The asset class returning up to 13% right now (without the equity-like risk)

Absolute returns are higher in private debt than they have been for some time. For instance, diversified sub-investment grade portfolios are easily returning 9-11%, while real estate-only portfolios are returning even higher - and with defensive characteristics, to boot. 

That's according to Schroders' Head of Private Debt Australia, Nicole Kidd, who notes that active investors continue to benefit from the higher rate environment. 

"Most private debt that we see in the Australian market is floating rate, so this has been great for private debt investors who have been able to benefit from higher returns as base rates have increased," she explains. 

That said, there are issues "percolating" in some areas of the private debt market, Kidd says. Ultimately, higher interest rates and inflation are here to stay - at least for a while - so borrowers who aren't appropriately managing their cost base and margins are in for "a bit of trouble", as Kidd puts it. 

This, coupled with higher inflation, supply chain challenges and less dough in consumers' pockets, means some businesses could definitely struggle from here. 

"There will certainly be some fatalities for those who have not been alert at the wheel," Kidd says. 

As part of Livewire's annual Alternatives Series, Kidd provides a beginner's guide to private debt, digests some of the key concerns circulating in the market, and outlines where she sees the most opportunity today. 

Note: This interview took place on 19 October 2023.

A beginner's guide to private debt

As Kidd explains, private debt is essentially a loan provided by a lender or a group of lenders to a borrower or a group of borrowers. This loan is outside of public or listed markets, and most often, is provided by a Big Four bank. 

Increasingly, neo banks and private credit funds such as Schroders' private debt team, are serving as intermediaries or alternative lenders for borrowers. 

So why would investors want to invest in something like this? 

"Basically, it provides investors with quite attractive fixed income-like returns, in a market that can be difficult to access - and that market is not correlated with listed markets," Kidd says. 

It also provides investors with some much-needed diversity in their portfolios. 

"It's also the lack of correlation to listed markets, the access, the complexity premium, and the illiquidity premium - particularly in the Australian market - which is over what you would receive in a public bond or a high yield bond because you can't just sell this type of instrument if you don't want to hold it anymore," Kidd says. 

"So you do have to have a longer-term investment time horizon and you need to be compensated for the fact that there isn't a secondary market." 

A complexity premium means that these investments are highly bespoke, and investors need groups like Schroders to get access to these transactions. This means investors are compensated for the amount of time and effort that goes into each individual deal. 

For those who don't know, private debt lenders sit ahead of equity shareholders when it comes to the obligations companies have to their investors. Private debt lenders often will hold security in the form of a property security, such as a mortgage or a "general secured charge" over the company's assets. 

"If obligations under loans aren’t met or a company defaults for any reason, lenders can step in and appoint receivers to control the assets and try to recover monies," Kidd explains. 

That said, there is no upside to being a lender – generally speaking, the best you are going to get back is your principal plus interest owed. Unlike in equities, where the upside could be hundreds of per cent or you could lose all of your investment. 

The impact of higher interest rates and inflation

Most of the private debt loans in the Australian market are "floating rate" - meaning, they have a variable interest rate that changes over the duration of the loan. 

"This has been great for private debt investors who have been able to benefit from higher returns as base rates have increased," Kidd says.

New loans, or loans that are being repriced quarterly, for example, are being written based on the floating rate - which is often the Bank Bill Swap Bid Rate (BBSY) plus the credit margin, she explains. 

While lenders have benefitted, borrowers have not. As many of you would know, rising rates and inflation have had a significant impact on our wallets (and on companies' cash flows). 

"Where cashflows have been impacted, this can lead to the credit rating of borrowers being lower than perhaps when the initial loan was made," Kidd says. 

"So, in a way, that can also be bad for investors as well, as we head towards this recessionary environment, if we are not already in it, which will likely lead to increased defaults." 

Schroders' private debt team is relatively new to the Australian market - having only been around for the past three years or so. 

This means that its portfolios do not have legacy assets in them - i.e. transactions/loans/deals that still have pre-COVID capital structures in place, or may still have interest rate hedging protecting cashflows, or may have benefited from more lenient treatment from lending groups during the pandemic. 

"There are definitely some issues that are percolating along in some parts of the market," Kidd says. 

"But if you are an investor or a borrower, you need to be engaging with intermediaries, such as ourselves, who are very active in their management of loans. If you are more passive in your approach and you are not keeping on top of what's happening with your borrower - then yes, you might be facing some problems in your portfolio." 

Ultimately, the higher interest rate and inflation environment is here to stay for at least a while, she adds. 

"Borrowers who aren’t appropriately managing their cost base and working hard to maintain their margins are going to find themselves in a bit of trouble. Interest rates for sub-investment grade borrowers have effectively doubled in the period 2021-2023," she says. 

"This, coupled with higher inflation, supply chain challenges and a lower discretionary income for much of the population who are also grappling with higher interest rates and cost of living, may not bode well for some. There will certainly be some fatalities for those who have not been alert at the wheel." 

The attributes of a good investment in private debt 

Today, the due diligence the team at Schroders is undertaking is "elevated" given the rapid interest rate rises we've witnessed over the past two years. And while Kidd believes the team has "always done a good job of predicting how businesses would react in a severe downturn", the analysis they are doing today is even more stringent than it has ever been before. 

"We also want to have a great dialogue with our borrowers, because if everything turns to custard, they should have comfort that we are open to a conversation to work out how to get things back on track," she says. 

"Therefore, knowing all your risks and the mitigants to those risks is the most fundamental part of our credit approval process. The second would be regular monitoring of performance against our original budget forecasts." 

So which businesses typically survive and thrive in more difficult economic environments? 

Kidd points to businesses with "strong, stable cashflows" which are integral to the economy or to the businesses they support. This includes healthcare companies or Software-as-a-service (SaaS) companies. 

"Healthcare in an economy that has a very strong universal healthcare model may exhibit very favourable characteristics," she says. 

"While SaaS opportunities are often asset-lite, and contrast to the almost infrastructure-like healthcare opportunities. That said, where the software is mission critical and low cost for the end-user, and there are demonstrated history of provision, we can definitely become comfortable with the rationale for lending." 

Kidd also names certain areas of the real estate market as opportunities - particularly assets that address housing shortages or neighbourhood shopping centres that support local communities. 

And, by virtue of the uncertainty we are seeing today, absolute returns are higher than they have been for some time. 

"Sub-investment grade diversified portfolios could easily be returning in the 9-11% range at the moment, given where base rates are," Kidd says. 

"Real estate-only portfolios could be returning in the 11-13% range even with pretty defensive characteristics. So compared to many other investment opportunities, private debt can look pretty attractive." 

In comparison, companies or sectors that have not been able to demonstrate resilience throughout the COVID period - or which are more exposed to inflation but can't pass through costs to their customers - are likely to suffer from here. In addition, companies that have no control over supply chains, or are "price takers" not "price makers" are likely to face headwinds going forward. 

"I’d like to think that we are open-minded enough to spend time to consider any transaction that comes across our desk, but we do have some no-go zones that are broadly aligned to our ESG principles, but also because the risk/reward is not comparable to other sectors where the cashflow certainty is much more attractive," Kidd says. 

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