The private debt market is around $23tr, but only 6% is currently served by private credit managers.
Schroders Capital has launched a private debt and credit alternatives (PDCA) business amid expectations that private credit will continue to thrive.
In October this year Schroders Capital, the UK fund manager’s specialist private assets business, unveiled the new private debt and credit alternatives business which will comprise real asset debt, structured and corporate credit, specialty finance and impact lending.
The business started with $30bn in assets under management and more than 100 investment professionals led by US-based co-heads Michelle Russell-Dowe and Stephan Ruoff, reporting into Georg Wunderlin, global head of private assets. Russell-Dowe continues her role as global head of securitised product & asset-based finance and Ruoff also continues as global head of insurance-linked securities.
Michelle Russell-Dowe, Schroders Capital
Russell-Dowe and Ruoff said in an email to Markets Media that interest rates have climbed for the first time in decades, which has brought uncertainty and volatility, but most of all, a massive income opportunity and they have seen an increase in investor appetite for income-oriented solutions.
The increased interest in debt instruments has ranged from liquid to semi-liquid to fully private, and has spanned multiple areas of the credit markets including corporate credit and alternatives such as asset-backed and asset-based lending. There has also been an increase in correlations over the past few years. For example, in 2022 both equity and debt had negative returns.
“This experience has influenced clients to seek less correlated return opportunities such as risk transfer and insurance linked securities,” they added. “We believe strongly in an approach that diversifies risk and in an increased allocation to income.”
Increased interest cost will change the dynamics of the markets as the returns of private debt and private credit are far more attractive. Russell-Dowe and Ruoff continued that with increased interest expense the growth prospects for asset prices and equity valuations feel lower than the past decade or so.
“This is indeed an environment where investors are paid for debt allocations and the additional protection debt affords can be hugely beneficial amid market uncertainty,” they said.
They expect increased defaults as the timeframe that borrowers have to attend to challenge is shorter when the cost of debt is 12% versus when it was 6% or 7%.
“We expect to see increased compensation in private debt and private credit, but given these market changes we also anticipate an environment of higher defaults, where selection, borrower, and leverage are all even more critical factors,” they said. “Likewise, we believe allocations such as infrastructure debt, asset-based finance and less correlated return streams make sense to ensure diversification of returns and variety in risk premia.”
Russell-Dowe and Ruoff also believe there will be tremendous opportunity in both U.S. and European real estate debt given the likely financing gaps created by bank regulation and trend change and that infrastructure debt offers an attractive opportunity with a fairly constant need for capital. In addition, the attractive re-pricing following a number of years of high natural catastrophe activity in insurance-linked offers good returns without macro-economic correlation.
“In terms of attractive, well-secured, shorter tenor, low volatility income, asset-backed debt is attractive and a place where inefficient markets offer excess return,” they added. “The true benefit here is the flexibility of the range of return profiles, which allows us to solve for a wide range of portfolio goals.”
Growth prospects
Georg Wunderlin, global head of private assets at Schroders Capital, said in a statement that global macroeconomics combined with the credit cycle are providing strong tailwinds particularly for debt and credit strategies. The private debt total market is estimated at around $23 trillion, but only 6% is currently served by private credit managers, leaving plenty of room for growth.
BlackRock estimated in its 2024 Private Markets Outlook that the global private debt market will reach $3.5 trillion in assets under management by year-end 2028.
There is a large amount of dry powder across allocators which indicates momentum will only continue to accelerate, as firms continue to lean into the asset class according to the 2024 Private Credit Outlook from Percent, which provides technology to modernise the private credit marketplace. Nelson Chu, founder and chief executive of Percent, said in the report that private credit stands at $1.3 trillion in assets under management, representing an estimated 25% of “dry powder” available for investment.
Percent said that although 2024 may see an increase in defaults, there will be plenty of opportunity for private credit firms to continue to step in and provide capital for high credit quality lower-middle market companies that are finding it difficult to access funding from banks or broader capital markets for a variety of non credit-related reasons.
Colm Kelleher, UBS
Colm Kelleher, chair of UBS, recently warned that the next financial crisis is likely to be in the non-bank lending sector and that the growth of private markets is a cause for concern.
Russell-Dowe and Ruoff said they are concerned about risk build up as the’ new shadow banking system’ has not had a stress test.
“While leverage is not at historic highs, in these markets the interest coverage has declined substantially, and we believe these markets will have a test,” they added. “Crisis is rarely predictable and certainly the banking sector was the most recent surprise.”
They believe strongly that mismatches between investment liquidity and fund liquidity is likely to be a problem but this may be less an issue in the private markets than in the public markets, or “semi-liquid” markets.
Private markets have historically been illiquid and Russell-Dowe and Ruoff argue that clients generally understand they are making an allocation that will be locked-up.
“But with public market equity and debt both declining in value at the same time in 2022, many of the same clients with significant private allocations became overweight in their less liquid allocations,” they said. “Most clients outside of the insurance segment are mindful of the budget they need for liquidity, but many have overestimated the need for liquidity and may have also misunderstood the liquidity of public market debt.”
They continued that clients are interested to learn that illiquid investments can have a variety of tenors, and they can create liquidity ladders by using shorter tenor asset-based or asset-backed private debt as well as debt such as commercial real estate loans.
“Many of the clients are facing extension of their private debt investments, so understanding how to make additional private asset allocations to support their cash flows from their private portfolios has been and will remain a key concern,” Russell Dowe and Ruoff added.
Competition
More fund managers have been entering the private credit space. For example, in the third quarter of this year BlackRock closed its acquisition of private debt manager Kreos Capital, which provides growth and venture debt financing to companies in the technology and healthcare industries. BlackRock has been building private markets capabilities and generated nearly $3bn of net inflows in the third quarter, driven by infrastructure and private credit.
Russell-Dowe and Ruoff argued that Schroders has come at the market from a less traditional stance than traditional private credit/debt shops. Their teams on average have more than 25 years of investment experience, but across a range of different disciplines within debt – mostly secured debts, as opposed to being heavily reliant on a very large corporate direct lending franchise.
Stephan Ruoff, Schroders Capital
“As we recently merged our debt strategies into the formation of our Private Debt and Credit Alternatives business, we’re now able to leverage our deep expertise and strong team dynamic of professionals who have worked together a long time,” they added. “This also enables us to communicate more effectively and flexibly across our segmented areas of expertise and capture the opportunity set across sectors.”
They also argued that being strongly backed by Schroders’ institutional platform is a differentiator because many of the private credit and debt markets today are where direct lending was a decade ago in terms of a high level of opportunity.
“Having some flexibility to pivot investments across sectors where the market affords opportunity, we offer better outcomes by “relative value play,” and we adapt our offerings to investor specific needs,” they said. “This is particularly important as desired outcomes can differ.”
The business also has considerable expertise in the markets across real estate, infrastructure, insurance-linked securities and asset-backed debts, and leverages proprietary data and partnerships according to Russell-Dowe and Ruoff.
Schroders Capital tends to focus on those sectors that are data rich, acquiring and developing data sets over the multi-decade track records of its businesses as Russell-Dowe and Ruoff said borrower, asset cash-flow, leverage and portfolio construction are all more important today than they ever have been.
“Another key to our success is also our subject matter experts who have been long standing experts in their respective fields,” they said. “For example, we employ and consult with engineers that have formerly worked on infrastructure projects or climatologists who evaluate natural catastrophe models.”
