Outlook 2024: Sick of market volatility? Look to private debt

Today’s markets are wracked with uncertainty. Over the past year, we’ve seen consensus move from hard landing, to soft landing, to no landing at all.

While the outcome may not be as dire as previously forecast, markets remain challenging – with persistently high inflation, higher rates and tight liquidity.  

Private debt is uniquely positioned to perform in this environment by providing investors with fixed income-like returns that are uncorrelated to listed markets. The loans tend to be floating rate, so as base rates increase so too do the coupons investors receive. And being privately negotiated, the terms and conditions of lending can adapt to limit downside.

Today we see new deals being struck at lower leverage levels and paying higher premiums to those written prior to mid-2022. So it’s no surprise investors are scrambling to the asset class in pursuit of attractive risk adjusted return. By 2027, global assets under management in private debt are projected to approach $3 trillion.¹    

But there is a flipside to that coin. Tighter financial conditions and higher cost of debt negatively impact serviceability and the pipeline for new deals.  

In this Outlook, I go through our approach to debt structuring, how we’re positioned, and the key themes that we think will define the space 2024.  

Liquidity is crucial

Investors simply can’t afford to approach markets with one or two outcomes in mind. Rather, they need to account for a range of outcomes.

Private debt is unique in this respect because all the risk is to the downside. Unlike other asset classes, like equities, we don’t generate more return from a deal if the borrower suddenly becomes more profitable. On the other hand, we stand to lose some or all of the investment if the borrower is unable to repay. Namely, if borrowing costs increase at a faster rate than cashflows, their ability to repay will be impaired.

These risks obviously go up in high cost environments. Inflation has come down off its highs thanks to rapid central bank intervention, but it still remains elevated. 

As mentioned earlier, private debt is typically floating rate, which can provide a valuable hedge against rising yields.

But inflation can contribute to lower enterprise valuation multiples and by extension lower leverage multiples for debt. For existing deals, increased cost pressure require prudent monitoring of business plans and borrower management teams, especially as it relates to cost management.

But with prudent risk management, these risks can be mitigated. We focus on the stability and resilience of borrower cashflows and ensuring there is an appropriate equity cushion within the capital structure.

Positioning

Beyond the cashflow imperatives outlined above, protecting the portfolio means investing in sectors that are insulated against the business cycle and waning consumer demand, and staying away from sectors that aren’t. The ability to deleverage via cost outs (where variability of cost base becomes important), improving EBITDA margins and cashflow generation is critical.

If we enter recession, or at least a period of depressed growth, discretionary spending can be expected to trend down, which will be a headwind for sectors such as tourism, certain parts of the retail sector and some areas of hospitality.

We are cautious on the construction sector, or any sector exposed to construction, because of the significant cashflow stresses that such businesses experience in inflationary times. By the same token, persistently lower unemployment is putting upward pressure on wage costs.

Relatedly, the housing crisis could elicit a fiscal response that creates more activity in the construction and infrastructure sectors but negatively impacts inflation in the short term. Possible changes to superannuation could incentivize more social and national building projects – again, stimulating the construction sector but also put upward pressure on the CPI number.   

Though we look at all transactions on their own merits, we think this is a sector where we need to add extra restraint due to the significant cashflow stresses that such businesses experience in inflationary times, including wage inflation driven by persistently low unemployment and lack of skilled trades – problems, I should add, that aren’t restricted to the building sector.  

For these reasons, among others, we expect banks to ration capital moving forward, to the benefit of non-bank lenders.

Services business in the construction and mining sectors, meanwhile, traditionally struggle during down markets as cost out programs turn to contractors first, and we believe this cycle will be no different.

That said, volatility there can also open up opportunities to hold appropriately structured sector outperformers where downside risk is scrutinised and mitigated.

Sectors with clear upside include healthcare given the aging demographic of the population and the government’s supportive funding model. It should be noted, though, that a rise in out-of-pocket treatment expenses and general consumer strain means certain ancillary businesses may observe some declining demand for non-essential treatments.

Infrastructure, or infrastructure-like assets, is another sector that performs well in inflationary environments. These assets are usually inflation-linked through regulation, concession agreements or contracts. It’s worth highlighting here a common misconception around debt versus equity –being, that infrastructure equity outperforms infrastructure debt during inflationary environments. While equity returns are generally higher than debt in these scenarios, inflation can swing the return profile in favour of debt. Whereas debt servicing costs can rise with inflation, equity holders bear the cost of cost pressure.  

On the real estate side, we like industrial and logistics where there is a severe lack of space in key urban markets, strong occupancy rates and rents adjusting to market rates.

We also believe neighbourhood shopping centres represent the most liquid part of the retail focused real estate market. They are large in number and small in area, have low levels of discretionary retail, and tend to be anchored by a supermarket. These qualities were borne out during the pandemic, when they outperformed as the rest of the market was under severe pressure. And we expect this outperformance to continue amid today’s ongoing volatility.   

1. Source: Schroders, Preqin, AUM from PreqinPro as at January 2023 and forecasts from Preqin Global Report 2023 – Private Debt. Past performance is not a reliable indicator of future performance. “Forward-looking” information, such as forecasts or projections, are not guarantees of any future performance and there is no assurance that any forecast or projection will be realised.

Read all the Australian Investment Outlooks for 2024 here.