Willis Towers Watson has published a new report, “Finding Value in Private Debt,” underscoring the challenges facing institutional asset owners when it comes to finding compelling opportunities in private debt.

According to the report, adoption of private debt has become more widespread among asset owners, with assets allocated to credit strategies more than tripling between 2007 and 2017. However, Willis Towers Watson researchers believe that investors are placing too much focus on mid-market corporate direct lending, “thereby missing out on opportunities in less competitive parts of the market that could offer greater return outcomes.”

“The private debt market has grown substantially in a relatively short space of time and continues to do so in an increasingly diverse manner,” explains Chris Redmond, global head of credit and diversifying strategies at Willis Towers Watson. “As the market widens, its complexities become more difficult to understand, with the majority of institutional investors continuing to concentrate their activities on mid-market corporate direct lending.”

The report suggests one main result is large capital flows into a squeezed portion of the market, creating downward pressure on returns and upward pressure on risk.

“With this portion of the market demonstrating signs of deterioration in future return potential, Willis Towers Watson believes that investors must make sure they continue to direct capital toward areas offering the best risk-adjusted returns,” the report warns. Adding to the issue, Willis Towers Watson finds there is “a tendency for managers to focus on ideas that can be quickly raised, are scalable and profitable to run—which ultimately results in them flocking toward very similar opportunities.”

Redmond points to better opportunities in smaller niche strategies, which are harder to scale and typically offered by specialist managers.

“These are often the most compelling, particularly when faced with higher valuations such as those we see in most credit markets today,” he explains. “Investors who are willing to pair with specialist lending teams in specific geographies and assets are ultimately going to derive the greatest benefit in the long term. Similarly, investors’ willing to embrace complexity and revisit asset classes tainted by prior poor performance are also likely to be well rewarded.”

One other challenge identified in the report is that many investors are unwilling to be a first mover into markets that have experienced historical performance issues.

“U.S. residential mortgages are a great example of this,” Redmond concludes. “It’s a sector that we believe has demonstrated improved fundamentals while delivering excellent performance, both on an absolute and risk-adjusted basis.”

The full report is available for download here.