This In Practice piece gives a practitioner’s perspective on the article “The Returns to Private Debt: Primary Issuances versus Secondary Acquisitions,” by Douglas Cumming, Grant Fleming, and Zhangxin (Frank) Liu, published in the First Quarter 2019 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Private debt is the main source of funding for private companies and is attracting significant attention from investors because of its potential to diversify a credit portfolio. Yet there are few studies on global private debt compared with the body of research on publicly traded debt securities.
The authors ask whether investors interested in allocating to private debt should adopt a buy-and-hold strategy, in which they purchase debt from an issuer and hold the debt to maturity. Alternatively, could they improve returns by buying private debt on the secondary market? Secondary trading takes place when a credit fund manager buys a loan from a seller who may be facing imminent liquidity issues. The buyer expects to find discounted loans in secondary markets, particularly if a seller is “distressed.”
The authors also examine whether private debt outperforms publicly traded credit consistently over the long term, taking into account such risks as liquidity risk, volatility risk, and systemic risk.
How Do the Authors Tackle the Issue?
Because information on private debt is less available than that on publicly traded debt, the authors collect data on loans manually. They find information on 443 loans made in 13 Asia-Pacific markets by 15 credit investment funds between 2001 and 2015. Each of the credit investment funds are selected for their ability to invest in both primary and secondary loans. The authors argue that analyzing loans across Asia Pacific lends robustness to the study because of the regional diversity of legal and economic systems and the differences in the size and maturity of credit markets in the region.
To compare the relative merits of a buy-and-hold strategy against secondary private debt investments, the authors measure the internal rates of return (IRRs) and return on investment (ROI) of the loans. IRR and ROI are two widely used measures by which investors assess the performance of a strategy. The authors group returns by a number of variables, such as debt seniority, loan size, industry, market, time period, and types of fund manager. It is intuitive, for instance, that there is a negative relationship between the size of investment—and thus the size of the issuer—and investment returns, because many smaller firms have lower credit quality and tend to offer less information to investors.
To identify whether ownership type influences returns, the authors also assess whether returns from leveraged buyout (LBO) debt issuers differ from returns from other types of issuer. In the case of LBOs, it is intuitive that higher leverage may equate to higher default risks.
The authors investigate whether private debt outperforms public debt and create a private debt return index based on their hand-collected loan data. The index represents possibly the first time a benchmark has existed for private credit returns, enabling a comparison of excess returns from private debt with those from public debt and other asset classes across geographies. The authors compare monthly returns from this index with those from public credit indexes and equity indexes to show the merits (or otherwise) of allocating to Asia-Pacific private credit. The public credit index used is the J.P. Morgan Asia Credit Index.
What Are the Findings?
A secondary loan strategy outperforms strategies that focus on buying and holding a primary issue. The (median) investment in a direct loan provides an IRR to investors of 22%, while the median secondary loan offers a more substantial IRR of 26%. It should be noted that investors do not reap the entire IRR because it does not take into account performance fees, upfront fees, or early prepayment fees. The higher IRR stems from the discount at which the secondary loans are bought and the relatively short holding periods compared with buy-and-hold loans.
The superior performance of secondaries exists whether the investment is LBO or non-LBO and across all the other variables the study took into account.
The authors also find that a diversified portfolio of private debt investments—both buy-and-hold and secondaries—consistently outperforms publicly traded debt. The average monthly return for the private credit index was 1.53% a month, compared with 0.58% a month for the J.P. Morgan Asia Credit Index. The authors’ bespoke index also outperformed the MSCI Emerging Markets Index, which returned 0.19% a month, as well as the Russell 3000 and the S&P 500 over the period.
Interestingly, the real estate sector outperformed other industries. A 1% increase in the allocation to private debt in the real estate industry led to a 4.8% increase in returns.
What Are the Implications for Investors and Investment Managers?
The authors’ findings suggest that an investor seeking higher long-term performance should hire fund managers who do not solely invest in buy-and-hold strategies but who also trade global private debt on the secondary markets.
The superior performance of secondary investments relates to investor concerns over the possible low quality of the underlying firm and illiquidity and the discounts these concerns create.
An allocation to Asia-Pacific private credit has the potential to increase risk-adjusted portfolio returns compared with investing in bonds or even equities. The range of institutional structures and political and legal systems in Asia Pacific creates market inefficiencies and arbitrage opportunities that an experienced fund manager can exploit.
The low correlation between Asia-Pacific private credit and emerging market public credit, emerging market equities, and US leveraged loan indexes potentially enables investors to diversify their portfolios.
Outperformance of private debt is positively related to volatility and negatively related to funding liquidity.
Finally, using a previously unavailable Asia-Pacific private debt index may offer investors new and beneficial strategies.