White Paper
Optimizing the Efficient Frontier: Opportunistic Credit Amid a Capital Structure Reset

For institutional portfolios with moderate-to-high allocations to public equities, we believe Opportunistic Credit (OC) strategies represent an underutilized means of achieving higher returns at the same level of risk.

In a representative institutional portfolio, with 70% weight on public market securities and 30% weight on private funds, we found that an optimization within the private sleeve favors OC over Private Equity (PE). In fact, OC’s lower correlation with the public portfolio, coupled with attractive returns and lower volatility, results in the efficient frontier being pushed out by 40 basis points annually per similar unit of risk versus a portfolio without OC.

Before running our optimization, we desmoothed the private fund indices to put private strategies on a level playing field with public securities. Published PE indices, in particular, have a built-in smoothing effect as the underlying PE fund assets are “marked-to-model” instead of marked-to-market, with suspiciously steady valuations that often lag large swings in public markets. After desmoothing, we found the volatility of PE doubles relative to the raw index—jumping from 10% to 20%—and the correlation with public equities hovers near 90%, consistent with academic and practitioner research.

While PE is the largest private asset class at $9 trillion and has delivered attractive historical returns, forward returns are likely to be lower due to capital saturation and the higher-for-longer interest rate regime, which limits the benefits of financial engineering previously enjoyed during the zero interest rate policy (ZIRP) era.

By contrast, OC is a relatively small asset class at $640 billion—just 7% of PE’s size—despite a growing global opportunity set of PE-owned companies requiring capital solutions, balance sheet restructurings and operational execution, which we believe will enable OC managers to achieve strong returns in line with historical averages.

In the U.S., elevated leverage, aging PE portfolios, and delayed restructurings suggest we remain in the early innings of a capital structure reset, which should benefit OC. Despite the PE industry extending runways with payment-in-kind (PIK) interest and liability management exercises (LMEs), the reality of high purchase prices during ZIRP followed by the normalization of interest rates has led to elevated leverage and liquidity constraints for many companies that will need to contend more holistically with their capital structures. 

In Europe, a sustained bank-led credit contraction, particularly for more complex situations that require bespoke financing, has resulted in a durable opportunity set characterized by regulatory dynamics and fragmentation, which has led to parts of Southern Europe in particular being structurally under-banked.

OC’s combination of attractive returns, lower volatility, and lower correlation enhances portfolio efficiency, while the normalization of interest rates and rising refinancing pressure have expanded the universe of companies requiring balance sheet repair. With dedicated OC capital comparatively limited, there is less competition for complex restructuring, capital solutions and special situations transactions —supporting continued alpha generation.