remains an uncertain economic environment.

Simone Westerhuis is Head of Investment Management at LGB & Co