Why Include Private Debt In Your Portfolio?

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Super-Rich Families Pour Into $787 Billion Private Debt Market

– Bloomberg (Dec. 9, 2019)

Ultra-Rich Families With Cash on Hand Pile Into Private Debt

– Bloomberg (May 4, 2020)

Why are the ultra-wealthy allocating so much more capital towards private debt right now?

With the financial markets in turmoil over the COVID-19 pandemic, investing in private debt is a risk mitigation move. While Wall Street has long pushed the 60/40 (60% stock/40% bonds) model for spreading risk, the ultra-rich are playing on a whole different level.

The idea behind the 60/40 allocation rule is that if stocks go down, bonds – which traditionally moved in the opposite direction of stocks – would pick up the slack to protect the portfolio. This may have worked in the ’80s when treasury rates hovered near 10%, but that rule no longer makes sense today where the 10-year treasury currently sits at 0.96%.

If you stick with the 60/40 asset allocation over the next decade, you will barely keep ahead of inflation. 

Morgan Stanley recently put out a report projecting the returns from a 60/40 portfolio to be just shy of 3% a year over the next decade. Average annual inflation over the past 20 years has been around 3.22%. Taking into consideration inflation, that’s a projected net annual loss of .22% per year over the next decade if you stick to the 60/40 model.

Ignoring the 60/40 rule, the ultra-wealthy balance their risk differently.

First of all, the majority of their portfolios are allocated to cash-flowing alternatives like private equity and commercial real estate and not public equity favored by the Main Street investor. With annual returns in excess of 10% for these investors, at lower risk than equities, the choice for these investors is a no-brainer.

The second thing that the super-rich do differently than their Main Street counterparts is they don’t counter risk in their portfolios with public debt like treasuries that pay less than 1%. They prefer higher-yielding private debt that makes much more sense in countering downturns in the private equity (PE)/real estate (RE) portion of their portfolios.

How much better are private debt returns?

According to the CFA (Chartered Financial Analyst) Institute, the average monthly return from private debt according to its private credit index was 1.53% a month. That translates to an 18.36% annual return. You can now see the appeal of private debt to the sophisticated investor.

Besides higher returns, private debt offers additional advantages over equity. Private debt holders may give up rights to appreciation and growth, but security and a fixed return outweigh the cons. That’s because debt holders have priority over equity holders to any company assets when a business goes south.

Because private debt typically offers fixed returns at lower risk without any upside, they make an ideal counterbalance of private equity that may offer potentially higher returns with upside but at the price of higher risk.

There is never a bad time to include private debt in an investment portfolio.

There may be times where a heavier allocation may make sense like in a downturn like the one we’re experiencing now, but it’s always a good idea to balance the higher-risk, higher-returns private equity/real estate mix with lower-risk fixed return private debt.

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