Vivian Tang: Hello everyone. This is Vivian Tang from abrdn Investments. And welcome to the “The Voice, The View” podcast. Each episode will bring to you expert voices and views to help you identify and profit from trends and opportunities around the world. Today, I'm delighted to be joined by my colleague Martin Barnwell, Head of Commercial Real Estate Lending at abrdn. Martin is also the portfolio manager of the abrdn Multi-Sector Private Credit Fund. Martin, welcome to the podcast.

Martin Barnwell: Thank you, Vivian. Really looking forward to our discussion today.

Vivian: Martin, before we begin, I think it would be beneficial for our listeners if you could tell us a little bit about yourself, your background and your journey to the role that you have today at abrdn.

Martin: Of course. I grew up in Ireland and I went to university there. That's where I started my career a very long time ago. In the early 2000s, I started off working in banking. I was focusing on credits and lending with a specialty in real estate. And that's where I've been in my career for nearly 22 years now.

Vivian: It's a really unique experience to have worked in the private credit industry for over two decades.

Martin: Yeah, that journey took me from Ireland to the US, where I spent a couple of years in Chicago. I was focused on real estate finance around 2008, which, as we know, coincided with the global financial crisis. So that role transitioned very quickly from growing and originating new assets for banks to restructuring, workout and enforcement. And that was a really interesting and educational journey.

I moved back to Ireland and continued in a restructuring role, and then got an opportunity to move to London – getting into the market there was a real passion and focus of mine. I worked in restructuring and workout there for a couple more years.

And then, it’s really the story of the growth of private credit. Regulation was tightening on banks post crisis. We were starting to see a pullback of lending in that market, a very significant one. And that created an opportunity for the non-bank lenders. So I was very lucky to be given the opportunity to join abrdn as the start of the journey of our private credit business. I joined the real estate lending team at that stage, and I've been with the team ever since.

Vivian: In your view, what are the features that have driven the increasing demand from investors allocating into the asset class?

Martin: Clearly, we've seen rapid growth in private credit investment over the last 10 to 20, years. I think you go back to 2008 as the spark that lit that fire for investors. What we saw was a very sharp retrenchment from banks at that point, really driven by capital requirements and bad debts that they were facing. But after 2008, the regulatory framework for banks changed massively; it became much more difficult for them to get into trouble like they did before, and therefore lending became more stable and more conservative. That meant less supply of debt in the market. When that happens in any market – when there's a supply/demand imbalance – returns have to improve to attract more diverse capital to that market.

And that's been where we've seen pension funds and insurance companies being attracted to that part of the market – looking to get access to private debt and take part in that really interesting growth story. And if we think about an insurance company or a pension fund and their funding profile, their liabilities, their investment outlook – it's actually quite long term compared to banks, which often have quite short-dated funding.

I've always thought that insurance companies make a perfect partner in a private credit investment structure because of that longer-term investment horizon they look at and the liability profiles that they have. So they're a natural partner for private credit investment, particularly some of those longer-dated deals, but also at the shorter-dated end. I think that's been one of the biggest reasons why capital has been attracted to the market.

But then private credit has attractive features in itself. What’s interesting about the private credit space? It's a fixed-income-like investment – it should provide stable and predictable cash flows. It’s bespoke in nature, which is really important. Compared to public credit – which is sometimes off the shelf and might use cookie-cutter structures – within private credit you have the ability to shape and structure those deals in a different way. If your requirements are a certain maturity profile; if you want fixed cash flows; if you want floating-rate cash flows; if you want index-linked cash flows… it's possible in private credit to structure deals that specifically meet all those requirements, and it can be tailored to rating, duration, return profile and asset class as well. That's a very attractive feature of private credit – that you can work with an investment manager to structure a mandate that's exactly meeting your requirements.

Vivian: I think it's really interesting to compare public credit with private credit.

Martin: Absolutely. And then within that, you can have tighter credit protections – you can have covenants which are perhaps a bit tighter than the public markets. You can often have direct security over physical assets, which really helps in a downside scenario and prevents more loss severity compared to public credit in many cases. And then perhaps most attractive of all, it can deliver an enhanced yield. That's really important for investors – you're getting a premium to the public markets, as well as all those other benefits that I mentioned.

Vivian: So can you tell us more about the concept of the liquidity premium in private credit? And how does it benefit long-term investors like insurance companies?
Absolutely. We just touched on that illiquidity pickup, which is so important to investors, and it's the key driver of attracting alternative sources of capital to the private credit space. I’ll describe illiquidity pickup very briefly.

If you're an investor and you're looking to make a transition from public credit into private credit, you want to trap that illiquidity premium. You're going to make an assessment based on the investment that you're in. You look at a basket or an individual bond of public credit assets, and you look at the spread that that basket or bond is delivering over the base rate, and then compare it to the private credit investment. You look at that spread, and that's where we look to calculate that illiquidity pickup. If you've got a public instrument delivering 150 basis points over base, and your private instrument is delivering 300 then you're able to trap that 150 basis points of illiquidity pickup in return. That's incredibly attractive. And it was especially so in those lower interest-rate environments when total returns were very, very low – then, adding 100, 150 or 200 basis points of illiquidity pickup was incredibly powerful.

We still think it's important and attractive today in a higher-returning environment. Some investors point out a trade-off: “Yes, I am capturing this really attractive illiquidity premium. But the clue is in the name – it's illiquid, and I can't sell it.” That can be true to an extent. But what we would say is that even within the private markets, there is a liquidity available for a number of these investments. And we think about liquidity in a sort of ladder or profile. You have a spectrum with more liquid assets at the top and illiquid at the bottom.

We work with clients in multiple deals. In corporate debt, for example, where it's a heavily syndicated market, there'll be a road show from an issuer, a number of interested insurance companies and pension funds and other sources of private capital will bid for these deals. The deals will often be oversubscribed, so you've got a lot of investors who are a bit frustrated and will have wanted more. So if you've decided to trade out of your illiquid private credit position in that corporate loan, you've got a natural pool of parties who were already invested in this deal, wanted more at origination and couldn't be satisfied. That creates a natural liquidity opportunity for you – you can sell that stake to an existing investor in the deal, or an investor, indeed, who missed out.

So there's a kind of natural liquidity that exists in a number of these assets, which is important to bear in mind as well. And then there's a possibility a grey market transaction – selling them to a limited pool of investors, where there is always potential interest. We would always say to investors, “Yes, it's a private investment. It is certainly a lot less liquid than public investments, but there are avenues of liquidity that you can explore throughout the entire life cycle of an investment, whether it's performing or not.” We would say that it’s important to bear in mind that you can potentially have your cake and eat it, when it comes to that illiquidity pickup and an element of liquidity in that transaction as well.

Vivian: Let's change the tone a little bit and talk about risk. We have read a lot about the systemic risk and potential defaults in private credit. Should investors be concerned?

Martin: It's a great question, and it's on a lot of investors' minds at the moment. You see headlines across the globe talking about the risk and potential for defaults in private credit. But before I maybe answer that question, I think it's important to take a step back and think about the universe of private credit. It's up to one and a half trillion in size , and it covers an array of different asset classes and strategies with their own unique risk profiles and market drivers.

There's a danger that when we talk about private credit, we think of it as a kind of homogenous, single asset class, and it's definitely not. Just within abrdn, we look at commercial real estate debt, corporate debt – which can be incredibly broad – infrastructure debt, and fund financing or subscription-line financing. Those are just a part of the wider private credit universe that we focus on and specialize in. But there's a much, much broader universe as well. There's direct lending, which is lending to smaller and mid-size corporates; specialty financing like music royalty financing, aircraft leasing and shipping financing; invoice discounting; distressed debts and so on. There’s a huge array of broad and diverse strategies within that private credit universe. And then within that, you can have senior, secured and investment grade. You can have higher yielding or unrated, subordinated and junior positions, all with very different risk and return profiles.

So it's important to understand that private credit does cover a huge universe of transactions. Having said that, I think when most people think of private credit they often think of direct lending, which is lending to smaller, newer and fast-growing companies who are really hungry for debt – a rapidly growing part of the private credit universe. According to Preqin, I think it's responsible for up to 70% of capital raised within private credit since 2020. And it is clearly an interesting part of the market for investors. I think in any part of the market where you see such rapid growth, you've got to consider that it's a more challenging economic backdrop for companies these days. We've seen significant inflation, a rapid rise in interest rates, and those interest rates persisting for longer than people expected. When you factor all those things together – and you're lending to companies which are weaker and not as strong as those big blue-chip investors in the investment-grade space – I think it's natural that we're probably going to see an increase in defaults in that part of the market. It's not really an area where abrdn operates. We very much focus on the investment-grade and conservative end of the market. So we're really, really positive about the outlook for private credit as seen through the abrdn Investments lens. But I think yes, you're probably going to see some more defaults in the direct lending space. And I think it'll come down to the manager underwriting ability and also their ability to manage workouts and enforcement strategies.

Vivian: Considering the diverse nature of the asset class, what are the most important features that you think an investor should consider when assessing a manager's private credit capabilities?

Martin: It's an important question, particularly if you're a newer investor in the private credit space. You're going to want to spend a lot of time understanding the market and then understanding and finding the right partner to help you navigate that market. And that is absolutely essential. A key thing you would consider from a general investment perspective is the quality of the people on the team. Because it's a private market, relationships and origination capability is so important. And the ability to originate deals and have a really experienced underwriting team to underwrite and evaluate that risk is hugely important. So you've got to have experienced people and teams to help originate those deals, but also underwrite and manage that risk, especially if things start to wobble a little bit, as they often do. So it's really important that the team has origination capability, but also experience of restructuring and working out deals if they don't always go to plan.

Processes are also massively important. Think of all the underwriting tools that are required to be successful, the rating tools to help you understand and communicate that risk to your investors, and the sustainability tools to help identify sustainability risks and opportunities in those deals.

Another thing to consider is track record. You want to look at the manager's track record. As private credit has been a really active part of the market for over a decade now, you can go in depth and evaluate a manager's performance and track record. And if they're telling you they're going to deliver this sort of return, then let's look at the deals they've done, how they performed through Covid, how they faced the recent interest-rate challenges and how that portfolio held up and delivered for its clients.

From the lens of an insurance investor, we like to think about processes in terms of the three Rs. You've got regulation, reporting and rating. For the first R, which is regulation – you should be working with a manager who really knows and understands the insurance regulatory framework that the client is operating in. At abrdn Investments we've got a very strong insurance heritage. We are very familiar with the investment regulatory regimes across the globe. Clients want to know that when changes happen, the manager is already on the front foot – implementing the changes into their portfolio, structuring deals that meet the new framework, is really important.

Reporting is often overlooked. But insurance clients know better than anyone that they require incredibly detailed reporting that has to be 100% accurate, and they want it very swiftly after the period ends. So working with a manager who has the platform and ability to deliver granular, high-quality, accurate and detailed reporting in a robust manner is hugely important for those insurance teams to help manage and understand the risks in their portfolios.
Finally, rating. Within private credit, we're often operating in unrated investments, where you're sometimes relying on the manager's own internal rating capability. That is so important when we think about that illiquidity pickup that's achievable. Say we're trapping 150 basis points of illiquidity pickup. What if we're not comparing the ratings in the right way? You’re trading out of an A-rated public credit bond, your manager tells you it's an A-rated private credit bond, but actually when you go and get it validated by an external rating agency they tell you it's a double B. Then you've not trapped positive illiquidity pickup. You're locked into an investment that's non-investment-grade, and that can have massive implications.

For insurance clients, using a manager who's got a robust and accurate rating methodology that's been externally validated by external rating agencies is incredibly important.

Vivian: Finally, what are your areas of strongest conviction for the second half of 2024?

Martin: This is great question to finish up on. We operate across infrastructure debt, corporate debt, real estate debt and fund finance. We're seeing strong interest from clients and great performance and origination flows in our corporate and infrastructure debt world. There are really positive fundamentals there, and we’re seeing strong interest on both sides of the supply/demand equation.

In terms of our house view and our outlook, we're probably most positive on commercial estate debt and fund financing in 2024. To take each one in turn: if you think about commercial estate debt or commercial estate lending, what we've seen – particularly in the UK and Europe. W – is fastest and sharpest correction in capital values on record in 2022 and into 2023. This is a real rebasing of the capital values of the asset that you're going to lend on so. As a debt person, I love that, because I'm coming in with a very defensive position. From a risk point of view, this is a great time to lend. Those values have corrected sharply, such that your pounds per square foot that you're lending against a property is at an all-time low. So that puts me in a secure defensive position, which I really like as a lender. And we're starting to see some green shoots in terms of the recovery phase in the real estate equity markets. It's early days, but we think that that should play out over the next couple of years, and we'll start to see growth in those capital values. It means the deal you're going into today should look even better in the future.

We saw those rapid interest-rate rises. They occurred incredibly quickly. But that means that if you're underwriting a deal today – a good deal in a high interest-rate environment – then it should be a better deal in a lower interest-rate environment whenever that happens in the future. That’s a real comfort for underwriting on both sides of the risk equation.

We've seen spreads increase as capital values fell. They’ve come in a little bit in the first half of the year, but they're still very attractive. So we're able to capture illiquidity pickups of between 100 to 200 basis points for our clients right now in the commercial estate debt space. We're positive on the fundamentals for real-estate debt, and we think that's a very attractive part of the market in 2024.

Another area of conviction is fund financing. Fund financing is subscription financing, where we're lending to a fund in the early stages of its investment period. But we're not secured against those investments that they're making – we're secured against the commitments from those investors. So if you've got a high-quality fund operator that's raised capital from multiple credible, well-regarded institutional investors, and we're lending secured against those investor commitments – at a significant discount – that puts us in a very comfortable risk position. And these deals are typically shorter dated, so between one and three years. They're often floating-rate in nature, so they provide an attractive investment at the shorter end of an investor's term spectrum. So that's an interesting part of the market to play in.

Banks have been very active in this space historically, but regulation and capital limits have impacted them; that’s requiring them to pull back a bit from the market and causing those spreads to widen a little bit, creating an opportunity for alternative sources of capital to step in. All those things together are making fund financing a really attractive investment opportunity now, and as a result of that risk profile, they're often very high in terms of the credit quality. We’re seeing single-A, double-A and triple-A opportunities offering a really attractive investment and illiquidity pickup compared to public credit at the shorter end.

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