MODULE 2: PUBLIC-PRIVATE CREDIT 2.3 Allocating to public-private credit

This video explores the how to introduce public-private credit to enhance fixed income, allocation and diversification of a portfolio.

Victoria Quach

Senior client analytics manager at Capital Group

7MINVIDEO

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Victoria Quach, Senior client analytics manager at Capital Group

 

Elsewhere in this course, we’ve discussed the key features of private credit and the roles that it can play in a portfolio — including seeking higher potential returns, greater diversification and an expanded opportunity set. But what does this look like in practice? Let’s consider how you might allocate to semi-liquid fixed income-based solutions in a portfolio. 

 

In this lesson, we’ll explore what adding some private credit alongside public fixed income can do for your client’s portfolio. We’ll look at some example personas and considerations related to liquidity. First, let’s look at a spectrum of success factors and their alignment to three common portfolio objectives: growth, growth and income, and preservation and income. Because this lesson focuses on allocating to private credit, we will focus our allocation examples on portfolio objectives where consistent income generation and diversification are critical like growth and income and preservation and income. 

 

For those investors seeking long-term growth of capital and income, the primary goal may be risk-adjusted return and yield while attributes like reducing drawdown may be less important. Investors seeking current income and capital preservation, limiting drawdown may be a primary consideration followed by yield and volatility — with returns and risk-adjusted returns being less important.  

 

While a well-designed fixed income allocation is essential for anyone with these objectives, it’s important to also consider how an allocation to private credit may support a variety of portfolios.     

 

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In the following sections of the video, hypothetical investor personas are considered along with sample portfolio allocations. Each investor profile highlights key characteristics that influence the asset allocation decision including risk capacity, time horizon and liquidity needs. The Public-Private+ Credit solutions proposed in the allocations are the Capital Group KKR Core Plus+ and Capital Group KKR Multi-Sector+ funds. 

 

Let’s consider a financially stable client, Sam, with a steady income source and ability to weather market downturns. Sam is seeking a balance of growth and income, with a long investment time horizon, and because of his steady income source can tolerate some illiquidity and market volatility.

 

Given Sam’s objectives, a traditional equity/fixed income allocation might be 75/25. If Sam doesn’t rely on his investment portfolio for liquidity, then he can put some of his excess liquidity capacity to work through private credit exposures that could seek higher yields and potential greater diversification.

 

How might his 75/25 portfolio be re-allocated? Well, let’s imagine the portfolio is converted from a liquid fixed income allocation to a semi-liquid 75/22/3 split. He may want to consider Capital Group KKR Multi-Sector+.

 

Next, let’s consider a client approaching or early in retirement. Carla is financially stable with some years to invest. She’s willing to take on some market risk but isn’t overly aggressive, aiming to generate income while maintaining growth potential. We would consider Carla a moderately conservative investor with an intermediate investment horizon. 

 

Given Carla’s objectives, a traditional equity/fixed income allocation might be 50/50. Again, if Carla was willing to give up some liquidity in her fixed income allocation for private credit exposures, how might her 50/50 portfolio be re-allocated? We might imagine that 14% of the portfolio is converted from a liquid fixed income allocation to a semi-liquid 50/36/14 split. Within that 14%, she may want to consider 7% allocation to Capital Group KKR Multi-Sector+ and 7% allocated to Capital Group KKR Core Plus+.

 

[upbeat music]

 

Now, we’re going to examine a relatively conservative use case for investors who want to take advantage of private credit with more of an eye towards risk management. In this final example, let’s look at someone who’s retired with meaningful assets who is willing to accept some volatility. Rose seeks income and wants to maintain purchasing power but needs modest capital stability. We would consider Rose a conservative investor given her medium risk and illiquidity capacity and shorter time horizon. 

 

Given Rose’s objectives, a traditional equity/fixed income allocation might be 20/80. If she was willing to give up some liquidity in her fixed income allocation, how might her 20/80 portfolio be re-allocated? We might imagine the portfolio be converted from a liquid fixed income allocation to a semi-liquid 20/70/10 split. Within the 10%, she may want to consider Capital Group KKR Core Plus+.

 

These sample portfolios illustrate why Public-Private+ funds may be a consideration for investors who can tolerate less liquidity and credit exposure in exchange for seeking added diversification, expanded opportunities and increased returns over time.

 

When considering and discussing such products with your clients, it will be key to explain the illiquidity challenges but also the potentially higher long-term returns or income and consider if this investment is appropriate, given these features.

 

When thinking about your current clients’ portfolios, ask yourself these three questions: Who has at least moderate risk tolerance? Intermediate or longer investment horizon? And finally, low-to-moderate liquidity needs? That wraps up this discussion of some potential allocation ideas for public-private solutions. Thank you for your time.  

 

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Is there a “right size” allocation for public-private solutions you should target for clients? The short answer is “no”: It will vary with each investor. Let’s look at a few sample portfolios and consider how you might allocate to semi-liquid fixed income-based solutions in a portfolio. 

 

In the following case studies, hypothetical investor personas are considered along with sample portfolio allocations. Each investor profile highlights key characteristics that influence the asset allocation decision including risk capacity, time horizon and liquidity needs.   

 

What to keep in mind

 

  1. An interval fund is a semi-liquid vehicle, and the underlying private investments are themselves generally less liquid than public securities. Moving into these products can mean sacrificing some liquidity in the pursuit of potentially higher returns.                                                                                    
  2. Consider public-private credit investments that are packaged in interval funds as a segment of a portfolio’s existing fixed income allocation.

 

Who are these products for?

 

Long-term investors who seek higher yields and broad sources of returns and who can tolerate lower liquidity may be better suited for these funds.

 

 

Consider the following hypothetical portfolios:

 

Case study #1: Sam

 

First, let’s consider a financially stable client, Sam, with a steady income source and ability to weather market downturns. Sam is seeking a balance of growth and income with a long investment time horizon, and because of his steady income source he can tolerate some illiquidity and market volatility.

 

Given Sam’s objectives, a traditional equity/fixed income allocation might be 75/25. If Sam doesn’t rely on his investment portfolio for liquidity, then he can put some of his excess liquidity capacity to work through private credit exposures that could seek higher yields and potential greater diversification. How might his 75/25 portfolio be re-allocated?

 

We might imagine that 3% of the portfolio is converted from a liquid fixed income allocation to a semi-liquid 75/22/3 split. Within that 3%, he might want to consider allocating to Capital Group KKR Multi-Sector+.

For illustrative purposes only.

Case study #2: Carla

 

Next, let’s consider a client approaching or early in retirement. Carla is financially stable with some years to invest. She’s willing to take on some market risk but is not overly aggressive, aiming to generate income while maintaining growth potential. We would consider Carla a moderately conservative investor with an intermediate investment horizon.  

 

Given Carla’s objectives, a traditional equity/fixed income allocation might be 50/50. Again, if Carla was willing to give up some Iiquidity in her fixed income allocation for private credit exposures, how might her 50/50 portfolio be re-allocated?

 

We might imagine that 14% of the portfolio is converted from a liquid fixed income allocation to a semi-liquid 50/36/14 split. Within that 14%, she might want to consider a 7% allocation to Capital Group KKR Multi-Sector+ and 7% to Capital Group KKR Core Plus+.

For illustrative purposes only.

Case study #3: Rose:

 

Now, we’re going to examine a relatively conservative use case for investors who want to take advantage of private credit with more of an eye towards risk management. 

 

In this final example, let’s look at a retired client with meaningful assets who is willing to accept some volatility. Rose seeks income and wants to maintain purchasing power but needs modest capital stability. We would consider Rose a conservative investor given her medium risk and illiquidity capacity and shorter time horizon. 

 

Given Rose’s objectives, a traditional equity/fixed income allocation might be 20/80. If she was willing to give up some Iiquidity in her fixed income allocation, how might her 20/80 portfolio be re-allocated? 

 

We might imagine that 17% of the portfolio is converted from a liquid fixed income allocation to a semi-liquid 20/70/10 split. Within that 10%, she might want to consider allocating to Capital Group KKR Core Plus+.

For illustrative purposes only.

Checkpoint

Now that you have completed this lesson, you should be able to confidently:

 

  • Begin assessing your clients’ portfolios for potential allocations to public-private credit solutions, considering each client’s unique goals and circumstances.                                                                                                  
  • Clearly articulate to your different client segments the potential benefits and liquidity risks of public-private credit solutions.

Takeaways

Allocating to public-private credit

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The next lesson you will learn more about the public-private credit funds from Capital Group and KKR.

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Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the interval fund prospectuses, which can be obtained from a financial professional and should be read carefully before investing.
For Public-Private+ Funds: Capital Group KKR Core Plus+ and Capital Group KKR Multi-Sector+ are interval funds that currently provides liquidity to shareholders through quarterly repurchase offers of up to 10% of its outstanding shares. Capital Group KKR U.S. Equity+ is an interval fund that currently provides liquidity to shareholders through quarterly repurchase offers of 5% of its outstanding shares. To the extent a higher percent of outstanding shares are tendered for repurchase, the redemption proceeds are generally distributed proportionately to redeeming investors (“proration”). Due to this repurchase limit, shareholders may be unable to liquidate all or a portion of their investment during a particular repurchase offer window. In addition, anticipating proration, some shareholders may request more shares to be repurchased than they actually wish, increasing the likelihood of proration. Shares are not listed on any stock exchange, and we do not expect a secondary market in the shares to develop. Due to these restrictions, investors should consider their investment in the fund to be subject to illiquidity risk.

- Investment strategies are not guaranteed to meet their objectives and are subject to loss. Investing in the fund is not suitable for all investors. Investors should consult their investment professional before making an investment decision and evaluate their ability to invest for the long term. Because of the nature of the fund's investments, the results of the fund's operations may be volatile. Accordingly, investors should understand that past performance is not indicative of future results.

- Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility. These risks may be heightened in connection with investments in developing countries.

- Illiquid assets are more difficult to sell and may become impossible to sell in volatile market conditions. Reduced liquidity may have an adverse impact on the market price of such holdings, and the fund may be unable to sell such holdings when necessary to meet its liquidity needs or to try to limit losses, or may be forced to sell at a loss. Illiquid assets are also generally difficult to value because they rarely have readily available market quotations. Such securities require fair value pricing, which is based on subjective judgments and may differ materially from the value that would be realized if the security were to be sold. Situations involving uncertainties as to valuation of assets held by the fund could have an adverse effect on the returns of the fund.

- The fund is a non-diversified fund that has the ability to invest a larger percentage of assets in the securities of a smaller number of issuers than a diversified fund. As a result, poor results by a single issuer could adversely affect fund results more than if the fund were invested in a larger number of issuers.

 

For Public-Private Credit+ Funds:

- Bond investments may be worth more or less than the original cost when redeemed. High‐yield, lower‐rated, securities involve greater risk than higher‐rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

- The funds may invest in structured products, which generally entail risks associated with derivative instruments and bear risks of the underlying investments, index or reference obligation. These securities include asset-based finance securities, mortgage-related assets and other asset-backed instruments, which may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market's perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations.

- While not directly correlated to changes in interest rates, the values of inflation-linked bonds generally fluctuate in response to changes in real interest rates and may experience greater losses than other debt securities with similar durations. The use of derivatives involves a variety of risks, which may be different from, or greater than, the risks associated with investing in traditional securities, such as stocks and bonds.

- The fund invests in private, illiquid credit securities, consisting primarily of loans and asset-backed finance securities. The fund may invest in or originate senior loans, which hold the most senior position in a business's capital structure. Some senior loans lack an active trading market and are subject to resale restrictions, leading to potential illiquidity. The fund may need to sell other investments or borrow to meet obligations. The funds may also invest in mezzanine debt, which is generally unsecured and subordinated, carrying higher credit and liquidity risk than investment-grade corporate obligations. Default rates for mezzanine debt have historically been higher than for investment-grade securities. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy.

 

For Public-Private Equity+ Funds:

- The fund also intends to concentrate in the financial services group of industries, and to invest at least 80% of its assets in securities issued by companies based in the United States.

- K-PEC and co-investment risks: The fund's investments in KKR Private Equity Conglomerate LLC (“K-PEC”) and co-investments alongside K-PEC or one or more other KKR vehicles that pursue private equity strategies entail additional risks. Private equity investments are typically illiquid, speculative, and difficult to value, often requiring multi-year holding periods with returns generally realized only upon sale or refinancing of a portfolio company. These investments depend on access to financing, and market disruptions or increased competition may limit opportunities and affect performance. The fund's significant investment in K-PEC creates concentration risk and a decline in K-PEC's value could materially impact the fund's returns. Co‑investment opportunities are competitive and limited and there is no assurance the fund will receive allocations or comparable terms and will generally have less information than for public companies. Through its investments in K-PEC or other KKR Vehicles and co-investments, the fund may have exposure to portfolio companies with limited operating histories, evolving markets, unproven technologies, and inexperienced management, which may require significant capital and create heightened vulnerability to downturns. Most holdings are illiquid, subject to resale restrictions and may require consents or be sold at a discount. Costs associated with investments in private equity are generally greater than those of investments in other asset classes. In addition to bearing their portion of the fund's fees and expenses, shareholders in the fund will indirectly bear a portion of the asset-based fees, incentive fees and other expenses incurred by the fund as an investor in K-PEC or other KKR Vehicles and in co-investments. Incentive fees are paid to KKR when the fund's investments in K-PEC or other KKR Vehicles and/or co-investments deliver returns in excess of a specified hurdle; when paid, these fees reduce the net realized returns of such investments.

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