What is driving the continued growth of private debt?
As LP appetites for private debt continue to hold up, fund managers are sitting on $364bn of dry powder, according to the latest Preqin numbers. And there is likely more to come: the number of private debt funds actively fundraising more than doubled between January 2017 to July 2021 to 651 funds seeking US$295bn (versus 303 funds targeting US$130bn).
Much of its growth is down to LP satisfaction at a time when persistently low interest rates and a desire for diversification are prompting investors to consider opportunities outside traditional fixed income products. This is especially true of investors that are dipping their toes into the market. “A number of our investors are newer to the asset class,” says Abhik Das, Head of Private Debt at Golding Capital Partners. “They tend to view private debt as a ‘simple’ replacement for fixed income and some even look at the asset class as a diversifier to their investment grade book. These investors tend to be happy with a 5% net return – for them, corporate, sponsor-backed direct lending is a good place to be.” Many more experienced LPs are also positive about the asset class. Generali Group, for example, is further down the line in building its exposure to private debt as it has been in the market since 2013.
“Private debt has performed well and in line with our expectations,” says the insurance company’s Head of Insurance Investment Solutions, Filippo Casagrande. “It has continued to deliver a premium to public markets and we’ve so far had a good experience through COVID.”
Even so, Casagrande adds a note of caution: “We need to continue to understand what’s happening in our portfolio and give it a bit more time to be sure that it will be robust for us,” he says.
As a relatively young asset class – in Europe in particular – private debt had been operating in largely favourable conditions for most of its life. Until COVID, that is. “Investors really needed a sanity test for private debt,” says John Bohill, Partner at StepStone Group. “Compared with other asset classes, such as private equity, it was relatively untested and many of the managers hadn’t operated through more challenging times. It is arguable whether COVID was an appropriate test, but most investors would agree that it was a destabilising event.”
And while most investors appear satisfied with the way managers have operated through COVID, many are looking further out to see what happens next in the market’s development. “There was a huge amount of government stimulus through the pandemic,” says a UK-based LP. “It was hard for a business to fail. It’s really only as we recover that we’ll see whether businesses are able to repay and how, and whether they have traded through this. We’re not through the crisis yet.”
Even when it’s clear at this stage that performance has been less than stellar, getting to the numbers may be tricky for now, as Leo Fletcher-Smith, Strategy Head, European Private Credit at Aksia, points out. “By the end of 2020, we saw a very distinct bifurcation – borrowers either did well or pretty badly with not much in between,” he says. “Yet 2020 performance numbers are polluted by noise that stems from GP-derived marks. In some instances, the marks are robust, conservative and accurate reflections of risk; in others, there is much more variability and subjectivity being introduced.”
Others agree that there are signs of a divergence in performance between different managers even if this hasn’t yet fully flowed through to reported figures. “COVID was a clear test to the system,” says Das. “And it was the first one for many. All managers had at least one or two issues in their portfolios but many performed very well through the period. I have heard, though, that there is some dispersion of returns coming through as some GPs were more disciplined than others and we are aware of situations in which companies ran out of liquidity well before a covenant breach. Some managers will have done very well out of the crisis; others won’t.”
“We expect to see the fundamental credit performance start to manifest itself over time in both marks and IRR,” adds Fletcher-Smith. “We’re seeing the seeds of divergence in track record and returns emerge, particularly in performing credit.”
For some, the pandemic has highlighted the benefits of scale. “COVID shows that this market naturally favours larger managers with larger, more diversified portfolios and diversified risks,” says Bohill. “If we look at US and European exposure, for example, we’ve seen pricing compression at different stages as liquidity measures have come in at different stages, so there is a lot of benefit of having exposure to both.”
It’s a different story for some GPs further down the size spectrum, however, he adds. “Where smaller managers have faced idiosyncratic exposure and had there not been support from governments and other stakeholders, they would have been somewhat challenged,” says Bohill. “We have seen some GP consolidation activity, but that hasn’t really been for defensive reasons – it has been largely driven by synergies. Yet, while we haven’t seen a clear out at market level, fundraising has naturally gravitated towards larger managers.”
Indeed, 61% of the capital being sought by managers raising for private debt was for funds of $1bn or more, according to Preqin. Yet this trend of capital concentration raises questions for some LPs. “We have a large amount of capital to deploy,” says Casagrande. “However, we are looking to mix investments in large debt funds with others of more limited size in order to limit negative consequences. One of these is that there is less efficient capital deployment and another is that you see a concentration of a few players into a limited number of super-large transactions.”
As a result, Casagrande says Generali’s approach has to be to “continue to improve our manager selection and understand how well GPs have access to different businesses and geographic markets”. Yet as a more experienced investor, Generali is also looking further afield than the larger brand name GPs. “In 2020, we started to look at some specialist and smaller distressed funds,” says Casagrande. “We’re looking for GPs operating in spaces where they can add value and have expertise in less competitive spaces, so we’re seeking opportunities in different strategies and that use different collateral from more traditional corporate lending, including areas such as mortgages and receivables.”
Indeed, as experience levels are ticking up among LPs, we’re likely to see a broadening of private debt options open up as investors seek further diversification and more efficient capital deployment. “Some of our European LPs have been investing in private debt since 2009 or 2010,” says Das. “They have large portfolios across senior-focused corporate private debt and are now thinking: what’s next? The beauty and problem with the asset class is that capital comes back quite quickly and so investors have to work out what to do with that capital. They are looking at other areas, some within the corporate space, such as subordinated capital to sponsorless businesses or large-cap second lien or mezzanine deals at the larger end of the spectrum. Many are also spending more time with distressed or special situation funds, as well as niche strategies, such as royalties.”
Others are seeking out what some might perceive as even more esoteric exposure. “We have a few positions in younger companies,” says the UK-based LP. “Venture debt and growth and technology lending are growing in Europe. These are, in many ways, counter-intuitive because companies are losing a lot of money and, in some cases, have little or no revenue. That goes against all the rules of debt investing, but they are raising a lot of sponsor capital, which is invested in intellectual property of some kind so there is good protection and recovery is strong. The returns are interesting, the cash yield is particularly strong and we have good downside protection.”
Overall, it looks as though LPs have had a positive experience of private debt investing so far. While there may be some bumps on the horizon as the effects of the pandemic and the withdrawal of liquidity initiatives start to work through the economy – with some managers affected by this more than others – the increasing breadth of opportunity in the asset class will continue to attract LP capital, both new and experienced alike. As the UK-based LP says: “The asset class is very rich and diverse. There are good reasons why new investors should stick to traditional direct lenders. The experience and quality of the managers and their depth of resource, especially around difficult credits, provides investors with reassurance. Yet there are also wider opportunities that, while time-intensive and require strong relationships with managers – offer good diversification and attractive returns.”
