Nations are competing to vaccinate their citizens and we are finally headed towards normality. At least that is what investors are desperately longing for. But it is still a mystery how that normality - or the new normal - will look like. Some of the big, not yet answered questions now are how and which companies will survive, and how the struggle of survival will, in turn, affect the shareholders of those companies, i.e. private equity funds and other owners, and those who have provided them with debt capital, i.e. private debt funds, banks, and other lenders. But what the pandemic has already shown is how private debt and especially diversified private debt programs have certain benefits over e.g., private equity or closed-end real estate funds in this kind of environment.
The uncertainty of spring 2020 drove a large part of the investor community to panic and head for the exit door as they decided that it was time to sell. As a result, many funds, especially bond and debt funds that offer daily liquidity, were forced to sell investments in order to meet the investors’ redemption requests and were thus not able to benefit from the low valuations and utilize the buying opportunity that emerged. In the meanwhile, those private debt funds that had the investor commitments ready were able to take full advantage of this forced selling. The funds that had fresh capital available were able to buy from forced sellers at valuations considerable below par. In addition, the illiquid nature of many private debt funds combined with their typical investing skill-set enable these funds to hold the bond or loan instrument through corporate restructuring and may thus even end up owning shares in investee companies at very low valuations. While owning a company is not typically plan A even for most opportunistic private debt managers, it is often a completely acceptable plan B that these fund managers are not afraid of pursuing.
At the same time, most of the private equity and real estate funds that had dry powder readily available in April of 2020 were not able to put that capital to work as practically no private asset owner needed or was willing to sell companies or real estate in their respective target markets at bottom valuations. As a result of the stimulus and support packages announced by the governments and the central banks, the markets snapped back so quickly that only in very few instances the market prices had to be lowered from the sellers’ expectations. However, in the markets that provide debt for these private transactions, the supply/demand dynamics are completely different and the liquidity requirements of various market participants meant that holders of some of these debt instruments became forced sellers. This in turn created real investment opportunities for private debt investors operating in the same playing field. In essence, the nature and dynamics in the debt markets enabled many of the private debt funds to invest in a countercyclical way and to utilize the buying opportunity that had emerged.
During last spring large number of managers in private debt funds that Mandatum has invested in identified these opportunities and due to the closed-end fund structure were also able to utilize the opportunity. The result was a great number of investments made at attractive entry prices. In turn, this required Mandatum’s private debt programs to fund many drawdowns and we were thus able to put a lot of money to work and start accruing returns for our investors. Many of these investments have since then generated equity-like returns for taking fixed income-type risk. Looking back now we are obviously very satisfied with the performance of these private debt funds that Mandatum has invested in.
How to successfully utilize private debt programs for countercyclical investing
When opportunities similar to what was experienced in spring 2020 emerge, in our opinion one important thing for an investor is to have undrawn commitments to opportunistic debt strategies. However, an investor needs to have sufficient liquidity reserves in place in order to, inter alia, be able to meet the drawdown requests from these opportunistic private debt funds to finance the investments made in a low-valuation environment. Otherwise, the investor may end up selling other risky assets, such as high yield bonds or even equities, in an environment when the value of those holdings is just spiraling downwards. This may naturally eat away some of the benefits of the private debt asset class. Thus, instead of financing capital calls from liquid risky assets, we believe an investor should have a certain target cash balance which can then be used to finance capital calls from opportunistic private debt funds. This way an investor can really benefit from the counter-cyclical opportunities created by a diversified private debt program.
To take full advantage of situations like the spring 2020 dislocation, it is necessary to be able to make new fund commitments within a very short time frame, however for most investors that is usually not possible. Therefore, instead of just having cash readily available it would be ideal to have enough commitments outstanding into high-quality private debt funds. We at Mandatum believe an excellent way to invest is to commit some funds into a balanced private debt program each year. This will help the investor to balance the cash flows better and will also enable a meaningful diversification of investments over time.
When it comes to the selection of private debt funds, we believe an appropriately diversified private debt program brings great benefits to investors, especially in situations similar to the one we faced last spring. During 2Q 2020 the M&A market was almost completely frozen and traditional direct lending funds were not able to deploy meaningful amounts of capital. But at the same time, an investor with opportunistic funds in the private debt portfolio benefited from the situation and was able to get meaningfully invested during the spring of 2020 and thus actually balanced out the whole program’s cash flow. That is additional concrete proof of the benefits of a diverse private debt program.
This article is being provided to you for informational purposes only and does not constitute investment advice or a solicitation to invest or to participate in any trading or investment strategy. Any investors should make their own assessment as to the suitability of investing in any of the discussed strategies and, if necessary, consult their own legal and tax advisors. The presented information is based on the information available at the time the article was created as well as on the views and estimates of Mandatum Group at that time.