In 2022, hardly any asset class was able to post a positive return, even the bond market experienced record losses.
Stock markets are on fire: rampant inflation rates, the war in Ukraine, interest rate hikes by central banks and fears of recession have wrought panic on world markets. As a result, few asset classes have been able to generate positive returns in 2022 and even the bond market, long considered a “safe haven”, has seen record losses of well over 10% this year.
Given the many challenges faced by the investment business, adding alternative investments can help optimize performance and protect investors’ portfolios from current and future macroeconomic risks. At the same time, investors achieve better diversification with alternative investments than with traditional asset classes and can generate uncorrelated returns through different income engines.
Since the 2008 global financial crisis, corporate financing costs have been significantly higher for banks. Regulatory pressure on their balance sheet structure and several scandals have forced them to significantly reduce their risk appetite in lending. They have gradually withdrawn from secondary and unprofitable businesses and provide much less credit to small and medium-sized enterprises (SMEs) and niche sectors and businesses. Now they focus on big players or cases with relatively low risk. With regard to, for example, trade finance, the capital requirements of some banks are estimated to have increased up to 70% with Basel III compared to Basel II.
Investor appetite for steady long-term income has remained at the same high level over the past decade.
Banks show restraint
With banks only partially assuming their role as lenders, a structural funding gap has emerged. This has been filled by the private foreign capital market over the past decade. Recently, i.e. after the coronavirus pandemic, the role of private lenders has increased significantly, as banks have become even more skittish when it comes to lending to SMEs.
Participants in the private debt securities market make capital available at different levels. Their investment funds can use direct loans to finance SME investments, offer bridging loans, take over a second lien on real estate loans (mezzanine financing) or even serve as an alternative source of credit for operations. the financing of cross-border transactions. Trade Finance funds have been a key driver of international trade, with global trade flows tripling from US$6.2 trillion to a record US$18.1 trillion over the past decade. Such a surge would not have been possible without trade financing from non-banking corporations.
Prioritize safety and performance
All of these private lending transactions are negotiated directly between lenders and borrowers, and therefore generally include a variety of elements that offer protection in the event of default or fraud. In the case of business concluded with contractual partners based in emerging countries, lenders can also take out geopolitical events insurance. They also often manage to integrate physical and financial collateral that can be reclaimed when borrowers default on the loan. In the past, obligations and restrictions have significantly improved the risk-return profile of investments. Borrowers are also willing to pay higher interest rates due to the large structural difficulties in obtaining finance. Private loan funds can therefore generate constant and recurring returns for investors.
The earnings are also significantly higher than the yields typical of traditional income-generating asset classes offered in the public market, such as investment grade securities or high yield bonds. These constant and recurring returns depend on the type of investment, the risk of the operation, the scarcity of available funds and, ultimately, the duration of the loan. In a diversified strategy, the combination of corporate financing, priority external financing, less secure transactions such as direct loans and subordinated home loans can generate a return in the high single digits or even low single digits, the double-digit range. And this, with fluctuations that cannot be compared with traditional asset classes (see graph 1).
Private loans as a source of cash flow
Investor appetite for steady long-term income has remained at the same high level over the past decade. This has resulted in significant capital inflows into these stable income opportunities related to the strategies being pursued in the private debt space. Private debt investment funds can provide a valuable source of predictable cash flow for investors. These can achieve substantial increases over public market benchmarks while investing in assets for which the likelihood of capital drawdown is less. These investments can also complement public corporate bonds by generating much higher returns.
In conclusion, corporate debt securities are, over the long term, the only asset class that has so far managed to deliver a clearly positive performance, regardless of the economic cycle (see chart 2).