Private debt funds: Wealth whispers

Private debt funds are opening up to high net worth individuals for the first time. Kathryn Gaw looks at the opportunities and the risks involved…

Private debt funds have long been the domain of institutional investors only, providing essential diversification with the promise of double-digit returns. But lately, the investor demographic has been changing. Over the past year, a number of private debt funds have been launched specifically for high net worth individuals (HNWIs) and the ‘mass affluent’, with mixed results.

According to calculations by Apollo Global Management, there is $187 trillion (£154 trillion) of high-net wealth globally, compared with $102 trillion of institutional money. This represents a huge market that private debt fund managers can tap into. What’s more, following several years of economic instability, these HNWIs are actively seeking new homes for their money. Private debt is viewed as an attractive sector due to its lack of correlation with mainstream equity markets, and the promise of inflation-beating fixed returns.

“It’s a big market,” says Claire Madden, managing partner at Connection Capital. “We’re only really scratching the surface. Everyone is seeing that interest rates maybe have peaked so they will have to start thinking again about diversification in the longer term by looking at alternatives.

“Investors have held off on longer-term alternative investing and now they’re looking to build up their portfolio again.”

Across the board it seems that private debt funds are getting a lot more attention, from investors and intermediaries alike. Research from the iCapital Financial Advisor Survey 2023 has indicated that private bankers have begun to recommend that their clients either keep the allocation to private debt funds in their portfolio constant, or possibly even increase the allocation in the future.

Read more: Apollo estimates private credit market is worth $40trn

With this in mind, it is no surprise that so many large asset management firms have begun to delve into the HNWI private debt market.

In early 2023, Blackstone launched a direct lending fund in the US – called BCRED – and followed this up with an ‘ECRED’ fund aimed at European investors. Approximately $12bn had been raised through the BCRED fund at the time of writing. However, the ECRED fund has struggled by comparison. Within the first six months of the fund’s launch, just $261m had been invested in the product, reflecting the difficulty of navigating the regulatory and tax issues within the European private debt market.

“The HNWI market in the US is very sophisticated – more so than Europe,” explains Madden. “There is no regulatory consistency across the European countries. It is not easy collating private money.”

BlackRock debuted a retail private debt fund of its own in June of 2023, named BDEBT. Around the same time, the asset manager acquired private debt manager Kreos Capital, with a view to capturing a greater share of the growing private credit investment market.

Read more: Blackstone raising $400m to boost private credit fund

“Private debt investing has become an increasingly important component of investors’ portfolios,” said Stephan Caron, head of EMEA private debt at BlackRock, at the time of the acquisition.

“Current market dynamics have made private credit an attractive asset class as investors focus on its income generation, low volatility, portfolio diversification and its low defaults versus public markets.”

HNWI-focused private debt funds have also been launched by Blue Owl Capital, Fidelity Investments, Ares Management, and Apollo Global Management over the past year, while Goldman Sachs and Arcmont Asset Management are set to debut their own private debt offerings for HNWIs in due course.

There are clear benefits for investors who are interested in allocating their funds into private debt vehicles. The most obvious benefit is the returns. On average, these funds will return 10 per cent or more to investors per year, regardless of stock market and economic volatility. Private debt funds also offer diversity in mature investment portfolios.

“For far too long private investors have been locked out of institutional-grade products and asset classes so there is an argument to look at how we can actually allow our clients to access the full range of products that institutional investors would have access to,” says Madden.

Read more: Private wealth is ‘phenomenal opportunity’ for alternative fundraising

However, she adds the caveat that these opportunities are only actually accessible to a subset of clients. They must know what they are doing, understand the risk, and be able to withstand the liquidity.

“Any fund that goes out and says they are investing in longer-term assets but offer liquidity suggests that there is a liquidity mismatch and it will only end in tears for the investor,” she adds.

Liquidity is the major drawback for HNWIs who are interested in private debt funds. While a small number of private debt funds offer quarterly liquidity, the majority will only allow investors to make withdrawals after a year or more, depending on the term time of the fund. As a general rule, once your money is in a private debt fund, it is locked in until the end of the term.

“The nature of the private debt market makes it inherently less liquid than the public bond market,” explains Dean Frankle, managing director and partner at BCG and leader of BCG’s asset and wealth management business in Western Europe, South America, and Africa.

“The lower liquidity levels are reflected in the lock-in periods, forcing investors to make more long-term asset allocation decisions.”

In response to this liquidity concern, some platforms have started to roll out private credit secondaries. Last month, Pantheon filed to register a “first-of-its-kind fund for the US private wealth market, focused on private credit secondaries”, the AMG Pantheon Credit Solutions Fund.

However, Frankle adds that the recent success of private market platforms among HNWIs indicates that wealthy individuals are happy to sacrifice some liquidity in their portfolio in favour of higher returns, diversification, and lower interest rate risk.

And then there is the question of taxation.

“The product landscape for private retail investments is still developing, making the taxing of private debt an individual matter for most HNWIs, which will most likely be subject to change with the introduction of new product wrappers and possible regulatory action,” says Frankle.

Read more: M&G launches £500m private credit fund

Issues of liquidity, taxation and regulation are already impacting the roll-out of HNWI-focused private debt funds. Several private debt fund insiders told Alternative Credit Investor that the gulf in tax law and regulation from country to country has made it harder to roll out new funds on a global scale, which may make them less attractive for multi-national asset managers.

“Besides the inherent risks of debt investments, such as counterparty risk, there are further potential risks concerning transparency as well as changes posed by future regulatory action, given that the uptake of private debt is a relatively recent trend in wealth management,” says Frankle.

“However, some advantages of the private debt risk profile over fixed income are floating rates, which offer better protection against interest rate risks and comparatively lower volatility, similar to the relationship between private equity and public equities.

“Periods of economic growth are sometimes also accompanied by increases in lending, making private debt an attractive alternative to fixed income, while the lock-in periods of private markets have the tendency to make private debt assets stickier overall.”

UK-based alternative lenders are all too familiar with these limitations. Increasingly strict regulation by the Financial Conduct Authority has made it harder for alternative lenders such as peer-to-peer lending platforms to market to and onboard retail investors. This has led some of the larger platforms to raise their minimum investment threshold, effectively pricing their products at a rate that only HNWIs could afford.

Read more: Blackstone raising $400m to boost private credit fund

“The really interesting market is in private closed-ended vehicles,” Madden adds. “These funds are structured in particular way which makes it very difficult for retail investors to get into them. There is a lot of regulation and very high minimum entry thresholds.”

Connection Capital has a minimum threshold of £25,000 for HNWIs, which is considerably lower than the £1m+ which is required by some private debt funds. These HNWIs are considered to be more sophisticated investors, who may have a background in private equity, hedge funds, investment banking, or professional services, says Madden. This means that they are more likely to understand risks such as the lack of liquidity, and the variable nature of cross-border regulation and taxation.

The private debt fund market may be slowly tilting towards HNWIs, but unless you have eight figures in the bank and a background in finance, these investments are likely to remain out of reach for the vast majority of retail investors.

But for the asset managers and alternative lenders who are eyeing this space, there is more than enough HNWI money to make it worth their while.