The world’s largest money managers are scrambling to capitalize on investor hunger for outsized yields amid persistent inflation and surging interest rates, and the solution many are pitching is an oddly familiar one: private-debt funds.
Over the past decade, investors were constantly sold on the merits of alternative investments – alternatives to traditional stocks and bonds. Of these, private debt became one of the most popular, particularly with retail investors in Canada.
Private-debt funds, also known as private credit, have been managed by companies such as Bridging Finance Inc., Ninepoint Partners LP and Romspen Investment Corp., and they attracted billions of dollars in assets. These funds became extremely popular with elderly investors because they paid generous yields, often around 8 per cent annually, at a time when government bonds and GICs offered next to nothing.
But their tailwind has disappeared. With interest rates rising at a stunning clip, many investment strategies that proliferated over the past decade are faltering, and in Canada private credit is among them. At the same time, Bridging Finance, which used to manage $2-billion in assets, is now under investigation by regulators and the RCMP, and the probes have rattled investors.
So, some Canadian private-debt managers are having difficulties with redemption requests. Ninepoint restructured its flagship private-debt fund in June after 25 per cent of investors wanted out. This past week Romspen, which has a slightly different business model as a private-mortgage lender, had to freeze redemptions altogether.
Despite the changing winds, the number of private-debt funds is growing. What was once sold as a means for getting yield in an era of ultralow rates is now marketed as a form of inflation protection instead. Interest on private debt tends to be a floating rate, so, like variable-rate mortgages, borrowing costs rise whenever central banks hike their benchmark rates. This money can be passed on to fund investors in the form of higher yields.
Alternative investments of all stripes are also getting more attention again. Because equity markets soared during the COVID-19 pandemic, investors made stellar returns off straightforward exchange-traded funds. Now that stock and bond prices are falling in unison, something that rarely happens, there are concerns the traditional 60/40 investment portfolio – 60 per cent stocks and 40 per cent bonds – doesn’t hold up any more.
Amid this uncertainty, new investing paradigms are being thrown around, and major asset managers are suggesting private credit will play a prominent role. Last year, private-debt managers raised more than US$250-billion for their funds, primarily in North America, and another US$160-billion in the first three quarters of 2022, according to Private Debt Investor, which tracks alternative investments.
Some prominent money managers have run private-credit arms for years, including Blackstone Inc. and Apollo Global Management Inc., but more are piling in or expanding, including Toronto-based Brookfield Asset Management Inc. and Hamilton Lane. Their funds often target high-net-worth, or accredited, individual investors.
“Credit is going to continue growing, because banks have been suppressed,” Mark Wiedman, head of international and corporate strategy at BlackRock Inc., the world’s largest asset manager, recently told The Globe. “Credit has shifted off of bank balance sheets into asset managers’ portfolios.” Private-debt funds can lend where banks are no longer able to because banks now have more stringent risk rules and higher capital requirements.
Major asset managers also stress that the private-credit market is huge, so the range of borrowers is quite wide. “There are safer places to be in the private-credit market, and there are riskier places to be,” said Mike Woollatt, head of Canada at Hamilton Lane, a Pennsylvania-based institutional investor that manages US$108-billion.
In late October, Hamilton Lane launched its Senior Credit Opportunities Fund, which is open to accredited investors in Canada and targets an annual yield of 6 to 8 per cent. That’s lower than some existing Canadian debt funds, and a reflection of ranking higher on borrowers’ balance sheets, increasing the likelihood of repayment.
However, there are limits to what is considered low risk. In finance there is a hard and fast rule, explains Greg Obenshain, head of credit at Boston-based Verdad Advisers. “If you’re a good borrower and have a strong balance sheet, you borrow long and fixed” – that is, long term and at a fixed rate. “If you’re a weak borrower, you borrow short, floating rate.” The latter is what private-debt funds offer.
Private credit is now pitched as an inflation hedge for investors because of its floating rates, but these higher costs can make borrowers even more vulnerable – because more cash flow goes to paying interest. As an investor, “the reason you’re getting more just made the company that much riskier,” Mr. Obenshain said.
The investing calculus has also changed. When investing in private debt, “you want a reasonable amount of risk premium,” said Dan Hallett, head of research at HighView Financial Group. Now that one-year GICs pay close to 5 per cent, an 8-per-cent yield on private debt isn’t as enticing. “Your risk premium has shrunk,” he said.
Investors who loved private debt are reconsidering – hence the redemption requests. The trouble is, private loans are illiquid, meaning they can’t be sold in a flash. So, private-debt managers typically limit redemptions to a small percentage of the total fund each month.
Some funds argue their underlying loan portfolios are in good shape, and their redemption woes stem from investor confusion about the withdrawal process. The fear of waiting to cash out can cause panic, fuelling even more redemption requests.
This week, Romspen announced it was freezing redemptions because of heavy investor demand, but added that “loan payoff activity remains suppressed” – another way of saying some loans weren’t repaid.
With interest rates expected to climb higher still, the sector will face a stress test. “The pain hasn’t come yet in lower-quality debt,” Mr. Obenshain said.
Tim Kiladze