Fiddich Review Centre
Alternative Investment

Liquidity risks flash private debt warning

The comfort blanket of juicy illiquidity premiums that private-debt investors enjoy in return for locking in to an opaque and illiquid market is being yanked away, as the risk of recession and rising default rates grows.

The turning economic cycle also exposes another inherent risk that is hidden from sight in the “Goldilocks” world of low inflation, low interest rates and booming asset markets: price discovery.

When times are good, private-debt investors do not need to sell, do not need the liquidity, and are comfortable with only periodic asset revaluations because the direction of travel is invariably upward.

Liquidity and pricing risk is naturally greater in private markets than traditional public markets like the S&P 500 or U.S. government bonds.

Within private markets, however, price discovery in debt is usually more regular and transparent. Analysts at UBS said private debt is typically valued on a monthly basis, compared with every quarter in private equity and up to once a year in REITs.

But according to alternative asset data provider Preqin, private-debt managers have so far done “comparatively little” to mark down portfolio valuations to reflect volatile market conditions, “partially out of hope that risk assets can rebound.”

Hope is not a strategy though, and if risk assets are cheaper over the coming year, private debt valuations will have to be marked down accordingly.

In its 2023 outlook released last week, Preqin forecast continued inflows in the coming years, adding that private credit remains an attractive long-term investment “for those able to tolerate its illiquidity.”

Private debt performed well this year, certainly relative to publicly traded bonds like U.S. Treasuries, which had one of their worst years on record as the Fed embarked on its most aggressive rate-hiking campaign in 40 years.

Research by analysts at UBS shows that private credit returns outstripped public-debt returns in every one of the last eight periods where the 10-year U.S. Treasury yield rose by 75 basis points or more.

The most recent period observed, from Q4 last year through Q2 this year, showed the lowest nominal returns for private debt of only 4.7%. But set against a historic 10.3% plunge in public markets, they outperformed hugely.

All well and good, but the fact that the most recent broad sweep of returns data is for a period that ended almost six months ago underlines the opaque nature of the market and not insubstantial price discovery risks.

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