Debt financing on private equity seen as one way to boost income

If your clients are thirsting for income, the current markets are offering them a long sip of sand. Yet one part of the solution to the thirst for yield is debt financing on private equity, says Brody Browe, senior vice president of investment management at FS Investments. Speaking at InvestmentNews' Alternative Investments conference in Miami Tuesday, Mr. Browe noted that investor goals are timeless. “You're building a portfolio for three things: Growth, income and diversification,” he said. “But there are challenges to achieving them.” For income investors, the challenge is low interest rates around the world. Despite the recent run-up in yields, the bellwether 10-year Treasury note still yields just 2.23%, and the average money-market mutual fund yields 0.14%. Furthermore, declining gross domestic product growth and bursting bubbles are deflationary, and deflation keeps interest rates low. Most experts now predict low returns from stocks going forward. Given that stocks have a standard deviation of 17, an average return of 4% to 6% doesn't offer a terribly good risk-adjusted return, Mr. Browe said. Yet the U.S. middle market accounts for about a third of U.S. GDP and a third of all U.S. jobs. By itself, the middle market would be the world's third largest economy. Private equity lending to that sector can produce yields of 7% to 12% for companies that originate the loans directly. Lenders have direct access to company information, and can tailor covenants in the loans to their requirements. The flip side, of course, is that private-equity loans are far less liquid than, say, bank loans or other broadly syndicated loans. For that reason, manager selection is vital. “Dispersion of returns is massive in private equity,” Mr. Browe said. “When there's information asymmetry, that's where the manager matters most.” More importantly, it's where clients' liquidity needs matter most.