Private debt is a diverse asset class with a broad range of sub-segments, including commercial real estate debt, infrastructure debt, private corporate debt and fund financing.
Private debt appeals to institutional investors as it tends to offer higher yields than public fixed income markets, enhanced capital efficiency, stronger investor protection (via bespoke loan structures and covenant suites) and low correlation with traditional asset classes.
It was identified as the most popular asset class in our APAC Insurance Investment Survey 2023, conducted with Quinlan & Associates, with 41% of respondents indicating they would allocate a “significantly higher or higher” portion of their assets to private debt over the next three years.
It shouldn’t come as a surprise. Private Debt Investor magazine found that global assets under management in private debt had grown 15% a year on average from 2012-21. Despite the prospect that momentum may slow, Private Debt Investor is forecasting double-digit annual growth for 2021-27 (see chart).
Private Corporate and Infrastructure Lending AUM
Source: Private Debt Investor, November 2023
Here we examine these underlying sub-segments in more detail and outline the differing characteristics of each.
Commercial real estate debt
This is an established private credit sub-sector that facilitates investment into loans secured by commercial real estate assets such as offices, shops, industrials/logistics, residential properties and alternative segments such as hotels, student accommodation, care homes and self-storage.
Traditionally it has been a bank-dominated asset class. However, the increase of non-bank lenders into the sector in the wake of the 2008 financial crisis has allowed institutional investors such as pension funds and insurance companies to diversify into it.
Commercial real estate debt (CRED) is particularly private, meaning it can be harder to source data relative to other sub-sectors. Nonetheless, investment has grown rapidly in the UK and, to a lesser extent, Europe. Non-bank lenders now account for around 40% of outstanding debt in the UK.1
Compared to other private credit asset classes such as infrastructure debt and private placement corporate debt, CRED is typically shorter in duration – the maturity of loan terms typically range from 3-7 years, although shorter and longer durations are achievable.
It can be structured on a fixed- or floating-rate basis, senior secured or subordinated, investment grade or high yield. Typically, it offers an illiquidity premium over equivalent-rated corporate bonds of 75-200bps.
Traditionally, transactions are bilateral and originated through direct relationships with borrowers. Deals are more bespoke as a result and can be tailored to meet an investor’s specific needs.
Having a secured interest in an underlying property and its income stream is a key form of risk mitigation. Following a default, a lender can enforce and gain control over the property and dispose of it to secure repayment of any outstanding debt. There are also loan covenants typically structured with minimal headroom, allowing lenders to take control following any decline in credit quality.
Typically, sustainability initiatives are focused at the secured asset level, with lenders assessing the risk on day 1 through intensive due diligence. Thereafter, margin ratchets can be used to incentivise borrowers to improve the sustainability and energy efficiency of their assets further.
This is a mature sub-segment that allows investors to participate in debt transactions secured against essential infrastructure assets such as hospitals, educational facilities, renewable energy and those in other sectors such as transport and utilities.
Typically structured by way of longer-dated and often fully amortising debt, infrastructure debt (ID) is attractive to insurers due to the long-dated, fixed-rate (or inflation-linked) nature of its cash flows.
Owing to the essential nature of the underlying asset, it is considered lower risk than similarly rated private credit asset classes, with returns tighter as a result. Insurance companies that invest in investment grade ID can also benefit from improved capital efficiency, given that the asset class is eligible for matching adjustment under many risk-based capital (RBC) regimes.
In terms of characteristics, it captures a broad investment universe from AAA to B with maturities ranging from 5-40 years, with ample opportunities at the upper end of this range and potentially longer. The illiquidity premium typically ranges from 25-75bps.
Infrastructure debt can also play a key role in driving an investor’s sustainability agenda, given its exposure to low-carbon assets such as wind farms, solar power and other renewable energy sources.
Private corporate debt
This is the largest of the private credit sub-segments. According to Private Debt Investor, it reached $500 billion in assets under management in 2021 and is forecast to reach $1.2 trillion by 2027.
Typically, the private corporate debt segment is formed of non-investment grade direct lending to corporations, often backed by private equity firms in relation to mergers and acquisitions. EBITDAs range from $5-$100 million2 and tenors are about five years. The format is usually floating rate and can include amortising, payment in kind and both senior as well as mezzanine financing.
Another large part of this segment is the private placement (PP) market. This is mainly investment grade, with debt financing predominantly provided by insurance companies or other asset-liability matching investors. EBITDAs are often larger – could be over $100 million – and are often fixed rate. The formats include bullets, amortising and are typically senior. Tenors can be much longer (available up to 60 years).3
Due to the market’s scale, PPs enable investors to diversify across a range of sectors, geographies and currencies to meet their objectives. Typically, the investment universe reflects all investible sectors that companies operate in across the public credit universe. For PPs, there are just as many, if not more, private operators in these sectors that require debt.
The universe is broad, offering investments that usually range from AA to B and capturing an illiquidity pick-up of 25-75bps.
Due to the range of cross-sector opportunities, PP investment can play a key role in an investor’s sustainability strategy. Mandates can be structured with exclusions or targeted at specific sectors such as renewables or those with a decarbonisation agenda.
Unique benefits for insurers in APAC
Private debt loans are treated more favourably than public debt under some RBC regimes in Asia Pacific in terms of solvency requirements, so these sub-segments appeal to insurance firms.
Under Singapore’s RBC2, for example, loans are only subject to a counterparty default risk charge, whereas fixed income instruments are subject to risk charges around interest rate mismatches and credit spreads. As result, investing in loans attracts a much lower capital-risk charge.
This favourable treatment is also reflected in lower capital risk charges. China’s C-Ross II rules, for example, stipulate that infrastructure debt and corporate bonds are subject to counterparty default risk. However, the primary factors (RF0) are lower for infrastructure debt than for corporate bonds across the credit spectrum.
Further, private debt is often secured by collateral such as property, cash or a letter of credit. Some RBC regimes, such as in Hong Kong, allow insurers to use the risk-adjusted value of collateral to reduce exposure to counterparty default risk. This is another way to reduce capital risk charges.
To understand the capital efficiency of private debt investments more fully, we compare private and public debt instruments under Singapore’s RBC2 regime in terms of yield per unit of capital risk charge – a parameter to evaluate capital efficiency (see table).
We present two investment cases. The first is a loan to a Class B (i.e. AA) borrower, with an illiquidity premium of 70bps (the average for our Fund Financing portfolio as of March this year). The second is a Class C public bond (i.e. A). The reason for the difference in credit quality of these investments is the bond needs to go one notch down (based on credit spread information on Bloomberg4), from AA to A or BBB+, to make up the 70bps yield gap. This table sets out the calculation of yield per unit of capital risk charge – demonstrating the capital efficiency of private loans.
Challenges and solutions
While private debt has attractive characteristics, there are obstacles that insurance companies need to overcome to capitalise on its potential benefits fully.
Globally, insurance regulators apply higher solvency risk requirements on investments into non-rated debt instruments. Singapore’s RBC2 regime, for instance, stipulates that the credit spread risk-adjustment factor for non-rated bonds with less than five years’ term to maturity is 325bps.
In other words, the Monetary Authority of Singapore (MAS) views the credit quality of non-rated bonds equivalent to those rated BBB to BB with same trailing 12-month range.
Thailand’s RBC2 is even stricter. If a bond is not rated, the regulator applies a 14% credit risk charge – the highest possible – meaning the bond is deemed of the lowest credit quality.
That said, it’s common for regulators to allow insurers to use internal credit ratings, provided their framework meets certain criteria. In practice, their process needs to be consistent with ones used by recognised ratings agencies and provide a plausible range of agency ratings for each instrument.
Given that private debt is often not rated publicly, insurers need to build up their internal credit rating capabilities. In Asia Pacific, they tend to partner investment managers for this.
Although the methodology for private debt credit ratings can be specific to each sub-segment, at abrdn we apply a consistent approach. Our credit rating methodology embeds four key principles:
- Consistent with approach of major credit rating agencies (Fitch, Moody’s and S&P).
- Leverages internal expertise and deep experience in public credit.
- Rigorous governance and oversight.
- Subject to back-testing, formal review at least annually and external validation, as needed.
For commercial real estate debt, we use bespoke ratings tools to derive a ratings recommendation. The first is a proprietary model, developed with an independent third-party risk-modelling specialist.
This stochastic model utilises a database containing more than 40 years of industry data on capital and rental values, broken out across 19 sectors split by sub-sector type and geography. It harnesses Monte Carlo simulation techniques to derive a probability of default, loss given default and expected loss for every transaction. The outputs are aligned to published expected loss figures from Moody’s to derive an equivalent rating.
In addition, we overlay a separate model that seeks to replicate the approach and methodology of S&P precisely. Our team analyses both outputs and typically proposes the lowest as its recommendation. Our investment committee – made up of independent specialists across fixed income, real estate and governance – review and approve the final rating for the transaction.
A top accountancy firm found abrdn’s core methodologies across private debt “fit for purpose” under Solvency II. Many of our internally rated loans are also subject to validation by Fitch and S&P.
Within commercial real estate debt, seven loans have been subject to external validation over the past three years. In each case, our internal rating was either in line (2 cases) or more conservative (5 cases) by at least one notch in credit quality (e.g. abrdn A rated versus S&P AA rated). We think this showcases that our approach to internal ratings is best in class.
The key tax considerations for private credit investors centre on the vehicle structure itself and the underlying investment. Although both issues centre around tax, they’re quite distinct.
In the first instance, institutions typically invest in private credit through segregated accounts or fund structures (either pooled or fund of funds). While segregated mandates can be cost-effective and tailored to an insurer’s needs (such as cash-flow matching), they can give rise to tax implications, depending on the nature and jurisdiction of the investing entity.
This is particularly relevant for investments in overseas jurisdictions with different regulatory and tax structures as well as currency factors. Fund structures can help to facilitate institutional investment by using bespoke structures that cater to investors from specific or multiple jurisdictions.
When it comes to deployment, underlying investments must be compatible with the fund or segregated account structure. Institutions should seek specialist advice when considering any new investment opportunity to ensure there aren’t negative tax implications and that interest on the debt instrument can be paid without withholding tax or other tax costs.
At abrdn, we have a team of tax specialists who are experts in private credit investment. They are supported by fund structuring specialists who ensure that any investment vehicle is appropriate for the nature of the planned investments.
Bespoke cash flow
Private debt encompasses a broad investment universe, and the structure of underlying investments can be negotiated and tailored largely on a case-by-case basis. Additionally, investors can source extremely long-dated opportunities, which are rare in public market bonds.
Insurers can use these features to create bespoke cash flows to match their liability cash flows. In Singapore and Hong Kong, for example, insurers’ private debt instruments are treated as “eligible assets” for a matching adjustment portfolio to provide an extra layer of capital relief for insurers.
In practice, cash-flow matching is not simply a line-by-line matching exercise, but subject to additional constraints:
- Minimum level of yield that insurers expect from a cash-flow matching portfolio.
- Issuer/sector limits (i.e. no more than 3% of the market value of the portfolio within a specific issuer or no more than 20% of the portfolio in financials).
- Ratings limits (i.e. no more than 25% of the market value of the portfolio can be held in BBB bonds), or limits on the ‘average rating’ of the portfolio.
- Regulatory tests before deploying matching adjustment. In Singapore, this includes tests for a shortfall in cash flows and widening of credit spreads. Insurers in Hong Kong are not required to pass similar tests, but implicitly they need an optimisation technique to maximise matching adjustment benefits.
Ultimately, adding private debt investment into a portfolio to generate bespoke cash flows requires the help of investment managers with expertise in private debt investing, asset liability matching and optimisation. For more information, click Cashflow matching for insurers and pension schemes.
Operations and reporting
A key consideration for all investors – and insurance companies in particular – is an investment manager’s operational platform. Insurers are data-driven and need detailed, timely information on investments to meet internal and regulatory obligations to benefit from lower capital solvency requirements.
RBC rules in Hong Kong, for example, stipulate that a fund is subject to a 50% shock – a level applied to other equities including private equity if a full or partial look-through approach can’t be applied. In addition, often information on private debt investment is not readily available. Consequently, some insurers experience challenges in asset valuation and pricing.
When choosing an investment partner, insurers require a manager with a sophisticated operating platform that not only provides high-quality accurate data within tight timescales (typically T+2), but also that the information produced is derived correctly under robust governance and oversight to ensure it meets regulatory obligations.
As a rule of thumb, investment firms managing private debt in a public pooled fund vehicle must have sound operational and reporting capabilities, since the fund will be subject to strict regulation.
When it comes to valuations and pricing, managers ought to have pricing methodologies and manuals for different sub-strategies, since there isn’t a universal, one-size-fits-all approach. We believe managers that use a “maker-checker” process with an independent team responsible for validating pricing demonstrate good governance.
Bloomberg. For illustrative purposes only. No assumptions regarding future performance should be made.
Forecasts are offered as opinion and are not reflective of potential performance. Forecasts are not guaranteed and actual events or results may differ materially.
- Bayes Business School Commercial Lending Report MY 2023
- Source: Bloomberg, FINRA, Private Placement Monitor, abrdn.
- Source: Bloomberg, FINRA, Private Placement Monitor, abrdn.
- 6 September 2023