Resilient Private Income in Late-Cycle Markets

Investors have increasingly embraced private income-producing assets amid a “lower for longer” outlook for rates and credit spreads, which has reduced the perceived opportunity cost for giving up liquidity. Yet most also recognize that the sheer volume of capital being allocated can compress the very illiquidity premium they are targeting. This is particularly true for corporate direct lending, the area that has seen the most vigorous capital formation in recent years. But potential sources of attractive income with resilient risk profiles do exist in other sectors – most notably in areas where traditional bank lenders face constraints and many non-bank lenders face barriers to entry.

Q3 2019 hedge fund letters, conferences and more

Late-Cycle Markets

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In the later stages of an extended economic cycle, however, it is critical to focus on resilience. While many participants are more concerned with deploying capital, we believe it is important to focus on the “three D’s” ­of portfolio construction (discipline, diversification, and disintermediation) and the “three R’s” of asset underwriting (repayment, refinancing, and recovery).

Attention to the ‘Three D’s’ is critical in an aging expansion

The significant growth of the private credit market has been concentrated in lending to sponsors acquiring middle-market companies ­– an area with few barriers to entry but one familiar to many yield-starved investors. Private equity sponsors can usually fend for themselves, and since corporate credit came through the global financial crisis relatively unscathed, the thrust of post-crisis re-regulation has instead focused on protecting consumers while making the banking system safer. But each cycle is different. Today, corporate credit is attracting headlines for aggressive leverage, earnings adjustments, and covenant erosion.

Discipline: Requires the right incentives

We believe retaining investment discipline is far easier if you aren’t under pressure to deploy a specific amount of capital in a particular sector in a limited period of time. Raising too much capital (particularly late in the cycle) or having too narrow a mandate may increase the temptation to stretch underwriting assumptions to fit the price needed to “win” deals. Broad, flexible mandates may help relieve that pressure by permitting a pivot to other sectors, origination channels, and asset types that are less crowded and offer more resilient characteristics. For example, we currently find lending standards in residential mortgage credit, and certain specialty finance sectors, to be more conservative than long-term averages.

Read the full article here by by Jason R. Steiner, Harin de Silva, Tom Collier of PIMCO, Advisor Perspectives

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