Opportunistic credit gains ground as private equity faces pressure

Opportunistic credit’s low correlation to public markets and returns profile mean it may be better suited to institutional investors allocating to private markets than private equity, according to Davidson Kempner.

A recent white paper by the $37bn (£27.8bn) investment firm found that in a representative institutional portfolio, with 70 per cent allocated to public market securities and 30 per cent to private funds, optimisation within the private allocation favours opportunistic credit over private equity.

The firm desmoothed private fund indices to place private strategies on a more comparable footing with public securities. It found that the volatility of private equity doubles relative to the raw index, rising from 10 per cent to 20 per cent, while its correlation with public equities approaches 90 per cent.

The report also noted that while private equity is the largest private asset class, at around $9tn, forward returns are likely to be lower due to capital saturation and a higher-for-longer interest rate environment.

By comparison, opportunistic credit is a relatively small asset class at around $640bn, roughly seven per cent of the size of private equity. However, the growing global opportunity set of private equity-owned companies requiring capital solutions, balance sheet restructurings and operational execution could enable opportunistic credit managers to deliver strong returns, Davidson Kempner said.

In the US, elevated leverage, ageing private equity portfolios and delayed restructurings suggest the market remains in the early stages of a capital structure reset, which is expected to benefit opportunistic credit.

In Europe, a sustained bank-led credit contraction, particularly in more complex situations requiring bespoke financing, has created an opportunity set, the manager said. Regulation and market fragmentation have also left parts of southern Europe structurally underbanked.

“Opportunistic credit’s combination of attractive returns, lower volatility and lower correlation enhances portfolio efficiency,” the report said. “Meanwhile, the normalisation of interest rates and rising refinancing pressure have expanded the universe of companies requiring balance sheet repair.

“With dedicated opportunistic credit capital comparatively limited, there is less competition for complex restructurings, capital solutions and special situations transactions, supporting continued alpha generation.”