Private-credit spreads have been slower to react than public spreads, given that pricing in private markets tends to lag, though we expect the illiquidity premium to increase from its compressed levels—a process already under way in the fourth quarter. Still, when public and private spreads converged earlier this year, it prompted a question from some investors: Should the ramping up of private-market allocations continue?
We believe that both retail and institutional investors’ allocations across private credit have slowed broadly given the macro volatility, while borrower demand for private funding remains relatively steady. The resulting supply-demand imbalance around capital has contributed to improved pricing through wider spreads or steeper issuance discounts—and through increasingly lender-friendly terms, such as meaningful call protection.
In commercial real estate debt, supply-demand imbalances favor lenders: banks have retrenched, more loans maturing has driven more refinancing (more so in Europe but also in the US) and debt liquidity is flowing to the highest-quality opportunities. Debt pricing has widened as a result of a higher yield base and higher risk premium. Structure is improving for lenders too, providing better downside protection.
For insurers invested in private equity, a difficult 2022 has hurt portfolio performance. Going forward, we think the average return on the average private equity investment will be in line with that of public equities after fees (highlighting the importance of manager selection in the private-equity space). In the context of private assets, and since private equity is generally less aligned structurally with insurers’ needs than is private credit, we think more marginal flows will head into areas other than private equity.
What a Reshuffled Landscape Means for the Focus on Private Assets
Private-spread widening has been catching up to that in public markets, though the illiquidity premium is still compressed in some areas of private markets. That illiquidity premium actually compensates investors for incremental risks, mainly illiquidity but also complexity and possibly credit-profile differences (typically offset by stronger deal structure and documentation). For simplicity’s sake, we’ll call the entire mix an illiquidity premium.
From the tactical lens, we think insurers should ask themselves three questions as they consider short-term allocation decisions:
1. Does the return potential on private assets still fully compensate me for any added risk?
The answer to this question depends on the specific public and private assets in question, but we can outline an example of the considerations in the context of US private placements.
Generally, we can look at relative value through the perspective of illiquidity compensation. In some cases, spreads on US private-placement transactions haven’t been high enough in the absence of more attractive covenants or diversification benefits. Investors with annual quotas may be less sensitive to this lens but faced with a choice between slowing the pace of origination or continuing at pace by adding assets that don’t fully compensate for illiquidity risk, we favor slower origination.
The yield surge is presenting a broader menu of options across public and private fixed income, while spreads are wider, and volatility is up. This environment makes disciplined analysis critical in evaluating relative opportunities, and the ratio of yield spread to total yield is a useful tool. In high-yield bonds, for example, we think the spread should account for two-thirds of total yield. The liquidity premium should be worth more, which means a higher required rate of return.
For insurers seeking to fulfil pre-agreed allocations, alignment is critical, too—with the manager’s view of relative value and with the role of private assets on the insurer’s balance sheet.
2. Does the specific private asset provide risk diversification and bolster my balance sheet?
With volatility and economic uncertainty up and central banks tightening, insurers are reassessing the resiliency of their balance sheets—across assets and on a net asset/liability basis. Inflation is sure to be a focus, including assessing the inflation exposure of current allocations and potential allocation changes at both the sector and asset-class levels.
For example, assets closely related to consumer staples are likely to face challenges in passing on the effects of rising prices to customers, while materials-related assets are expected to have positive correlations with inflation. Generally, sectors exposed to real and physical assets or commodities would likely fare better in higher inflation—and can be found across public and private fixed-income markets.
Several private asset classes combine exposure to real and physical assets with defensive qualities, which could be attractive in uncertain markets. Private markets may also make it easier to combine long-term inflation hedges with defensive characteristics. Real estate debt, for example, avoids taking first-loss exposure, in contrast with real estate equity. What’s more, infrastructure-related investments have historically posted higher recovery rates than corporate bonds.
Floating-rate debt offers potential inflation protection too, though insurers will need to consider their appetite for floating-rate assets within an asset-liability matching (ALM) framework. Floating-rate debt can also be found in public and private markets; much of the private-credit arena is floating rate. Given the heightened macro risks, the balance of insurance portfolios’ exposures to macro and idiosyncratic risks is also worth examining. Focusing on exposures to carefully selected investments driven more by idiosyncratic risk can enhance diversification and may make portfolios more resilient.
Generally speaking, private assets often provide access to different risk drivers than public assets, and their privately negotiated nature often offers greater protections (in the form of covenants). Those protections are certainly attractive in uncertain times.
3. Do I still have the same capacity for illiquid assets today?
Higher volatility and interest rates have raised the issue of illiquidity-risk capacity for the first time in years. The UK liability-driven investment turmoil highlighted that unexpected collateral calls can increase the need for short-term liquidity. Insurers’ hedging requirements differ, of course: they’re fully funded, using derivatives to reduce net asset/liability gaps rather than amplify exposures. However, they’ll likely be stress testing exposures in order to dimension potential liquidity needs.
On the liability side, given the higher costs of living for policyholders, insurers may be considering the impact on policy-lapse experience (particularly within the life insurance sector); lapses can also be a draw on liquidity. In the property-and-casualty space, insurers are likely to be considering the impact of inflation on claims (replacement costs).
Because the value of insurers’ private-market exposures may have declined less than public-market equivalents, private-market allocations may have risen closer to or beyond their targets. To the extent allocations have been based on illiquidity appetites, insurers may pause to think through potential liquidity needs from a liability standpoint before adding less-liquid transactions—though as fully funded investors, their illiquidity appetites are less likely to be affected.
To wrap up the tactical discussion, insurers face a broader menu of investment options, with some public-market options offering comparable expected returns to private-market equivalents. But it’s important to receive adequate compensation for the associated risk and liquidity characteristics (particularly the perceived liquidity of public markets).
Viewing the Problem Through the Strategic Lens
In the long run, we think institutional investors will continue their shift into private markets, because private markets offer genuine portfolio diversification. For insurers, private allocations will also account for ALM considerations, seeking the most efficient return for a given appetite for risk (economic, regulatory or both), as well as portfolio constraints.
For the return side of the equation, we believe private-market assets will continue to exhibit a premium over public-market equivalents (Display) in the long term, driven largely by illiquidity and complexity premiums. The complexity premium can be broadly defined as incremental return for the ability to source, assess and execute customized deals.
