In private debt, you win by not losing, and key to not losing is good manager selection. But with a massive number of ‘me too’ players entering the market, that’s getting harder.
Private debt’s ‘Goldilocks moment’ has seen a massive uptick in inflows as big investors try to lock in equity-like returns for a fraction of the risk – and sparked the usual talk of bubbles that crops up whenever any asset class seems to be getting too hot.
But private debt market dynamics are still favourable, according to Mercer Australia alternative investments director Marcus De Kock, and the real way for investors to protect themselves is to take a good hard look at their managers.
“What we might see happening is other providers that haven’t necessarily played in this space for very long might see opportunity, and you might get a lot of ‘me-too’ players come into that market, so investors have to be very careful and very selective,” De Kock said. “When it comes to private debt there’s not really upside; you’ve got to be well diversified, and our mantra is that you win by not losing.”
There are opportunities for some new players, but it’s still a difficult asset class to get into and you can’t just start from scratch, de Kock says.
“You want people who’ve done this for a long time – whether it’s a well-experienced team from an investment bank with a long track record that’s setting up a new shop, but the trouble is for new players to come in they need a lot of capital in order to come and compete,” De Kock says.
“That’s the real challenge; a new manager starting out will often have to look at the small end of town, because if you’ve got $100 million you don’t want to put $100 million in one loan. Suddenly, you’re restricted in which areas of the market you want to play.”
Where there is a start-up advantage is in the fund-of-fund space, where players that have built strong general partner relationships by investing in private equity funds can get a leg up in origination. But just because there’s an opportunity doesn’t mean everybody will be successful.
“There’s going to be a lot of new players coming in and trying to access that opportunity and you have to do your due diligence,” De Kock says. “At the end of the day, the private markets are an alpha play, and that comes through manager skill; if you’re not choosing the best and right managers, then your portfolio can start looking very badly.”
Zombie outbreak
But the real sore point across the alternatives universe is venture capital, De Kock says. A Mercer report on the outlook for private markets in 2024 tracks an emerging phenomenon they dub “zombiecorns”: companies that “eat cash, rot away inflated company valuations and spread their own kind of contagion”.
“Many investors have retreated from venture capital and growth equity, realizing they need more significant expertise to survive the ‘zombie outbreak’,” the Mercer report says. “We expect many to need assistance in maintaining the current inflated valuations of several of their portfolio companies simultaneously.”
But there’s not just the zombiecorns to contend with. The venture capital space has seen an influx of inexperienced players with plenty of dry powder on hand, and investors “do get burned”, De Kock says.
“We saw that in 2021-22. The venture capital market is quite interesting, particularly if you look at the late-stage area. You often find that when venture capital starts doing well you get a lot of tourist investors, hedge funds that start playing in this space – and then when things go wrong the late-stage venture capital is more closely linked to public markets, the NASDAQ and tech indices. When that falls, valuations are quick to move unlike in other parts of the private market world.”
Lachlan Maddock is editor Investor Strategy News (Australia)