Mike Grdosic, Senior Investment Analyst, Lonsec
There have been a significant number of ‘evergreen’ private debt funds launched in Australia over the past few years. A key risk of these funds is the potential mismatch in liquidity as the underlying asset class is illiquid.
This insight focuses on the differentiated features of private debt that make its liquidity risk more manageable than that of other private asset classes, such as property, infrastructure, and private equity. Other aspects will also be discussed to help investors understand the mechanisms in place that assist in the management of liquidity risk in private debt ‘evergreen’ funds.
‘Self-liquidating’
There are features associated with private loans that make them ‘self-liquidating’, that is, generate high cash flows that can be used to pay liabilities such as redemption requests:
- High coupons/margins, paid monthly
- Short maturities, typically 3 – 5 years
- Some private loans are amortising – e.g. asset-backed finance
- Issuer and borrower have pre-payment options
Private direct loans are typically structured to pay a high margin above the reference cash rates, typically paid monthly and predominantly passed through as distributions. These margins are in the order of 4% to 6%, depending upon the credit risk, position in the capital structure and quality of any collateral supporting the loan. Loans also have relatively short maturities, typically 3 – 5 years, with the issuer and borrower having an option to pre-pay or redeem the loan early, in certain circumstances, albeit with penalties. Some loans may also be amortising, meaning a small amount of principal is repaid at each coupon period. These ‘self-liquidating’ features of private debt result in significant monthly cashflows entering the portfolio, which requires constant reinvestment and/or distribution back to investors.
Portfolio management
Portfolio management approaches also assist with reducing liquidity risk, such as:
- ‘Laddered’ loan maturities
- ‘Crossing’ benefits
- Liquid asset pool
- Debt facility
Private debt managers typically spread-out (‘ladder’) loan maturities across time, resulting in a steady amount of monthly principal cash flows being returned, typically 2-5% per quarter. Larger portfolios with a diversified investor base allow for higher ‘crossing’ benefits, where applications and redemptions can be netted, reducing the net demand on liquidity. In addition, part of the portfolio is typically allocated to tradable securities (liquidity pool) that can be sold on short notice. Hard limits are typically in place for this liquid asset pool, ranging from 5 to 20%. Finally, most managers set up a debt facility, with say a bank, that assists not only in enhancing returns via a modest amount of leverage applied (typically 1x) but also provides flexibility to manage redemption requests or capture new market opportunities.
Structural features of the fund
The legal structure of the fund usually has features that help align the illiquid nature of the underlying assets with the liquidity terms of the fund. Typically, investors can gain access to their capital every quarter, capped at 5% limit of the NAV of the fund. This means, if a sufficient number of investors put in a redemption request in a particular quarter, only 5% of the portfolio NAV can be available. If an investor’s redemption demands have not been met, another request can be made in the next quarter. Finally, the fund also has the ‘extreme option’ of suspending redemption requests, as it may be in the best interest of investors in certain circumstances.
Global private debt – currency risk
For global private debt funds, foreign exchange risk can potentially have a large impact on liquidity as currency hedging is typically undertaken. At the extreme, the liquidity demands from currency hedging may impact the funds’ ability to pay out distributions. To reduce this risk, managers typically stagger the currency hedging contracts over the year to spread out the liquidity demands. Secondly, the Responsible Entity (RE) of the domestic fund will typically elect accounting standards (AMIT/TOFA) that can assist in smoothing out the currency hedging impact from an income distribution or tax perspective. Notwithstanding these measures, material and sustained declines in the domestic currency may still temporarily impact a fund’s ability to pay out distributions, although this has not been experienced to date.
Other risks
Some private loans contain ‘payment-in-kind (PIK)’ features, which result in all or part of the interest being capitalised and paid at maturity. Investors should be alert to high amounts of PIK loans in portfolios, as this increases the adverse impact of a potential default and may lower the amount of interest distributed each period. Ultimately, private debt investments involve exposures to loans with a higher risk profile, so a synchronised rise in defaults typically associated with a recession may inhibit a fund from making regular distributions and restrict liquidity. However, experienced managers with strong credit skills, coupled with high issuer, industry and regional diversification, will minimise these risks during such periods.
Overall, private debt is illiquid, requiring a patient investment approach. However, liquidity risk can be managed relatively well with private debt, as long as the above mechanisms and activities are in place, which is a strong focus in Lonsec’s review of private debt funds.
Important Information: This article has been produced by Lonsec Research Pty Ltd ABN 11 151 658 561, AFSL No. 421445 (Lonsec). Generation Development Group Limited ABN 90 087 334 370 is the parent company of Lonsec Research.
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