Private debt is one of the most attractive asset classes. The growth of private debt funds has been spectacular, with very attractive risk-adjusted returns for investors. The attractiveness of private debt has several reasons. Firstly, the post-crisis financial regulatory reforms have led banks to reduce their lending activities, particularly to small and medium-sized businesses. This has further intensified during the Covid-19 crisis. Secondly, the demand for credit from businesses has not fallen to the same degree, leading to unmet demand. And thirdly, the demand from institutional investors for debt that yields more than government debt remains robust. Historically, the private debt market consisted of specialized funds that provided mezzanine debt, which sits between equity and secured/senior debt in the capital structure, or distressed debt, which is owed by companies near bankruptcy. However, following the financial crisis, a third type of fund emerged. Known as direct lending funds, these funds extend credit directly to businesses or acquire debt issued by banks with the express purpose of selling it to investors.
Leading alternative asset managers have all expanded their product offerings to include private debt funds. They are joined by many specialized new firms. The strong demand by institutional investors has enabled these funds to expand rapidly in size. Collectively, more than 500 private equity style debt funds have been raised since 2009. The private debt industry has quadrupled surpassing $800 billion, according to the alternative data provider Preqin.
However, the private debt universe remains somewhat opaque. There are several types of private debt funds that can differ in terms of structure, risk and duration. For example, most private debt managers use closed-end fund structures with long investment horizons and very limited liquidity. Also, some funds invest in areas with equity type risk/return characteristics, such as mezzanine debt, subordinated loans, convertible loans or even equity components, including warrants and private equity co-investments.
Katch investment group decided to focus only on the lowest risk areas in the private debt space around the globe. It is mainly active in senior secured lending, senior real estate debt and other niches in the direct lending area that combine a high level of seniority and real asset guarantees. What is more, the group focuses on short-term opportunities, where the competition from banks has decreased even more, as new regulations and bureaucratic processes have made banks slow in approving credits. Also, the high rotation in short-term loan books enable asset managers to provide liquidity to investors. The fund structures are typically open-ended with monthly or quarterly subscriptions and redemptions. This is a key advantage for investors that oftentimes struggle with capital calls and the illiquidity of closed-end funds.
One of the challenges in private debt has been the lack of benchmarks. Some investors are using the S&P/LSTA Leveraged Loan Index or the Bloomberg Barclays High Yields Bond, that both are a very bad proxy for the private debt asset class. The Cliffwater Private Debt index has more merits as it seeks to measure the unlevered, gross of fee performance of US middle market loan, as represented by the asset-weighted performance of the underlying assets of business development companies (BDCs). A BDC is the equivalent of a REIT (Real Estate) but for loans in the US.
However, this benchmark does not really reflect the investment approach of Katch in terms of its geographical exposure, duration and risk. This is why the group decided to create the Katch Open Ended Private Debt Index (KOEPI). The equal-weight index is designed to track the net of fees performance of short-term secured lending strategies, such as real estate bridge loans, trade finance, life insurance settlement, and other short-term asset backed lending strategies. The index starts in January 2017 and currently consists of 23 mutual funds. The index is rebalanced quarterly, since several funds only publish quarterly NAVs. The publication of each quarterly performance will take place between 75 and 90 calendar days after the respective valuation date.
Currently, the index includes funds in the areas of trade finance (33%), credit opportunities (28%), bridge loans (22%) and life insurance settlement (17%). Geographically, it is exposed to Europe (39%), North America (33%), Asia (11%), Africa (11%), Global (6%). The index combines some of the most important indexing requirements: It is unambiguous as the weight of each fund in the index is known, it is investable and the performance is easy to measure as the constituents NAVs are widely available and updated via financial data providers, such as Bloomberg.
However, investors should be aware of some biases and limitations. For example, since the index does not include funds that went out of business, there is a survivorship bias. This means that the historic performance of the KOEPI index might be overstated. In addition, Katch Investment Group is committed to increase the transparency and reporting standards in the private debt area. Even though the number of funds in the index is certainly representative for the space, it would be desirable that more funds can be included in the index in the future, once they improve their price dissemination practices.
Article by Stephane Prigent, CEO of Katch Investment Group.
If you want more information, you can contact him through this email: sprigent@katchinvest.com
For Meritxell Sedo
