Alternative Investments and Private Debt Digest - October 2022 Edition

Welcome to our monthly digest about investing into alternative assets and digital lending companies.

We covered some of the top headlines from the previous month.

Alternative Assets and Private Debt

1. How Do the Wealthy Invest?
2. Whisky, Art, and Farmland: Alternative Assets in Retail Portfolios
3. Looking for alternatives: the investment trust route
4. Is Private Credit a Bubble, or Just a Little Frothy?
5. Ahead of the curve: Beefing up guardrails as risks rise in private credit
6. Private credit is the new mega-trend for LPs

How Do the Wealthy Invest?

Do the wealthy invest differently from everybody else? And, if so, what can we learn from them?

While the wealthy used to invest in stocks, bonds, and real estate, this study suggests that, going forward, they may prefer investments like crypto, private companies, and other alternatives.

Younger wealthy households would feel differently about how to get rich than most people who get rich, because they got wealthy due to exceptional circumstances in the first place. They are more sceptical of traditional investments, with allocation to stock and stock funds of 25% versus 55% for older investors; more likely to support sustainable investing (i.e. ESG) and allocate around 15% to cryptocurrency investments, versus older investors’ 2%.

High net worth (HNW) investors allocated around 50% to stocks, 20% to bonds, 25% to alternatives, and 5% to cash, while ultra-high net worth (UHNW) investors allocated around 30% to stocks, 10% to bonds, 50% to alternatives, and 10% to cash. This divergence of capital away from traditional asset classes like stocks and bonds and towards alternatives (i.e. private equity, hedge funds, etc.) seems to be positively correlated with the amount of wealth that someone has.

There has been a shift toward alternatives among the wealthiest investors, which suggests that as an investor’s assets increase, they tend to allocate more to alternative investments.

Whisky, Art, and Farmland: Alternative Assets in Retail Portfolios

As major global stock benchmarks have all tumbled by double digits since the beginning of the year, it’s no wonder more and more retail investors are searching for ways to enter the alternative investments sphere.

Not only are the means of investing in alternatives expanding, but the alternative universe itself is much wider than it used to be just a few years ago. Formerly, alternative investments meant either hedge funds, real estate, or private equity; now, they also include managed futures, venture capital, structured non-OTC products, e-sports, cannabis, cryptos, crowdfunding, P2P lending, collectibles, art, alcohol, third-party funding, NFTs, and more.

Alternative assets have little or no correlation to stocks and bonds, which makes them attractive to investors, specifically in times of turmoil, and they often have higher return potential than stocks and bonds.

A lack of products tailored for retail participation has been one of the key barriers up until now, but that is beginning to change as the industry innovates. Now, technology-enabled platforms are giving individual investors access to the kinds of alternative investments that were previously only available only to institutional and high-net-worth individuals. In addition to the vast number of designated platforms, there are also those offering exposure to a number of assets. There are even sorts of “funds of funds” for alternatives that fit retail investment capabilities.

Looking for alternatives: the investment trust route

Investment managers are betting that the special characteristics of the British investment trust — an investment vehicle structured as a publicly traded company that is rare elsewhere in the world — can help them weather the storms now hitting the markets. One key merit of the trusts is the ability to hold illiquid assets within a company that allows investors to buy and sell shares daily in a liquid market. Crucially, the managers don’t have to sell the underlying assets if investors sell the trust company.

For alt enthusiasts, undervalued trusts look like an opportunity. Even with traditional sources of income-like bonds coming back into play, plenty of managers still expect the rise of alternatives to continue, though with a shift in emphasis towards inflation-protected income from assets like infrastructure and long-term property holdings. The eclectic range of assets now on sale in investment trusts reflects the explosive growth of alternatives across the investment industry.

As wealth managers increasingly see trusts as a means to invest in alternatives and dial back their exposure, DIY investors have taken up the slack, stepping in to buy trusts in increasing force.

Is Private Credit a Bubble, or Just a Little Frothy?

The asset class has exploded in popularity over the past two decades — but that doesn’t mean it’s about to blow up. Institutions and individual investors alike have flocked to the asset class. Estimates from various sources indicate that the private credit industry today has total assets under management of about $1.2 trillion. This represents pretty strong growth — nearly 25 percent per year for more than two decades. Investor demand for private credit remains robust even in the current conditions — so much so that critics may be asking: Is private credit a bubble?

There’s a pretty good reason for the high demand: strong returns. Private credit has delivered annualized returns of about 9.2 percent (from 2008 to 2021), and outperformed the next best sector, high-yield bonds, by nearly 200 basis points per annum.

Looking at expected losses, private credit still compares favorably with junk bonds. Junk bonds are subordinated debt, while private credit tends to be in a senior position, with many direct lenders still being able to obtain traditional covenant protections. Private debt holds up well in comparison with high-yield, with loss ratios roughly half those of the public comparables.

Higher returns in private credit relative to broad high-yield exposure still appear realistic; direct lending doesn’t look like fool’s yield yet. When private credit no longer demonstrates a sufficient yield premium net of expected credit losses, it will be time to reduce allocations.

Ahead of the curve: Beefing up guardrails as risks rise in private credit

Weaker credit fundamentals – as evidenced by rising leveraged loan default rates – and mass exposure to covenant-light loans reveal greater risks on the horizon. From a standalone viewpoint, the risks seem innocuous, but in concert they could easily upend markets. As typical private credit portfolios are concentrated and show vulnerabilities to a range of stress scenarios as credit fundamentals weaken, robust credit monitoring, early detection of risks and customised scorecards are essential, especially as the asset class continues to grow and is here to stay.

Periodic reviews, specialist insights, and consistent covenant and compliance tracking of underlying holdings from origination through to divestment are crucial as the pool of debt offerings grows across multiple strategies. The private debt borrowers cannot be evaluated using the same tools and methods as for traditional debt or standard loans, hence, the deployment of customised or bespoke scorecards that capture borrowers’ creditworthiness and are customised to suit the needs of end-borrowers, is required.

Significant challenges lie ahead for private credit investors, but firms with a targeted strategy based on careful monitoring and a robust early-warning system, will be well placed to navigate this phase.

Private credit is the new mega-trend for LPs

Private credit has been called as a “long-term mega trend” within alternatives, which has been experiencing mega-trend status itself for almost a decade:

• Last year, private credit assets under management exceeded $1 trillion for the first time. Over the next five years that figure is expected to more than double.
• Target allocations to private credit among pension funds in double figures
• Direct lending will remain the standout strategy as interest rates rise
• Average credit fund size approaches $1bn as larger managers dominate
• A scarcity of private credit solutions in the 250-500 bps range could also create an additional opportunity set for direct lenders.

Almost nine out of 10 private equity GPs have increased or maintained the use of private credit in their buyout financing over the past three years, and are now working even more closely with direct lending credit funds to fill the gap left by syndicating banks with mispriced loans on their books.

Alternative Lending

1. Are SME Lenders facing a ‘perfect storm’?
2. What Higher Interest Rates Mean for DeFi
3. LendingClub sends a warning to the market
4. How can 'buy now, pay later' get better?

Are SME Lenders facing a ‘perfect storm’?

The challenging economic environment has hit small businesses everywhere. They’re needing to manage cash flow in the face of rising business costs, as well as having to consider the cost of borrowing. Much of this strife was prompted by the inflation seen around the world. But there is also a UK - specific issue relating to the recent political volatility and its knock-on effect on markets. With added uncertainty over energy costs from April next year, many small companies will be deeply concerned that the cost of doing business will become unmanageable.

Lenders and borrowers are advised to focus on the shorter-term economic situation. From a lender's perspective, it is necessary to be a little bit more conservative, and allow some more headroom in terms of running sensitivity analysis. Despite all the negative data and sentiment, SMEs are generally good at navigating crises, with their resilience coming from the owner-managers who run the business as if it's their own personal baby.

What Higher Interest Rates Mean for DeFi

Common sense tells us investors should seek the highest yields with the lowest risk. Considering that U.S.Treasuries are considered one of the most risk-free investments available, it’s surprising to see DeFi platforms attracting any sort of capital. However, data shows all DeFi platforms are still holding Total Value Locked (TVL) of $52.3 billion, though a close inspection shows us this number has been falling. The biggest drop came after the first large interest rate increase in May 2022. As traditional and DeFi rates diverge further, we should expect to see further capital fleeing from the DeFi marketplace.

It’s been suggested that one saving factor for DeFi is the difficulty in moving funds out of DeFi platforms and back into traditional finance. The question now is whether continued interest rate increases will drain capital from stablecoins to the point where it has a meaningful impact on the DeFi ecosystem. Theoretically, borrowing rates on lending platforms will naturally rise as the circulating supply of stablecoins drops.

Potential trends:

• While stablecoin lending could drop off until the friction between traditional and decentralized markets abates, we may see a shift in lending towards Ethereum.
• Another potential trend that could increase interest in the DeFi space, despite lower lending rates, is fixed rate lending. The addition of fixed rate protocols would theoretically help DeFi connect more with traditional finance, thus lowering the friction between the two systems.
• The addition of fixed rate protocols would theoretically help DeFi connect more with traditional finance, thus lowering the friction between the two systems.

LendingClub sends a warning to the market

LendingClub originates some of its loans and then sells them to investors, an arrangement often called marketplace lending.

The company reported an 8% quarterly decline in the total value of its loan originations, driven by a decrease in marketplace loans and impacted by higher funding costs for certain loan investors. Investors in consumer debt are seeking higher yields and getting pickier as interest rates rise. That has put a squeeze on marketplace lenders. LendingClub can reprice its loans to meet those higher funding costs over time, but the company needs to remain competitive against credit card rates, as the majority of its personal loans are people refinancing credit card debt.

How can 'buy now, pay later' get better?

Better pricing strategies, more consumer education, and BNPL-specific promotions could improve the BNPL experience, the experts say. Banks and fintech firms that provide BNPL will need to balance the following elements to build profitable BNPL businesses:

• Focus on profitable market segments and on providing higher approval rates
• Improve pricing strategies (for pricing arbitrage)
• Offer a mix of installment lending products and other banking products (besides BNPL)
• Improve payment experience for business customers
• Consumer education and standardized disclosures will be key in making BNPL a sustainable long-term product category
• Greater transparency, doing away with hidden fees and underwriting properly
• Diversifying and improving value propositions to better serve consumers.