Combining Public and Private Debt: Considerations for Investors

We believe there are a number of good reasons fixed income investors should consider a one-portfolio public/private debt solution.

The structure and valuations of the fixed income market have changed significantly in the decade since the financial crisis. Some of these changes, such as the decline in fixed income term premia and the overall low level of global interest rates, likely are temporary and will unwind as global central banks continue to push toward more normal monetary policies. Others, however, are likely to persist; regulations that require banks to hold more capital, for example, is a change that emerged 10 years ago and is likely to be with us for at least 10 more.

Institutions have been forced to adjust their approach to fixed income investment as a result of these shifting market dynamics. One notable development has been the embrace of increasingly sophisticated investment strategies that seek to boost returns while optimizing portfolio liquidity; this has included adding exposures to private debt markets, either through separate mandates managed in parallel with public market investments or combined in a single public/private fixed income portfolio. The merits of a combined approach appear fairly straightforward: By expanding the opportunity set to include private securities, a fixed income investor should be able to generate more attractive returns—in part by harvesting the illiquidity premia that accompanies private debt—while gaining access to differentiated exposures that promote greater portfolio diversification.

Executive Summary

  • Private debt—corporate lending, consumer non-residential and small-business lending, and residential mortgage lending, among other more-niche categories—presents investors with an expanding, differentiated opportunity set offering potential return, liquidity and diversification benefits that may complement their public debt holdings.
  • While liquidity historically was the key practical distinction between public and private debt securities, the line between the two has begun to blur in the post-crisis world. Looking forward, investors should structure portfolios in anticipation of the further convergence of liquidity characteristics across these markets.
  • Post-crisis changes on both the supply side and the demand side of the private debt market have fueled its recent growth. We believe these changes are structural in nature and will continue to support the development of private debt and the benefits of its integration into investor portfolios.
  • New regulations in the wake of the financial crisis have made certain risk exposures prohibitively expensive for traditional banks in both the U.S. and Europe, creating a funding gap that increasingly is being filled by nonbank market participants.
  • Any consideration of the benefits of adding private debt to a portfolio of public securities must center on the trade-offs—based on the interaction and correlation between liquidity compensation and other risk factors—an investor makes when allocating capital away from public markets and toward private ones.
  • Given their information asymmetries and barriers to entry, private markets may offer more attractive opportunities to capture certain risk premia relative to what is available in the public markets. Moreover, these premia likely are higher in private markets, suggesting that private debt investors able to accurately assess default- and severity-adjusted spreads have the potential to add incremental returns compared to public markets.
  • We believe there are a number of good reasons for fixed income investors to consider a one-portfolio public/private solution, the most significant of which is that it allows investment managers to create more compelling liquidity characteristics compared to separate allocations while better capturing risk premia and relative value opportunities across the liquidity spectrum.
  • While a combined public/private debt portfolio may be suitable for a range of investor objectives, effective management of such a strategy will require an investment manager whose processes, platforms and experience are equally robust in both markets.

Private Debt Assets Under Management Have Spiked Post-crisis

Assets under Management, in Billions of $

Source: Preqin. “Private Debt” in this instance includes venture debt, special situations, mezzanine, distressed debt and direct lending.

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