With the banking sector increasingly driven to re-evaluate its lending strategies in the face of regulatory pressures and increased funding costs, an investment executive says the resulting demand-supply imbalance for capital presents an attractive opportunity for private credit and private debt.
Appearing on the Relative Return podcast, Mariana Paul, investment specialist at O’Connor and head of sales and distribution for Southeast Asia at UBS, said regulatory impediments, particularly post the Global Financial Crisis, have created an “attractive structural alpha opportunity” for the asset class.
“This has exacerbated the demand supply imbalance, widening the funding gap, hence creating opportunities for independent asset managers like ourselves to capture yield premium versus the more traditional avenues,” she said.
“In fact, not only managers but investors are also recognising this opportunity and see the benefit of that uncorrelated alternative source of returns and the diversification this asset class bring to their portfolio, hence compensating them through the risk premium of this less liquid asset.”
She described private credit as a “powerful complement” to traditional fixed income strategies, offering incremental income generation, potential resilient return enhancement, and diversification.
Within this, she outlined two distinct areas offering long-term structural alpha opportunities, namely, trade finance or working capital, alongside direct lending to the non-sponsored borrower segment.
“What is attractive about working capital finance is that as an asset class, it has historically lower default rates and higher recovery rates versus their comparable public bonds just due to the structure of the loan and how creditors are viewed,” Paul told InvestorDaily.
Last year, the Asian Development Bank’s 2023 Trade Finance Gaps, Growth, and Jobs Survey reported the global trade finance gap over the last 10 years grew from $1.4 trillion to $2.5 trillion and is expected to grow further over the next decade.
Paul highlighted a significant opportunity in this space due to growing unmet financing needs, as globalisation and invoice automation converge to bolster participants, transactions, and market opportunities.
“O’Connor has been investing in this space since 2019, and we are seeing really attractive risk-adjusted returns here,” she said.
Similarly, in the case of direct lending, she said there exists a significant, persistent supply-demand imbalance within the non-sponsored segment. She noted that it has become increasingly overlooked by middle-market direct lending funds due to certain complexities.
In light of this, the investment executive noted that, while private credit may offer attractive returns, it remains a complex investment opportunity. Primarily, it holds risks such as capital deterioration, as returns are directly related to the business success; illiquidity of assets; weaker credit profiles; and relaxed underwriting standards.
“Hence, it is important for investors to do their due diligence, both from an investment perspective as well as the team experience and operation aspect,” Paul told InvestorDaily, adding that a strong record, effective investment process and risk management framework, and transparency should be taken under consideration.
Previously, Metrics Credit Partners managing partner, Andrew Lockhart, also highlighted the emerging opportunity for private credit providers to fill the funding gap and cater to borrowers seeking alternative finance options, as banks increasingly cede market share.
Speaking on an InvestorDaily webcast, he explained: “We certainly are of the view that the market will continue to move towards private investors, private credit providers, and the regulated banks will probably continue to move more and more towards consumer home loan financing and lending for small and medium sized businesses.”
Moreover, from an investment perspective, private credit remains appealing due to its ability to provide an attractive source of income while offering defensive characteristics in investors’ portfolios.
“[Investors are] looking for reduced correlations across asset classes, and private debt delivers that,” Lockhart said.
“We’ve seen situations where people have invested historically in more traditional fixed income asset classes, like bonds, and they’ve just not performed, and so they’re looking at how to reduce that duration risk and how to get a more direct exposure.”
Last year, private capital assets under management in Australia grew by over a third (33 per cent), according to latest figures from Preqin and the Australian Investment Council and reaching nearly $140 billion.
The research also pointed to the increasing popularity of private debt supported by robust deal activity and tighter lending conditions among traditional debt providers.
As at June 2023, private debt AUM stood at around $188 billion.
