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Dom Giuliano, Deputy CIO and Head of ESG at Magellan, provides colour on some promising renewable-energy stocks, the efforts three portfolio companies - Amazon, Eversource Energy and Nestlé - are making to reduce their carbon footprint, and new investment Booking.com.

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Continued from yesterday's article - click the NEWS tab at the top of the screen to see our Newsfeed

As we noted in part one of our recent primer on private and public credit markets, Public and private - perfecting the blend, the asset class of fixed income has changed dramatically in the past few years.

Refer to part one to understand these aspects of present-day credit:

• Why fixed income is changing and won't be changing back
• How public and private debt differ
• What the illiquidity premium is - and why it exists
• Why we are seeing a structural decline in the banking sector's appetite for risk
• Why private equity is moving into the business of lending.

In this conclusion, we examine how co-mingling public and private credit in a single portfolio can be an attractive investment.

THE LIQUIDITY TRADE-OFFS BETWEEN PUBLIC AND PRIVATE DEBT

In contrast to private markets, public debt market liquidity, while still ample in some areas like government bonds and bank debt, has become less abundant in the wake of post-GFC regulations that have made "warehousing" securities more capital intensive for market-making investment banks.

And as we saw during the financial crisis and more recently at the height of the COVID-19 market selloff, even public markets may dry up under extreme conditions-exactly when liquidity is needed most for many investors.

Furthermore, with bank market makers holding fewer securities in inventory and dedicating less capital to trading activities, the ability of the capital markets to accommodate rapidly shifting investor flows is compromised.

This is exacerbated by different characteristics of the investor base for public debt - with a much higher concentration of leveraged investors who use repo or prime brokerage financing for their government bond holdings and most liquid corporate bonds, magnifying liquidity risk when fundamentals shift.

This dynamic doesn't exist to nearly the same degree in private markets, insulating them from these leverage-driven liquidity events that are becoming more common in public markets.

Moreover, liquidity is becoming more concentrated in the market's largest public credit issues, which often have large sector concentrations to bank financial credit, a trend that is particularly acute in Australia.

This has already shown to be exacerbated in "risk-off" market environments, as we saw in March 2020. In contrast, private debt markets typically finance smaller companies in less cyclical sectors and have limited exposure to the types of businesses that employ a steady stream of short-term funding, suggesting less exposure to funding risk in private debt markets than in public markets.

Examples include banks and large corporates with access to the commercial paper market or who utilise factoring arrangements such as that facilitated by recently collapsed Greensill Capital.

This all suggests that the liquidity trade-off for private debt investment in the future may not be as high as it has been historically and will also present a considerable opportunity for credit investors with the flexibility to take advantage of dislocated markets. This is particularly apparent as risk premiums in public markets have declined over time.

Time series of risk premiums in public fixed income markets

On the other side of the coin, private debt presents investors with a differentiated opportunity set that may complement their public debt holdings.

Given the complexity of sourcing, structuring and analysing securities in the private markets relative to the public markets, a particularly skilled and sizeable private debt manager may have a notable advantage over the less-adept competition that can't leverage scale to the benefit of their investors.

This is an inbuilt source of alpha and excess return that is more structural in nature to the private debt asset manager than public markets, where cycles of alpha production can be more variable and less controllable.

Furthermore, since private debt strategies typically deploy investor capital over a multiple-year period rather than all at once, managers are structurally positioned to take advantage of shifting opportunities and valuations as they arise.

And the limited liquidity in private debt suggests that in difficult market environments investors may be less adversely affected by the distressed selling of other investors and can often better control the ultimate outcome of an investment.

THE CASE FOR COMBINING PUBLIC AND PRIVATE DEBT IN ONE PORTFOLIO

Having established that the liquidity divide between public and private debt markets is more nuanced than meets the eye, it stands to reason that perhaps there are good reasons that the two asset classes can coexist in the same portfolio.

Private debt is, for the most part, non-tradable, and asset managers and investors in the space generally view these investments as buy-and-hold.

However, unlike private equity, where a buyer must be found either by listing the asset on public markets, trade sale or selling to another private equity sponsor, in private debt markets the portfolio manager can manage the liquidity profile of the asset pool through the maturity and/or amortisation profile of the debt itself.

This is a very important distinction between the two asset classes, and the critical reason why blending public and private debt in a single portfolio is possible when compared to managing public and private equities.

Firstly, the illiquidity premium is also more valuable in a low-rate environment as its contribution to total return becomes more meaningful, as can be seen below.

As returns from this risk premium are driven by very different factors to cash rates, duration and credit risk, it thus adds considerable and meaningful diversification to both a blended public/private credit portfolio as well as to a broader multi-asset portfolio.

ISOLATING THE RETURN DRIVERS IN CREDIT

In addition, the traditional advantages of robust security selection and asset allocation processes on the public-only side are further enhanced by the differentiated opportunity set available in private markets. Compared to distinct public and private portfolios, a one-portfolio solution can offer investors:

• A holistic approach to assessing the credit and liquidity-risk adjusted returns available across fixed income markets and to allocating capital opportunistically and appropriately
• Improved risk efficiency, as public and private investments can be considered in aggregate when managing the portfolio's industry, sector and credit-quality characteristics, and sector and market cap biases inherent to the public market structure can be diversified through private credit
• A mechanism to take advantage of short-term dislocations in capital markets and their knock-on effects in private markets that wouldn't otherwise be possible managing separate, fully invested allocations in both asset classes
• A relatively straightforward and efficient way to introduce private debt exposures into an investment program without additional staffing or monitoring costs or having to manage capital calls for closed-end institutional fund structures or additional equity market beta and liquidity risks for investors accessing private debt via listed investment trusts or companies.

A combined public/private portfolio also has an edge in capitalising on stressed financial conditions, as liquidity at the total portfolio level can be deployed across both public and private markets as appropriate to take advantage of market dislocations.

Put another way, it enables investors to average into private debt markets across the cycle in a low-risk way, lowering the timing risk that one might otherwise face putting capital to work in a private-debt only strategy that needs to be fully invested as fast as possible irrespective of the asset class relative value on offer.

From a credit cycle perspective, the best risk-adjusted returns are often found in public credit right after market dislocation events such as COVID-19 as valuation recovery occurs, whereas private debt tends to offer better relative value during the middle and end of the credit cycle as banks ration credit and public market spreads become compressed.

Furthermore, if you take the perspective that illiquidity premium is a real risk premium in the same vein that credit spreads or duration/term structure are as per above, then it can be helpful to analyse how it behaves relative to these other traditional fixed income risk premiums.

The variation in illiquidity premiums reflects the inefficiency of private markets, meaning there is a cyclical and idiosyncratic component. Amidst CIPAM's historical deals, for example, historical average illiquidity premiums are 2.2% but there is significant variation. Anecdotally, it appears that the level of the risk premium is lower when public credit spreads tighten (i.e. when public markets are performing well) and higher when they widen. 

Historical illiquidity premiums in Australian and NZ credit

While it may seem counterintuitive, managers of combined public and private debt strategies can also utilise market liquidity to their advantage. In times of dislocation within the liquid markets, new issue volume can slow due to heightened uncertainty.

During these periods, agile managers can fill the void by providing much-needed liquidity to companies that might otherwise be able to tap public markets, often with enhanced terms. In addition, structures can be more lender-friendly due to the reduced number of financing solutions available.

Thus, actively rebalancing using the amortisation profile of private debt and "locking-in" long term illiquidity risk premiums at optimal times relative to public markets and vice versa can add considerable value across the credit cycle.

Institutional and retail investors need liquidity for any number of reasons. We would argue that asset managers can deliver more attractive liquidity characteristics and capture attractive illiquidity premiums across both public and private debt markets in a combined portfolio than in separate liquid and illiquid mandates that are run in parallel.

By delegating this asset allocation to the manager who is closest to liquidity conditions and relative value opportunities across both sides of the public/private spectrum, you can remove many of the frictions faced by an asset allocator having to manage these liquidity demands themselves and give them a known product-level liquidity profile (e.g. monthly liquidity with a 10% gate per month).

Part of the liquidity enhancement in a one-portfolio solution is simply a function of the structure of some private investments. The short duration and amortising features typical of private securitisation deals create natural liquidity over time, for example, while private corporate or real estate debt issues also may generate pre-maturity liquidity events should the interest rate and spread environment incentivise borrowers to prepay their loans.

Liquidity enhancement also can come from the seamless integration of public and private portfolio management efforts.

For example, short-duration public investments such as asset-backed securities or investment-grade floating-rate securities can be added to maximise portfolio income while also providing funding, over time, for private investments.

Asset allocators running separate allocations or products are less able to do this as they won't be intimately familiar with the amortisation of the private debt profile and/or may have to hold zero-carry cash to fund capital calls for closed-ended private debt allocations with uncertain timing.

As the opportunity set evolves and expands - particularly in diverse private markets - combined portfolios may be better positioned to capitalise on innovative new structures as well. This could include innovative structured finance arrangements where unique economics can be extracted by virtue of meeting unique needs (for example, regulatory capital relief structures for banks or unique securitisation arrangements for non-bank lenders or other types of corporates).

INVESTOR APPLICATIONS OF COMBINED PUBLIC AND PRIVATE DEBT PORTFOLIOS

A product or mandate offering a combined public/private debt strategy can be suitable for a range of investment objectives. These include:

1. Absolute return or higher targeted alpha strategies

Broad and flexible strategies tend to lend themselves to higher absolute or relative return objectives, as the expansive opportunity set naturally presents more possibilities. In addition, as any solution offering a meaningful private debt allocation is very unlikely to offer daily liquidity unless it is prepared to take significant fund lock-up risk, the greater flexibility public/private mandates have in deploying capital can help make absolute-return objectives more achievable, particularly if interest rates rise and credit spreads widen through avoiding redemption risk at the worst possible time and thus enabling higher conviction investing during times of market stress.

2. Liability-aware strategies or goal-based investment approaches

For investors operating in a liability-hedging framework or managing portfolios designed to fund certain future spending objectives at points in time (goals-based investing), public/private debt portfolios offer a number of advantages. For many of these portfolios, this type of highly opportunistic strategy can help generate additional returns and income as a complement to the liquid, high-quality investments held to match those liabilities or goals. In addition, given that many such portfolios have less need for current liquidity than traditional portfolios, we believe that a public/private combination can be beneficial to target higher income and returns and thus drive higher plan funding levels or probability of meeting the specified goal.

3. As a complement to core fixed income

With an environment of low interest rates, relatively low credit spreads and potentially declining diversification benefits from duration exposure, we believe investors also should consider an opportunistic-type allocation as a complement to their core strategies. Introducing private debt via a combined public/private portfolio can offer investors modest exposure to this market segment - and its potentially higher income and return levels and diversification benefits - without the complexity and with greater liquidity than a separate private debt allocation would demand.

4. As an alternative to traditional credit strategies

Combined public/private portfolios in one strategy potentially can be used as part of a long-term allocation strategy, allowing managers to deploy capital into private debt opportunistically over an extended period of time whilst maximising carry from public markets and benefiting from the market intelligence and a consistent approach to relative value assessment obtained through activities in both markets. With relatively low yields currently available in public markets, this type of unhurried approach may prove attractive to some investors.

CONCLUSIONS

The traditional way of looking at both equity and fixed income asset classes is to divide them strictly along public and private market lines, and to allocate to separate strategies accordingly.

While the nature of private equity favours highly binary and time-dependent liquidity profiles, hindering the ability to dynamically allocate across asset classes holistically from a relative value perspective in the same portfolio, the divide in liquidity between public and private credit is much more blurred.

Furthermore, the liquidity premium itself has characteristics of being its own asset class from a diversification perspective, applying to both public and private debt assets, and time varying in quantum across the cycle.

As demonstrated above, these asset classes have complementary qualities that can be exploited to efficiently manage exposures throughout the cycle, while building a portfolio that provides diversification and yield premium relative to traditional fixed income.

Furthermore, an allocation to both public and private credit within a single portfolio management approach maximises an investor's ability to take advantage of dislocations across both markets.

Co-authored by: Sam Morris, CFA - Senior Investment Specialist, Fidante Partners & 
Pete Robinson, Head of Investment Strategy and Portfolio Manager, CIP Asset Management.

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The structure and valuations of fixed income markets have changed dramatically over the past decade or so. Most obviously, interest rates have decreased dramatically and the compensation for taking traditional forms of fixed income risk have declined in tandem. Some of these changes may unwind as we enter a world of higher inflation and withdrawal of central bank stimulus measures over the coming years, but other changes are much more structural in nature.

In particular, regulations requiring banks to hold more capital are likely to persist, with an enduring impact being a withdrawal of banks from competing in certain types of lending and reducing their balance sheet commitments to liquidity provision in public credit markets during times of stress. This is creating both challenges and opportunities for asset managers and their investors as alternative sources of credit provision whilst navigating a disrupted liquidity environment and low returns for their traditional liquid bond portfolios.

As such, institutional and retail investors have been forced to adjust their approach to fixed income because of these changing dynamics, with the embrace of private debt markets alongside exposure to traditional public credit allocations in an effort to boost returns. Private debt is a complex asset class that can offer a differentiated opportunity set with unique return, risk, liquidity, and diversification benefits.

Part 1 of this paper will explore the issues above and, while Part 2 will examine how co-mingling public and private credit in a single portfolio can offer a solution to many of these issues and may offer one of the best opportunities to maximise the potential of each.

Distinguishing between public and private debt

Private credit is often also referred to as "direct lending" or "private lending" or even "alternative credit." Irrespective of the name, they are basically loans to borrowers originated directly by a non-bank asset manager rather than via an intermediary.

Unlike traditional bond issues or even syndicated loans (such as US term and leveraged loans), there is little intermediation between borrower and lender. The lender basically arranges the loan to hold it, rather than originating to sell it. As such, the borrower and the lender have a much closer and more transparent relationship, directly negotiating the terms of the finance.

In a recent Economist magazine special report on the asset management industry, one of their concluding forecasts was that private debt would become an increasingly important asset class. As the Economist notes, 

"The growth of private debt is, in large part, a response to the retreat of banks from lending to midsized businesses and their private-equity sponsors. Asset managers, starved of yield in the government-bond markets, are happy to fill the void." (1)

Private debt is now a significant subset of broader credit markets globally. Underlying exposures include private loans to mid-size or non-listed corporates (often backed by private equity sponsors), commercial, industrial and residential real estate loans that sit outside the risk appetite of the banking sector, as well as loans secured by securitised assets such as mortgages, other loan receivables (particularly from non-bank lenders) or 'alternative' cashflow streams such as royalty streams, insurance premiums or solar panel lease payments.

A key distinction-and advantage-across many types of private debt is the ability to customise lending terms thus exercise greater control over credit risk protection compared to public markets. Private credit investors can influence or dictate elements such as coupon and principal payment schedule (amortisation), loan covenants, information access and control rights, tailoring investments to their desired liquidity, return and credit risk profile.

In addition, this customisation does not come at the expense of returns. By not introducing an intermediary to arrange the transaction, the fees otherwise paid to the arranger can be shared between borrower and lender, enhancing the overall return profile of the investment relative to syndicated transactions.

Australia remains a relatively nascent market compared to offshore growth in private debt assets and corporate credit generally. But this comes with significant advantages due to the lack of competition from asset managers bidding down yields and credit protections to obtain deal flow means that underwriting standards and margins remain strong.

Sources: Private debt investor, Prequin, CIPAM Estimates

What is the Illiquidity premium and why does it exist?

Any risk premium in investing can be thought of as a transfer of economic rents from risk avoiders to risk takers. In equities, for example, there is a strong, academically established risk premium for investing in small cap companies. This is theorised to exist because these stocks often have less liquidity stemming from their lower overall market capitalisations and lower free float for external shareholders as well as less diversified revenue streams and/or robust balance sheets.

In many respects, similar arguments can be made for the existence of a higher rate of return expectation for private debt over public credit. 

The simplistic explanation is that private debt arrangements do not have the consistent structural features of public credit that facilitate consistent and efficient investor evaluation, such as official credit ratings, combined with security identifiers and legal structures that enable centralised clearing and settlement and thus easy trading.

This means that borrowers who obtain financing from such sources must pay a higher interest rate for a given level of implied credit risk to lenders, who need that higher rate of return to justify their reduced flexibility in managing their investment. Thus, by comparing the rate paid between private debt and public debt at the same assumed credit rating or risk level, one can establish a proxy for the quantum of the illiquidity premium.

Term Adjustment based on difference between 5 and 3 year discount margins for Credit Suisse Leveraged Loan index. Rating Adjustment based on difference between the Credit Suisse Leveraged Loan index. Currency Adjustment based on the short term rolling cross currency basis of 10 basis points less the cost of holding 10% in liquids at a cost of 4% for hedging purposes. All figures based on 31 December, 2020.

But this does not explain why borrowers choose to, or are forced to, access private debt financing in the first place.

The Structural Decline in Bank Risk Appetite

Obviously a structural decline in bank lending to non-investment grade corporates, commercial real estate debt, non-public asset backed securities financing (such as warehouse funding facilities (2) for non-bank lenders), long-term project finance and other sub-asset classes of the private debt universe due to tighter regulatory and capital rules has decreased the options available to such borrowers. This increased cost to hold risk has meaningfully altered bank business models. As a result, banks have grown more conservative as they now must consider the risk-adjusted returns of potential loans in the context of more stringent and complex capital requirements - pushing them towards prime home loan origination at the expense of lending to businesses, for example.

Changes in bank lending patterns have an important implication for investors. Bank securities-both fixed income and equity-should have different risk-return profiles going forward, as investors in bank-issued bonds and stocks are much less exposed to mid-size corporate lending and many types of real estate financing as well as fixed income trading revenue via the balance-sheet activity of their bank holdings.

Source: 1 APRA, 2 Standard eligible mortgage with no mortgage insurance

While these regulations have made the global banking system safer and have reduced risk to the financial system, certain risk exposures have become prohibitively expensive for traditional banks as a result of the new rules, creating a funding gap that increasingly is being filled by non-bank market participants. These regulations also have ushered in the rise of 'fintech' lending platforms and financial-disintermediation technologies that provide individuals and small businesses access to new sources of financing. Private credit is often an important source of funding for such new business models, particularly via so called 'warehouse funding' prior to them being able to securitise assets into public markets.

But other factors play a role as well.

The Growth in Private Equity Sponsorship

Firstly, the shift toward private markets has been a consistent macro trend over the past few decades: while private markets have grown substantially during this period, the number of publicly traded companies has declined over the past 20 years. As a result, there are more private companies that require debt financing to fund their growth. Therefore, making private loans to private-equity sponsor backed companies is a big source of private debt origination in Australia and offshore.

Generally, the private equity asset class has focused on companies with high cash-flow generation and stable business models, and the companies are often leaders in their specific segments.

Secondly, these borrowers are accessing private debt because they are looking for partners they can rely on to participate alongside them in a journey toward their objectives. They are also looking for some degree of flexibility or tailoring to line up the terms of their debt financing with their business objectives as well as speed and certainty of execution (particularly in a time-pressured acquisition financing scenario). Some or all of these factors are why many borrowers are willing to pay a premium over other lending alternatives.

Finally, many borrowers in private credit are too small to access liquid capital markets or don't have the revenue and resources to justify paying for and supporting the due diligence of public credit ratings agencies like Fitch, Moody's and S&P or covering the significant fees of an arranger (plus all the other service providers) who are tasked with structuring and distributing a debt package. Thus, private debt markets are an attractive source of funding for acquisitions, organic growth, and scaling through capital investment outside of raising additional equity.

In many ways, the making of a loan is analogous to the manufacturing of a product. In some cases it makes sense to have each stage of the manufacturing process (the due diligence, structuring, documentation and syndication) completed by a different party. But often it is more cost effective for a borrower to work with an individual lender who has internalised the manufacturing of a loan for themselves. What the borrower pays in terms of a higher interest rate is offset by the lower cost of the manufacturing process.

Source: Prequin Pro 2020, Australian Investment Council (AIC)

Lastly, an important distinction between public and private markets is that private lending markets are inefficient. In public markets, arrangers effectively run an auction process to establish the lowest yield at which they can sell all of the debt. In private markets, there is generally no auction process. Often a borrower will approach a very small number of lenders (in some cases only one lender, especially where there is a long-standing relationship) and consider the overall package- timeliness, flexibility of terms, execution risk (i.e. does the lender have to syndicate some risk in order to do the full deal), quality and reputation of the lender in addition to the cost of the borrowing. This inefficiency is an opportunity for private lenders, who arguably see more deals and have a better idea of risk and return than the borrower (or the borrower's owner), to identify the best opportunities. 

Continued in tomorrow's Newsfeed - look for Part 2

Co-authored by: Sam Morris, CFA - Senior Investment Specialist, Fidante Partners & 
Pete Robinson, Head of Investment Strategy and Portfolio Manager, CIP Asset Management.

IIn this episode of The Ardea Alternative podcast, Laura Ryan, Tamar Hamlyn and Alex Stanley discuss interest rate rises in response to inflation and what it might mean for fixed income assets.

Despite the best attempts of forecasters, the unpredictable nature of how the market will respond to a company's earnings leaves many working feverishly to calibrate their respective positions, especially when anomalies are rife. 

For example, it is not uncommon for a company's stock price to increase when the market expects a greater decline in revenue than what is reported. Conversely, if a company does not achieve expected revenue targets (even if these revenues are positive), then it can result in a decline in the company's ticker price as forecasters adjust their valuations.
It seems that recently, earnings season has become further complicated through the introduction of new and 'undefined' metrics that impact:

1.  the 'top-line', the company's ability to drive increases or preserve its revenue stream within the marketplace;
2.  the 'middle-line', the company's ability to effectively manage their costs, improve current processes to become more (cost) efficient, and manage its overall financial wellbeing (including debt obligations, etc) and;
3. the famous 'bottom-line', the residual between how much money a company can bring in, and what it costs them to get there.

The 'bottom-line' may not always paint a clean picture, given 'up-and-coming' businesses often reinvest heavily in market share acquisition strategies (such as marketing, or developing new products). This subsequently drives up 'middle-line' costs with the hope of gaining future 'top-line' benefits. Without itemizing each variable that sits within the top to bottom line segments, we trust the point has been made - earnings season is complex. More so now, it seems, with new environmental, social and governance (ESG) metric expectations.

Many businesses are now facing significant shareholder pressure to factor in ESG metrics. Whilst driving up middle line costs now, ESG so far appears to have significant customer and employee retention benefits, as well as being the public 'right thing to do'. The cynic may challenge whether these programs are truly driven by ESG good or future 'top-line' benefit. Whereas the optimist might assert that whilst either motive could be true, greater ESG benefit cannot be a bad thing, irrespective of the method(s) used to get there. 

This discussion calls into question the purpose of a company (generally speaking, to operate in self-interest) vs. the operation of a government (establishing the rules that do not allow this self-interest to operate unfettered). It is the classic economics example of 'who pays for the light bulbs in streetlamps?' The cynic argues that through the creation of jobs and payment of various taxes, it is the company who pays for streetlamp bulbs. The optimist, true to character, would just be happy they don't have to walk home in the dark.

If earnings season wasn't already complex enough, the wider adoption of these new metrics can feel like trying to drink water from a fire hose. Like anything that is new, there will inevitably be kinks that need to be ironed out and parameters that need redefining. Perhaps the nirvana for these new metrics and their wide-scale adoption comes through regular policy and regulation revisions that encourage and guide companies to do what is considered socially better. Or maybe the onus is on the companies to willingly take on these new expectations from the community and thereby lobby the policymakers to formalise these shifts. 

Is only doing the right thing because you were told to do it enough in our customer-aware world? Either way, we suspect this debate is far from over and we watch with great intrigue how this may continue to impact future earnings seasons.
In conclusion, earnings season and finding the next best company is fraught with hurdles that are likely not made much easier with the level of information available. 

We'd argue that this is only going to become increasingly complex in an environment where pundits and analysts are doing their best to quantify and price-in a rise in interest rates, ongoing supply chain constraints and inflationary pressures that are seemingly going unchecked. 

Relying on strictly linear forms of measurement or analysis is likely to negate an investing edge and conversely, too much information is likely to saturate one's bandwidth with little clarity on how to use it. We'd argue that the best way to navigate earnings season, or any other disruptive market cycle, is to not only remain convicted to one's tried and tested investment thesis, but also keep half an ear to the ground for emerging trends to consider how these might need to be examined