3.1 How Institutional Investors Can Use Long-term Private Debt as an Impact Investment Strategy
By Ommeed Sathe, Vice-President, Impact Investments, Office of Corporate Social Responsibility, Prudential
- For investors, long-term private debt offers compelling combinations of tangible social benefits and allows for larger allocations, current yield and more predictable cash flows without investment limitations inherent to early-stage private equity and venture capital.
- Private debt offers the opportunity to structure legally enforceable covenants around social performance and ensure heightened reporting requirements.
- For investees, private debt can provide long-term financing, resulting in better planning and financial stability for the borrower and allowing for a longer investment horizon to incorporate more sustainable approaches.
Prudential Financial, Inc. (“PRU”) established a dedicated impact investing (II) unit in 1976. Since that time, the group has made nearly $2 billion in investments across a variety of asset classes, including private debt and equity, mortgages, tax credits, real estate investment trusts and structured products. The current portfolio is approximately $400 million and PRU recently committed to increase the portfolio to over $1 billion by 2020, making it one of the largest institutional impact investors in the world.
While PRU’s II unit makes investments across asset classes, we are relatively unusual in that over 60% of our portfolio is comprised of private debt instruments. We believe that customized private debt solutions2 can significantly advance social impact while maintaining appropriate risk-adjusted returns. For example, our recent debt authorizations have supported capital intensive next-generation manufacturing enterprises, innovative education delivery models and new approaches to the provision of life-saving commodities. These social strategies have been achieved while producing strong yields and loss severities that outperform those of public high yield debt.
PRU’s focus on private debt is a stark departure from the mainstream conversations around impact investing, which have tended to coalesce around either public markets (carbon disinvestment, ESG screened bond funds) or early-stage private equity/venture capital. While both of these broad rubrics offer promise for creating social impact, each has significant drawbacks that limit their potential appeal to institutional investors. In the public markets, collective action among numerous investors is required to lead to proactive changes and, for the most part, these changes tend to consist of avoiding harm rather than creating affirmative social benefits. For large institutional investors, the sheer breadth and complexity of their portfolios may also make it infeasible and potentially hypocritical to engage in this level of investor activity. On the other hand, while early-stage equity investments can provide a direct and tangible connection between an investment and the intended social outcome, they often involve heightened risk and tend to be categorized as alternative investments, which comprise a very small part of most investors’ portfolios.
We believe that private lending can be a middle ground that provides greater control over social benefit by the investor while also allowing larger allocations, current yield and more predictable cash flows. Our experience therefore suggests that increasing private debt allocations within impact portfolios can help play a crucial role in scaling those portfolios, particularly for institutional entities and endowments. In the analysis below, we explore key benefits that private placements hold for generating social impact and delivering appropriate risk-adjusted returns. We then turn to barriers to entry to increasing private debt allocations.
Private debt as an effective tool for scaling social impact
Jobs and basic needs: Distilled to their essence, many of the world’s greatest social challenges are either the absence of basic needs – such as food, water, shelter and energy – or an outgrowth of poverty from a lack of employment. From an investment perspective, most interventions around basic needs tend to be capital inefficient and therefore disfavoured by traditional venture capital and private equity. Likewise, most early-stage investors target interventions that can scale rapidly with limited increases to overhead (i.e. hiring). This leaves a wide array of socially beneficial and job-creating opportunities that will not be well served by conventional early-stage financing. On the opposite end of the spectrum, most large public market entities only derive a modest amount of revenues from addressing these underserved markets and it can be very difficult to direct investments to these purposes in public markets. In addition, numerous socially responsible borrowers lack the scale to address traditional public markets and may need greater flexibility than can be provided through public markets.
Mission control: Many early impact investors have invested in equity transactions (either directly or indirectly) in which their capital is pooled with traditional capital. As equity investors, there is typically little operational control (absent a board seat) and without a “Benefit Corporation” legal structure, or something similar, little to safeguard the social mission of a company. By strong contrast, private debt instruments offer the opportunity to structure legally enforceable covenants around social performance and, at a minimum, secure heightened reporting requirements. From a social perspective, this is a major advantage that private placements hold over public bonds.
Sustainable extraction models: Long duration debt instruments are also crucial to aligning business practices to more sustainable approaches that generate benefits over a long period of time. The most obvious example of this is energy efficiency financing, in which the investment horizon (for both borrower and lender) essentially dictates which improvements are financially feasible as well as the aggregate amount of energy savings. Longer investment horizons also allow numerous other sustainable practices, including responsible farming, marine stewardship and sustainable timber, to generate adequate returns to offset initial shortfalls or investments in innovation.
Improved alignment: Longer investment horizons can also foster greater alignment between capital providers and borrowers. For many operating businesses, the need to continually refinance indebtedness is a constant distraction that takes away from operational improvements and restrains innovation. Perhaps the best example of this in our portfolio is our long-dated charter school loans that finance facilities on a 15-20 year basis, allowing management to focus solely on operations without worrying that a single lean year will throw off their next refinancing.
Arguably, this need for patient capital could eventually be met in the public markets, but currently they fail to appropriately price these investments since they couple early-stage operational risk with significant asset protection. It is also far easier as a single senior creditor to structure customized covenants and identify and establish appropriate approaches to solve for operational deficiencies.
Changing operator profile: Non-profits (and many cooperative structures) are excluded from equity financing, dramatically limiting the field of potential investees. Perhaps the best example of the role that liquid long-term debt markets can play in fostering social impact by non-traditional entities is in American affordable housing, where over 1.5 million units have been produced by non-profits, many of which access private debt for projects at leverage ratios above 90%. Allowing non-profits to compete in this market has made it easier to direct public subsidies into the sector and also provided a crucial safeguard against abuses from purely profit-motivated enterprises.
Private debt as a strong solution for institutional investors
Private debt offers low hurdles: All forms of public debt are witnessing unprecedented low yields and the spread compression for more risky assets has been significant. As a result, the “market rate” return for debt investments presents a very low bar and the implied yield on the high yield index has recently fallen below 6%. As a risk-adjusted return, this figure seems especially paltry since research suggests that, over a 40-year period, high yield debt instruments have suffered average loss severities of approximately 240 basis points.3 For an impact investor, this means there is ample room to either make safer or higher yielding investments. Since implementing our current investment strategy, PRU has done both.
Debt can price opportunity cost: This is a subtle but important factor for many of the institutions currently lost in the debate over whether impact investing provides a market rate of return. Debt can be externally or internally rated and compared to an appropriate benchmark. Where necessary, a fixed expense can be incurred to account for any perceived below-market characteristics and this amount can become a part of an annual operating budget. As investments perform (particularly when they exceed expectations), this initial discount is fed back into investment performance. This fixed opportunity cost also allows for appropriate internal risk management and a clear means of establishing budgets and authority for impact investing groups.
Debt is familiar and scalable: Many large institutions have significant regulatory or cultural barriers against private equity or similar alternative asset classes. As a result, allocations to these assets are often modest and they are expected to generate outsized returns (despite the spurious evidence on median historic performance). This creates a significantly higher perceived opportunity cost for impact investing. By contrast, fixed-income allocations are generating extremely low coupons and many debt managers are desperately looking to identify new yield producing assets. This dynamic makes it far easier to raise impact investing capital for debt investments than equity investments. Debt markets are also designed to handle larger commitments and can better digest larger minimum investment sizes.
Debt provides early performance signals: Unlike private equity and venture capital, which exhibit pronounced “J curves” and therefore delay evaluation, debt investments can provide quick insight into portfolio performance. This allows for positive feedback and increased allocations as well as negative feedback to permit strategy changes.
Barriers to entry for increasing private debt allocations
Unfamiliar asset class: Traditionally, private placement debt instruments have been a relatively modest part of the overall debt marketplace with a fairly consolidated marketplace of originators. In the mainstream market, Prudential Capital Group is one of the largest entities and has a portfolio of over $68 billion as of 31 March 2014. Because the size of the market is limited and less liquid than that of public debt, a number of investors have historically ignored private placements within asset allocation strategies and therefore adding them as part of an impact mandate may necessitate a broader conversation.
In that regard, the historic performance of private debt is encouraging when compared to public debt and for many institutional investors the lack of liquidity in this marketplace is not as significant a hindrance. Furthermore, asset management fees on private debt are significantly less than on private equity or many other alternative assets, making it cheaper to use fund intermediaries. Private placements also offer additional features not always available for equity-based strategies. These include participations, syndications, small direct sales and investments in sub-accounts of established fund managers.
Limited intermediaries: All impact investing intermediaries struggle to reach sufficient size to become sustainable organizations. This is particularly acute for private debt since management fees are typically lower, and there is limited carried interest and significant overhead involved with establishing a lending operation. As a result, there are few standalone intermediaries in this space. While non-specialized private debt intermediaries could create separate accounts, they will typically lack the deal flow from specialized originators and also may not be familiar with either the markets for social purpose enterprise or the credit enhancements that often support these actors.
Alternative credit profiles: A number of social purpose enterprises are small to mid-market-sized companies that will lack accurate third party ratings. They also frequently address markets or segments in which there are complex interactions between government and private resources (healthcare, education, non-profits) that play a crucial role in shaping the likelihood of repayment. We have found at PRU that the quasi permanence of our financing and our willingness to explore alternatives to traditional rules for credit have led to solving our clients’ financing requirements while maintaining a strong portfolio of credits. We also have often worked closely with borrowers to identify and recruit appropriate forms of enhancement where transactions needed these features.
Exercise of remedies: One of the most difficult aspects of using debt for generating social impact is the inevitability of having to exercise remedies that can in certain instances put an enterprise out of business. This can create awkward reputational challenges and strong disincentives to taking action. Arguably, a key reason for institutional investors to use fund intermediaries is to avoid this dimension. It is also worth noting that socially aligned lenders can also extend greater flexibility than conventional lenders in exercising remedies and facilitating restructurings.
Equity in disguise: For entities making debt investment directly, it is vital that debt not be used to support transactions that actually require equity investments. One of the reasons we maintain a diversified portfolio is to preserve the ability to consider whether a transaction is best made using debt or equity (or not made). Keeping such a blended portfolio is crucial to maintaining disciplined underwriting and retaining the flexibility to target attractive investment opportunities across the capital spectrum.
While there are a number of barriers to identifying and making private debt investments, it is an asset class that can play a crucial role in both creating social impact and scaling the level of institutional commitments to impact investing. We at PRU have found that maintaining a significant commitment to private debt has been crucial to our evolution and we intend to maintain that commitment as we grow the portfolio to over $1 billion in assets.
Prudential Financial, Inc. of the United States is not affiliated with Prudential plc. which is headquartered in the United Kingdom.
This material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service. Prudential Financial, Inc., its affiliates, and their financial professionals do not render tax or legal advice. Please consult with your tax and legal advisors regarding your personal circumstances. Prudential, the Prudential logo and the Rock Symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. Prudential Financial, Inc. of the United States is not affiliated with Prudential plc., which is headquartered in the United Kingdom.