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Private debt: resilient through rising rates, inflation and recession risks

Institutional investors set aside capital for private debt during the era of low rates, but the alternative asset class could still be attractive in the current environment, according to Australia’s Queensland Investment Corporation.
Private debt: resilient through rising rates, inflation and recession risks

The current global economic outlook points towards higher rates, rising inflation and the possibility of a recession, but Australia’s Queensland Investment Corporation (QIC) thinks it is still an attractive market environment for private debt.

The government-owned investment firm set up its private debt team in 2021 and is planning to hire one or two more managers for its multi-sector team in Australia, Andrew Jones, QIC’s head of private debt, told AsianInvestor

Andrew Jones, QIC

The private debt unit currently has nine investment managers in total, spread equally across Australia, the US and the UK. Most recently, QIC hired Bettina Lung for its multi-sector private debt team in Sydney from Aware Super’s credit income team in late June. 

The launch of those capabilities is driven by demand from QIC’s sovereign and insurance client base, where they want to have differentiated but predictable yield with stability and add diversification to the portfolio, according to Jones.

“A combination of higher returns, more opportunities to create conservative lending structures, and also less competition from capital as investors, for example, withdraw from high yield strategies, will give us a great opportunity to build an attractive portfolio in both our private debt strategies,” he said.

QIC is the asset management arm of the Queensland government that also manages assets on behalf of superannuation funds in Australia, and other public or private pension funds and life insurance companies across the world. It managed A$101 billion ($69 billion) of assets as of the end of 2021.

“Both of those pools of capital will be important components of the [private debt] strategies going forward,” said Jones.

In April, the new team closed its first investment in US-based solar owner and developer Cypress Creek Renewables (CCR). As a joint lead arranger alongside others including Canada Pension Plan Investment Board (CPPIB) and CarVal, QIC will provide a $450 million delayed draw sustainability-linked note to fund the growth of CCR’s solar and storage project pipeline.

READ ALSO: Private credit fastest growing alternative asset class among asset owners

CHANGING ENVIRONMENT

QIC’s private debt team was built in a low-yield environment in 2021. But as the market is heading towards higher rates and prices, Jones thinks the environment is generally still favourable to its private debt investment.

One of the benefits is that private debt is typically floating-rate loans correlated to interest rates. But the flip side is that such an environment creates more pressure on companies’ earnings and credit worthiness, he said.

“If the economies around the world do move into a recession at some point in the future, it would be quite common for us to see higher default rates and losses at that point of the credit cycle. Potentially that implies that there's more risk in the future for loans that have been written maybe a year or two ago,” Jones said.

In that sense, private credit investors who have allocated to resilient businesses in a downturn that have less correlation to GDP and are less cyclical, or have protected themself from interest rate hikes, for instance through hedging strategies, will be better protected.

But on the other hand, new investors can adjust lending standards to fit their risk profile, probably offer less leverage, and target businesses that are safer and more stable and safer compared to what they would have invested in previously, he said.

“Looking forward, margins are likely to increase and already started to increase, so your reward for the risk that you're taking on will be higher if you invest in new loans,” Jones said. “So there’s a different outlook for people who have already invested money compared with people who are investing from now on, and one will need to be cautious. But for one that's newly investing, there's, I think, quite a positive outlook.”

Since QIC’s private debt strategies – infrastructure and multi-sector – are both new, it is taking advantage of the current environment with higher credit spreads and less competition, to take more control as a lender.

“Both of those strategies will benefit from those headwinds and are well positioned to manage the risk of default going forward,” Jones said.

He noted that the infrastructure strategy by nature is lending to stable, predictable businesses that are non-cyclical with less correlated to GDP movements. “Infrastructure debt is one we point to as being well positioned to outperform in a rising interest rate environment.”

The multi-sector strategy in Australia will be targeting businesses with adjustments in their underwriting conditions based on the current economic outlook, where they will offer less leverage that is higher pricing with better terms than what might have been the case historically, he added.

DIFFERENT TARGETS

In the hunt for lending opportunities in global infrastructure, QIC focuses on developed markets, especially North America and Western Europe, with a preference for the energy transition, decarbonisation, and digital infrastructure such as telecommunications towers, fibre networks, and data centres, which all require massive capital demand and growth.

It also sees traditional projects such as transportation, ports, toll roads, and airports playing an important role in their portfolio in the future as those economies bounce back from previous Covid restrictions.

In the domestic multi-sector strategy, QIC is looking for multi-sector corporates owned by private equity firms, and businesses owned by asset managers and real estate developers in Australia, in the form of corporate leveraged loans, real estate debt, and asset-backed securities (ABS).

Both infrastructure and multi-sector strategies will be focused on medium- to large-sized companies.

For QIC, a loan to an infrastructure asset is usually four or five years, while corporate debt is three or four years long. It tends not to issue a loan as long as 10 years because private debt investors usually prefer flexible capital that can be recycled every few years, Jones noted.

He did not provide return targets for QIC’s private debt investments, but noted that historically, they range from mid-single digits up to low double digits.

If a manager is promoting returns which are in the mid-teens or higher, generally they are talking about a strategy focused on distressed debt, or some type of workout situations or loan-to-own strategies, Jones said.

The vast bulk will be found between those mid-single digits to low double-digit return targets, he said.

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