Ewan Macaulay outlines why private debt markets in real assets offer compelling relative-value opportunities, despite macroeconomic uncertainty.

Read this article to understand:

  • How ongoing macroeconomic headwinds could impact private debt markets
  • Why we may be about to see a power shift from borrowers to lenders
  • The importance of ESG considerations in private debt

2022 was a bruising year for investors, with public and private markets suffering sizeable markdowns as soaring inflation led central banks to tighten monetary policy forcefully for the first time since the global financial crisis. Volatility has continued in 2023, with tightening credit conditions leading to contagion in areas such as the US regional banking sector.

The outlook remains shrouded in an unusual level of uncertainty. Data suggests rates may need to stay higher for longer in the US and Europe if the pace of economic activity is to slow sufficiently to get inflation back to target.

While the price of debt instruments traded in private markets has declined, the magnitude of the move is in some cases far lower than that seen on comparable public debt, where credit spreads have widened appreciably in anticipation of weaker economic conditions. This has led to a substantial reduction in the illiquidity premia on offer from investments in infrastructure debt, real estate debt, private structured finance and private corporate debt, as shown in Figure 1.

Figure 1: Illiquidity premia in private debt asset classes

Illiquidity premia in private debt asset classes

Source: Aviva Investors. Data as of March 2023

How will private debt markets respond to further headwinds?

Given the ongoing risk of recession in the US, UK and EU – especially if central banks see the need for more aggressive action to quell inflation - private debt markets may need to continue cheapening relative to public debt in the near term. After all, illiquidity premia on private debt instruments typically tend to increase during period of economic stress, as illustrated in Figure 2.

Figure 2: Illiquidity premia in times of stress (basis points)

Past performance is not a guide to the future

Source: Aviva Investors. Data as of March 2023

Illiquidity premia would be expected to rise should credit conditions continue to tighten, as has happened in the US and to a lesser extent Europe, due to recent problems in the banking sector. Meanwhile, the longer-term trend by UK defined-benefit pension schemes to reduce their exposure to illiquid assets as they prepare for buy-outs could reinforce this move.

Default rates will almost certainly rise as earnings and access to liquidity decline

Default rates will almost certainly rise as earnings and access to liquidity decline. However, private debt should be aided by its superior downside protection in the form of collateral and financial covenants compared to public debt. This has historically led to significantly lower losses on private debt compared to comparable public bonds, as illustrated in Figure 3.

Figure 3: Losses in private debt versus public debt (basis points)

Note: Historic data set ranges from 1983-2021.
Source: Aviva Investors, Bayes Business School, Society of Actuaries, M&G, Moody’s, May 2022

Given private debt’s ability to outperform during periods of economic weakness, the asset class can be a helpful diversifier for portfolios with exposure to more traditional, pro-cyclical asset classes such as real estate equity.

Figure 4 shows the strong diversification benefit of adding private debt to a portfolio of asset classes within real assets. The dashed line box highlights the low, or even negative, correlation between real asset equity (both infrastructure and real estate) and various private debt instruments.

Figure 4: Correlation between real asset markets (five-year IRR)

Correlation between real asset markets

Source: Aviva Investors. Data as of March 2023

Opportunity knocks: Our sector-by-sector analysis

We believe we are entering a period of compelling relative value within private debt as the power balance shifts from borrowers to lenders. Pockets of value have already begun to emerge as flightier sources of capital have flowed out of some areas.

We are entering a period of compelling relative value within private debt

Figure 5 shows our relative-value analysis on different parts of the real-assets universe. Private debt shows up especially well in terms of risk-adjusted return expectations, as other, more volatile areas of the real-assets universe continue to re-price.

Figure 5: Five-year expected risk-return premium for select real asset markets

Source: Aviva Investors. Data as of March 2023

We see compelling opportunities in the following areas:

Real-estate debt

While acknowledging the inherent, cyclical risks within real estate, as well as the near-term pressures on property valuations from rising interest rates, we currently view UK real estate debt as attractive in the short term. We believe property valuations are closer to the bottom in the UK than in other countries, meaning they should be at less risk of suffering further material falls. In particular, we like:

Senior real estate debt:  In our view, and despite negative headlines around pockets of commercial real estate, the senior part of the market remains attractive given the rise in underlying yields. This, along with the relatively low risk (due to financial covenants and collateral against the loans), creates better relative-value opportunities than real estate equity at present. Additional support for the current vintage of new deals comes from the steady supply of transactions, partly driven by net-zero considerations and the need to retrofit properties.

Whole loans:1 Interesting opportunities are arising within UK and European whole loan debt, where yields are now above those achievable on real estate equity for the first time since 2007 – essentially providing investors with equity-like returns for debt-like risk. Moreover, weaker interest coverage ratios due to higher rates and the retrenchment of bank lenders will likely create a ‘funding gap’ in this market. We expect opportunities for institutional investors to step into the market and achieve more favourable pricing and terms.

The next two years could present a once in a generation opportunity

Given the speed of the fall in valuations, plus the downside protection within real estate debt provided by covenants and collateral, the next two years could present a once-in-a-generation opportunity to take advantage of market stress and repricing.

Nevertheless, investors will need to be watchful of rising credit risks by focusing on safer parts of the market, selectively picking assets whose value has already fallen sharply, or which have strong occupational demand. In doing so, this will reduce the dangers posed by rising to loan-to-value ratios and refinancing risks.

Infrastructure debt

Senior infrastructure debt: We currently see strong relative-value in senior infrastructure debt in Europe and the UK versus other real asset markets, driven by higher underlying yields and the low-risk, defensive nature of the asset class. We would expect infrastructure debt to outperform in the event of a downturn given the stability of cashflows, nature of the underlying assets and inflation-linkage in many deals.

Structured finance and private corporate debt

Private corporate debt (PCD): PCD markets tend to lag public bond markets by three to six months. With public bond spreads having already widened in anticipation of weaker macroeconomic conditions, we expect PCD to do likewise over the remainder of 2023. This, along with higher underlying yields and strong downside-risk mitigants (financial covenants, collateral), should create opportunities for investors.

The market dislocation in the second half of 2022 created opportunities in ABS

Structured finance: The wider market dislocation in the second half of 2022 created opportunities in the asset-backed securities market. For example, spreads on AAA-rated tranches of collateralised loan obligations (CLOs) widened to around 200 basis points in the fourth quarter, offering an attractive entry point. Importantly, this was driven by CLO managers’ need for liquidity given the balance sheet-light model most use; it did not reflect an increase in underlying credit risk, particularly in higher-rated market segments.

Risk versus returns

Figure 6: Five-year expected risk versus absolute returns in real assets 

Source: Aviva Investors. Data as of March 2023

Figure 6 shows our relative-value analysis on risk versus returns across the real asset universe over the next five years, including both debt and equity segments. In short, we see a compelling case for real assets debt at the current time.

However, investing in private debt can be complex and take longer to implement relative to public markets, while liquidity is another important consideration. Lining up deals can be a lengthy process, while establishing investment vehicles with the right structure can also take several months. On that basis, investors might want to prepare the groundwork now in anticipation of being ready to allocate later in the year.

ESG: A key consideration for private debt

Investors can consider ESG factors when considering an allocation to private debt. One consideration is the potential for assets to become stranded or obsolete over time, without intervention or improvements.

For example, when looking at real estate debt, investors who improve the energy efficiency of a building to meet or exceed regulatory requirements, either through the acquisition process or by existing ownership, should benefit from lower vacancy rates. And, from an occupier’s perspective, more efficient buildings are cheaper to run. This explains why there tends to be a flight to quality in many office markets, particularly regional ones, with demand for buildings that meet more stringent criteria outpacing supply.

Conversely, should a landlord fail to make the required improvements to a less energy efficient office, they may struggle to let the building and the asset may become stranded. Furthermore, new regulations could necessitate costly upgrades.

The same consideration applies to markets like infrastructure, where technological advances in fibre optic cables are effectively rendering older copper cables obsolete. Fibre cables are not only more efficient and less energy intensive than copper cables, but are less vulnerable to extreme weather conditions.

It is not just technological advances that can increase obsolescence risk. Climate change could have the same effect. This was illustrated in France last year when energy supplier EDF temporarily reduced output at its nuclear power stations on the Rhône and Garonne as heatwaves restricted its ability to use river water to cool the plants.

Other assets located close to coasts could prove vulnerable to rising sea levels or an increase in storm surges. Such physical risks needed to be factored into a holistic ESG assessment of new opportunities to mitigate risk.

Considering an investment’s ESG credentials is not merely a matter of filtering out riskier assets. Integrating ESG into investment processes has the potential to add value by helping investors identify ways in which they may improve an asset’s ESG credentials.

In the debt world, this could take the form of writing ESG covenants into legal agreements to mandate reporting of certain ESG metrics or identifying specific metrics for a borrower to improve upon and incentivising them to achieve these. These could include improving the EPC ratings of homes or commercial buildings, installing energy efficient lighting or insulation, replacing gas boilers with heat pumps, or increasing recycling rates or the volume of materials re-used or re-purposed.

Investors are increasingly using private markets as a means of influencing social and environmental changes, including establishing diversity, equity and inclusion policies to improve the diversity of a borrower’s workplace. Other examples include establishing partnerships to install rooftop solar panels or EV-charging infrastructure.

Private markets can also add value in areas or sectors that urgently need investment and cannot access government funding, such as social housing. Investment in this sector can deliver positive impacts to local communities and address urgent social and national needs, at the same time as providing stable cashflows for investors. This is why it is an important area of focus within our private debt business.


  1. A whole loan is a type of loan made against real estate assets, akin to a unitranche loan in the corporate debt world. It is a first-ranking loan provided at a higher advance rate than a typical senior loan, paying a blended return equivalent to that of senior and mezzanine/junior tranches. The loan is secured by a first-ranking mortgage and comprehensive security package.

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