2022 Private Credit Commentary from TriLinc’s CIO

Read commentary from TriLinc’s CIO Paul Sanford and others on Private Debt and Nonprofits from this just published report from FIN News.

Nonprofit News Special Report: 2022 Alternative Investments Outlook. Article Republished With Permission of FIN News. No changes have been made to the text of the article.


Relatively steady economic growth in the face of global supply chain bottlenecks and the ongoing COVID-19 pandemic, which has driven inflation higher than the Federal Reserve had anticipated, leaves endowments and foundations looking for ways to preserve the value of their portfolios without missing out on outsized returns.

As these nonprofit investors anticipate dampened returns for public stocks and bonds for the foreseeable future, they are increasingly reliant on their alternative allocations to reach their performance benchmark plus inflation in today’s market. The reliance on alternative investments led investors and allocators to pinpoint small, niche private equity managers, short-trading hedge funds and global private debt funds as key areas to capitalize on with the goal of yielding outsized returns.

 

Private Equity: The Smaller, The Better

Companies of all sizes continue to find more or better capital solutions in private markets as many investors assume a consistent, if somewhat slow, economic growth for the near future.

“We expect above-trend growth in 2022, although slower than 2021,” said Andrew Pease, global head of investment strategy at Russell Investments, in its 2022 market outlook. The Seattle-based investment firm anticipates “robust household income and accumulated pandemic savings” alongside other economic drivers to fuel 4% in real gross domestic product growth in the U.S. this year.

The anticipated growth is more favorable than the -3.4% and 2.3% change in real GDP growth in the U.S. in 2020 and 2019, respectively, according to data from the World Bank.

“We expect robust business investment in 2022, particularly as a record earnings recovery and backlogs align the ability and need to invest for corporations,” the Russell outlook states.

The World Bank also finds that the number of publicly listed funds has been shrinking over the last two decades, a trend many nonprofit investors and their consultants expect to continue — or even accelerate.

As a result, many have prioritized private equity in their illiquid allocations to reap returns they do not expect to find in public market assets, despite high valuations for the asset class.

“It’s no secret that private equity — venture in particular — has had a tremendous year,” said Geri Melchiorre, senior director of investments at the University of Illinois.  “Success begets success, especially in private equity where excess dry powder drives up valuations. At some point, one would assume that valuations and exit multiples will come back to earth – when and how quickly will be key to the persistence of the rally.”

Melchiorre, who oversees an approximately $1 billion endowment, added that the university targets private equity managers “who are disciplined in their purchases from both a valuation and strategy perspective” and “can withstand pressure.”

Loyola University of Chicago is building out the private equity portfolio within its approximately $1 billion endowment for many of these reasons, CIO Katharine Wyatt said.

The university’s private equity portfolio grew to a total of $157.3 million as of June 30, up from $92.4 million as of June 30, 2020 and $80.3 million as of June 30, 2019, according to its most recent annual financial statement.

“Private equity continues to be a good source of return. Certainly, when you look at the landscape, after so many strong years, even after COVID, I think that there’s still opportunities even though private equity is pretty expensive,” Wyatt said.

J.P. Morgan Asset Management increased its compound return expectation for private equity to 8.1% for 2022, up from 7.8% for 2021 and well above the the firm’s 4.1% return expectation for U.S. large-cap equity for 2022 and 2021, according to its Long-Term Capital Market Assumptions Matrices.

The $1.7 billion University of Nebraska Foundation considers private equity as essentially a compulsory asset class for higher education institutions or foundations that need to generate a 5% return plus a “specter of inflation,” a hurdle that fixed-income, hedge funds and real assets may not achieve, according to V.P. of Investments Brian Neale.

“As far as investing in private equity, there is no alternative,” Neale said. “You have to get those returns and that’s where you’re going to get those from. That’s going to continue, not just for the next five years, it’s a secular trend at this point.”

Neale noted that the “holy grail is finding those niche managers that are able to build track records through relationships or through differentiators.”

Many nonprofit investors and allocators seeking outsized returns have identified smaller private equity managers as attractive, especially ones with assets under management under $1 billion that are able to find deals in the lower middle market that some of the largest firms may be missing.

Jay Ripley, partner and co-head of investments at outsourced cio Global Endowment Management, recommends smaller private equity buyout strategies as the firm finds “private equity remains one of, if not the most, attractive asset classes going forward.”

“In general, the larger multiples of earnings you get when you buy a smaller company and sell at a bigger price. That is a true and pretty well-worn strategy, and that is a really good reason to invest in small buyouts,” Ripley said.

“What is attractive is the firms that can engage with portfolio companies; complement an add-on from a related firm that may be accretive in some fashion. Ultimately, the buyout firms that we are looking for are the strategies that can control their own destiny. For example, if a firm says it wants its earnings to double, we like when a private equity firm can effectuate those double earnings,” he added.

Loyola’s Wyatt carried a similar sentiment, saying the university was attracted to “nimble” private equity managers.

The institution eyes firms that “buy companies and improve operations and drive EBIDTA growth; maybe buy a company that is smaller, not quite as stable, but the manager creates operating efficiencies and grows the business,” she said, noting that with these investments, “you can exit at higher multiples, so there’s multiple arbitrage potential that can be a source of return.”

University of Tennessee CIO Rip Mecherle noted that “smaller funds tend to have more attractive opportunity sets,” including small-cap buyout, growth equity funds and specialized secondaries, that were worth the manager fees.

“The smaller firms aren’t going to have an incentive or the wherewithal to offer lower fees, and if it’s a good firm that’s staying small and delivering returns, that’s fine. We don’t want to see good managers struggling to keep their own lights on,” he said.

Smaller private equity managers can capitalize on highly volatile sectors like retail, according to Timothy Ng, senior consultant at Fiducient Advisors.

“You have to look at a smaller manager, niche or distressed-type managers, those who are raising $400 million to $1 billion in funds, that are able to take advantage of idiosyncratic or distressed opportunities, and a lot are focusing on retail markets, like financing Neiman Marcus, for example. That’s going to continue, especially given the volatility of the market,” Ng said.

A large amount of capital has flooded the buyout and venture capital space with private equity funds’ total assets under management hitting an estimated $5.1 trillion globally in 2021, up from $1.7 trillion in 2010, according to data from Preqin’s Future of Alternatives report. The London-based firm expects that total to balloon to $9.1 trillion by 2025.

The funds raised by smaller private equity managers preferred by many endowments and foundations only account for a small amount of that dry powder, with most of the sidelined capital targeting a small group of the largest companies, according to Wyatt.

“If you look at the capital raised in PE by fund size, almost half has come from funds $5 [billion] and up. And the funds that are sub $500 [million] represent maybe 10% of the capital. It’s really top heavy, and conversely, if you look at the private companies by revenue, there are so many more smaller companies than large ones,” Wyatt said.

“What you have is a lot of capital pursuing small amounts of opportunities and small amounts of capital pursing a broad swath of opportunities. We like that mismatch,” she added.

The smaller companies that many of the largest private equity managers may overlook provide an opportunity for small buyout or growth equity managers to create value or facilitate a strategic sale or initial public offering on the exit side, according to Pete Keliuotis, executive v.p. and head of the alternatives consulting group at Callan.

“If you’re managing a smaller company, you have more avenues to exit and more opportunities to create value on the operations side for a smaller company. The smaller companies don’t have depth of professional management, sometimes led by entrepreneurs or led by venture firms, versus large companies that have generations of leaders and succession planning and tend to be more professionally run, with fewer opportunities for value add,” Keliuotis said.

He cautioned that the risk is that “during the downturn, they have fewer tools to make it through a difficult period, maybe have less ability to dip into the credit market, but that’s changing with private credit providing more opportunities.”

 

Venture Capital: Giving ‘The Future More Credit’ Than Ever

The COVID-19 pandemic has upended the ways in which many work, live and consume, fueling a broad trend of businesses transitioning from “analog to digital” like never before, opening up tremendous optimism for venture capital, according to GEM’s Ripley.

“With the acceleration, the fundamentals and outlook for tech are certainly better than ever, in which you have cohorts of people engaging with new tech like they weren’t before, like grocery app delivery, and the prices are adjusting accordingly,” Ripley said. “You can see that in VC record funding rounds. You see people are giving the future more credit than they used to.”

Last year was a banner year for U.S. venture capital, as the aggregate amount of investment hit $329.8 billion by year-end, “nearly doubling 2020’s total of $166.6 billion — the previous record,” according to preliminary data from Pitchbook.

Cambridge Associates’ U.S. Venture Capital Index generated a ten-year net internal rate of return of 18.7% as of June 30, 2021, and for the more short-term inclined, it registered a one-year net return of 88.1%, according to its 2022 outlook.

“The lesson for investors has been that technology continues to see companies valued at one trillion and then see two or three trillion and that has really excited the imagination. That lends itself to mispricing assets at times, but our view is VC is an active game,” Ripley said.

With so much money flowing into the space, the important question for managers and investors is if returns are more dependent upon “financial engineering” as opposed to revenue, according to Nebraska’s Neale.

“That question is going to become more important because money is going to get more expensive, especially with the Fed raising rates [this] year, and that may be a concern for asset classes with excessive amounts of leverage like private equity or venture,” Neale said.

The Federal Reserve’s Federal Open Market Committee signaled at their Dec. 15 meeting that the central bank would raise interest rates three times in 2022, expecting the moves to help ease inflation while keeping the labor market tight and economic growth steady.

Swiss private equity firm Partners Group’s 2022 private markets outlook report finds that rising interest rates may be one of the headwinds stifling the economic growth that undergirds the private equity asset class along with “supply chain constraints, delivery delays, inflationary pressures.”

“With extremely short processes and high valuations having become the norm, the only way to prudently invest in this environment is to adopt a targeted sourcing approach, building strong conviction in those investment themes that will continue to generate sustainable growth, regardless of economic dynamics. This typically requires multi-year preparation and research work before a target company within an attractive segment becomes available for investment. Today, only a few firms have the resources, commitment and long-term view to implement this strategy,” the report states.

 

Hedge Funds Prove Their Worth During Volatility

Though not as flashy as venture capital or buyout private equity, hedge funds still play a prominent role in endowments and foundation portfolios, diversifying sources of returns depending on degrees of exposure to public markets.

Hedge fund strategies that have some short-term trading capabilities and can capitalize on the recent and enduring market volatilities, like global supply chain bottlenecks or market scares due to the emergence of the new Omicron COVID-19 variant or a wider equities downturn, will perform the best, according to investors and allocators.

“Most likely, there will be more volatility, or even a flat or down equity movement, and clients will be looking more towards hedge funds as a diversifier,” Callan’s Keliuotis explained.

But with hedge fund managers, especially long/short or other strategies with significant public market exposures, managers need “to be clear about how they add value to justify the fees,” Keliuotis said.

“It’s hard to justify a two-and-twenty fee if you get a return in the mid-single digits, and that’s the challenge for hedge funds,” he added.

Fee structures was one of the reasons the $8 billion Indiana University Health stays away from beta returns in the hedge fund space, according to V.P., CIO and Treasurer Josh Rabuck.

The Indianapolis-based hospital system instead focuses on “true diversifiers that are what we think is an alpha portfolio,” he said.

“There is a potential for beta creeping into your hedge fund allocation over time, particularly in the last couple years,” he noted. “More managers will be looking more directionally as far as the positions that they want to have. That isn’t bad, but is a risk management consideration. Where are your returns going to come from? The question is how much alpha are you paying for, and do you need to absorb some beta to get at alpha.”

Endowments and foundations have been able to net double-digit returns in the space recently, as the HFRI Fund Weighted Composite Index showed a 10.3% annualized return for year-end 2021 and a 10.86% return for the three-year period ending Dec. 31, according to Hedge Fund Research’s data tables.

“With the performance recently being double digits, for there to be more widespread interest [in hedge funds], that will have to continue,” Keliuotis said.

Ng at Fiducient Advisors said that was one reason that the Chicago-based firm prefers hedge funds with “shorter trading durations … especially with the market dislocations.”

“Since March 2020, if you just followed the equity markets, then you did well. But now, you need a tactical component. I firmly believe in the market volatility that we’ve seen — like around Black Friday, when another coronavirus variant was announced, or concern about what bill will come out of Washington, what a central bank will screw up, or how the elections in Europe will go — you are going to need that tactical component to complement the longer-term relative value,” Ng said, adding that “long only is not going to do it.”

J.P. Morgan Asset Management expects long bias hedge funds to generate a 3.3% compound return for 2022, down from its 3.4% 2021 expected return, and lower than its 3.8% and 3.6% return expectations for relative value hedge funds and diversified hedge funds, respectively, for the year, according to its long-term capital market assumption matrices.

The tactical component can be a positive element for hedge fund managers, but investors should focus on the manager’s core strategy and determine if they are comfortable with the manager’s risk appetite or strategy, according to Indiana University Health’s Rabuck.

To LPs, they have to think about the core strategy of the hedge fund manager and see if they are comfortable in the places that they are normally playing in and then, when a manager wants to take a ‘shot on goal’ with a good trade, examining, for example, how big is that shot, how big is that rotation, et cetera,” he said.

“What we still like about hedge funds are their ability to be nimble, the ability to be good short sellers, and provide alpha on the long side,” Loyola’s Wyatt said, noting that the Chicago-based university prefers hedge funds that focus on growing sectors, like health care, biotechnology and therapeutics companies.

“As the markets are shifting and trying to digest what is front of us, inflation and rising rates and the Fed’s drawing down of its balance sheet, there will be more volatility, which I think the nimbleness of strategies like hedge funds like to traffic in,” she added.

Global macro hedge funds may be the best positioned to generate strong returns in a volatile market in 2022 and outperform public equity markets, according to Meisan Lim, senior investment director of hedge funds at Cambridge Associates.

Macro managers have a “flexible mandate in which they can go long or short, and can access a wide variety of instruments” and therefore “generate returns that are uncorrelated to major markets,” Lim said, in the firm’s 2022 market outlook report, noting that the “average macro strategy has traditionally outperformed equities by a large margin when markets were most volatile.”

 

Private Real Estate: Inflation-Sensitive Or Inflation-Hedge?

Today’s market has plenty of sources of volatility that some hedge funds may take advantage of. This is especially true after public health officials loosened restrictions on commerce and daily life — notwithstanding an ongoing surge in Omicron variant cases — and millions of Americans began spending pent up savings, jamming global supply chains and, in part, leading to a rise in inflation.

The U.S. economy’s annual rate of inflation has consistently hovered well above the Federal Reserve’s 2% threshold this year, according to the most recent data from the Labor Department consumer-price index, which measures what consumers pay for goods and services like clothes, groceries, restaurants, recreation and vehicles.

The department’s index rose to a 7% inflation rate for the one-year period ending Dec. 31, the largest 12-month increase since the period ending June 1982, according to an announcement from its Bureau of Labor Statistics.

Over the last year, some asset allocators and consultants have suggested that nonprofit investors may be wise to invest in private real assets and real estate funds in particular for a diversified source of returns that correspond with economic growth and inflation.

Indiana University Health is “pretty active in real assets, including real estate, infrastructure and some commodities” specifically to “deliver cash flow and capitalize on growth in normal situations but have options for inflation,” Rabuck said.

While the recent rise in consumer prices seems less transitory than the Federal Reserve had hoped for and Americans continue to change how they work, travel and entertain themselves, many investors are uncertain about the underlying fundamentals and inflation hedging potential of private real assets, especially real estate.

Private real estate can serve as an inflation hedge when the strategies have exposure to sectors where property leases are relatively shorter, like apartments and storage facilities, and therefore can be renewed annually and adjusted as inflation picks up, an attractive holding in a rising interest rate environment, according to Keliuotis.

However, in areas of real estate where the leases typically are longer-term, like office or retail, asset holders receive cash flow that does not adjust with inflation and therefore the value can decrease, he cautioned.

This dynamic means the most promising real estate exposures will likely be in the high growth, multifamily real estate markets in the Sun Belt — including Raleigh, Durham and Charlotte, N.C. as well as Nashville, Atlanta and Phoenix — that “will continue to grow and drive performance in the asset class in a positive way,” Keliuotis said.

GEM’s Ripley also pointed out that a rise in inflation means construction costs will rise as well and the impact of that on performance will be different from market to market.

“Like everything in real estate, it will be local, some cities have strong correlation to inflation but some have some beta source that isn’t that,” he said.

Loyola’s Wyatt carried similar sentiments and while the institution invests in real estate, it is “not convinced it’s a direct inflation hedge, but a good and diversified source of return.”

“For us, inflation hedging needs to be more tactical, and they tend to be more commodities. Not positive long-term real return, but maybe in the short term. Over the long term, equities are the best inflation hedge for the portfolio,” she said.

“There’s some truth to the argument that leases reset with inflation, but generally if you see inflation spike, the leases don’t renew for a while after,” she added.

The University of Nebraska Foundation has adopted a “wait and see approach as far as private real estate,” Neale said.

The major dislocations in markets that many investors predicted, especially concerning housing shortages coupled with growing housing demand, movement of businesses and professionals away from gateway cities like New York to Florida and other areas, “haven’t materialized just yet,” he said.

“My concern is home valuations are through the roof, but how much juice is still there to squeeze?” he said. “The jury is still out, and we’ve been cautious on real estate.”

J.P. Morgan Asset Management expects U.S. core real estate funds to generate a 5.8% compound return for 2022 and U.S value-add real estate strategies to show a 7.7% compound return this year, according to its long-term capital market assumptions.

 

Think Private Debt’s Not Worth The Illiquidity? Think Beyond The U.S.

In a high inflation and historically low-rate environment, endowments and foundations expect little or even negative returns from their fixed-income portfolios, and some see private debt in a similar light, without much upside as far as risk, according to asset allocators and consultants.

“We really don’t find that space attractive. Given the liquidity you are giving up, the spread you get is not all that meaningful,” Wyatt said, noting that Loyola does have a small allocation to private credit, but to strategies that are “a lot more nuanced, maybe some cash flow assets, but specialty finance or very niche.”

“What you see across the board in direct lending is covenant loosening. It’s been covenant light for long time, and you are often giving up rights as creditor, as there is so much competition and rates are so low,” she said.

And yet, there may be ample opportunities for private debt managers to provide distressed credit or other opportunistic strategies to improve businesses in the U.S., according to some consultants and managers.

“From a portfolio composition perspective, we view private credit as just another form of fixed-income, no different than bonds, but with much less liquidity and a much better expected return outlook,” said Paul Sanford, CIO at TriLinc Global, a diverse-owned private credit impact fund sponsor, and investment committee member at the $4 billion City of Hope hospital network.

“Therefore, the difference is between poor expected performance for bonds and the illiquidity of private credit, but the illiquidity premium for private credit is several points. So, to me, that is a no brainer to absolutely be looking at private credit. Foundations and endowments need stable yielding assets, that they are not going to get that in bonds,” Sanford said.

Though nonprofit investors are right that core direct lending will not “capture [private equity]-like returns without a lot of leverage,” there are areas like specialty finance or distressed credit opportunities that capitalize on dislocation, including non-corporate or asset-backed lending, that can yield 10% to 15% returns, Keliuotis said.

“In private credit, the reaction we often get from nonprofit clients, which, in general, have less exposure to private credit than corporate and public benefit plans, is that they look at the space as bonds, they see the upside, but it’s just clipping coupon,” he said.

“In our view that is an over-simplification of how the private credit market is laid out,” he added.

“With the limited number of illiquid dollars to put to work, some people probably lean away from private credit and put those dollars into real assets or private equity. That’s one view, and I think we subscribe to that view partially,” Rabuck said, noting that the institution still wants to find some capital to put to work in the private credit space.

“We’re a little bit torn because there are way more interesting things in private credit, in below-investment-grade or floating rate credit, than marketable securities, for example,” he said.

“We don’t think there’s a need to necessarily increase allocations there, but we do like to have some reserved for a distressed cycle. So, getting that available but not committing, that’s the other angle with private credit,” he added.

Distressed and other opportunistic private credit strategies are attractive because they can offer returns above traditional fixed-income without sacrificing downside protection, according to Adam Perez, senior investment director of credit investments at Cambridge Associates, in a November market outlook.

“For nonprofit investors with annual spending objectives, the degree of flexibility offered by private debt funds can be attractive. A higher velocity of capital in shorter average life investment vehicles allows for a quicker return of capital to investors than, for example, a typical private equity fund might afford,” Perez said.

He noted that levered senior debt or specialty finance strategies could yield “low-teens percentage annualized returns and attractive multiples on invested capital, while keeping risk in check through downside protection” for nonprofit investors.

TriLinc Global’s Sanford pointed out that nonprofits that are seeking opportunistic private credit strategies run into a crowded space in the U.S. that is “over allocated, with too much money chasing many of the same opportunities.”

“It is well publicized that covenants have gotten lighter and yields went down in the recent U.S. credit cycle. And in order to be effective in the U.S. private credit market, you need to find origination channels that aren’t already dominated by the very large institutional players, like BlackstoneKKR, et cetera. That’s the risk in the U.S. credit space,” Sanford said.

The global private debt space has grown to roughly $1 trillion as of November compared to approximately $300 billion a decade prior, with much of the growth in the U.S., Lim noted in the November report.

The crowding has led some nonprofits and allocators to seek private debt opportunities outside the U.S., especially as many companies abroad are affected by the global supply chain bottleneck, according to stakeholders.

There’s definitely opportunistic private credit opportunities coming out in Asia, with the Chinese real estate development story. We’ve seen some opportunities in esoteric lending strategies, and not just corporate lending,” Rabuck said.

In the global small- to mid-size corporate space, there is a gap of funding of about $5 trillion according to estimations from The World Bank, which is what private debt managers can capitalize on, according to Sanford.

With the pent-up demand and savings from the COVID-19 pandemic stressing the global supply-chain and causing a bottleneck of raw materials and merchandise that has yet to fully correct itself, there may be more private credit opportunities overseas, especially for smaller companies that may need extra capital to adjust to ever-changing landscape, Sanford said.

The firm typically provides term loans, typically three-to-five-years, “we essentially act as a community small business bank in markets that don’t have small business banks,” in areas like China or Ecuador, and trade finance or inventory financing, business that is directly affected by the supply chain issue, he said.

“I’m based in Los Angeles, and up until recently, there were lines of ships as far as you could see waiting to get off-loaded in the port. So, another year of that is possible, but hopefully it ends up sooner than that,” he added.

Nonprofit and allocators scouring for private credit opportunities around the globe is indicative of the wider trend that nonprofits have to be creative in their portfolio construction in order to find the returns or capital preservation that they will not likely get in traditional equity and fixed-income markets, according to investors and allocators.  

“The easy money has been made, and investing will be a little bit more challenging going forward,” Nebraska’s Neale said.

The information contained in this article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. The statements and opinions expressed in this article are those of the author. TriLinc cannot guarantee the accuracy or completeness of any statements or data.