What can we expect to see?
In the space of just a decade, European private debt has grown from a small, niche corner of alternative investment strategies to a significant contributor of finance to the region’s companies and an important element of institutional investors’ private markets exposure.
This reflects a global trend of investors seeking yield at a time of low interest rates and of banks retrenching in areas such as financing private equity-backed transactions. Indeed, worldwide private debt dry powder reached record highs at the end of December 2020 of US$320bn, up 19% on 2019 figures, according to Preqin. Yet, in contrast to the more established US market, most players in the European private debt scene had only experienced favourable economic conditions up until last year.
This had previously led to some to question how Europe’s nascent market might fare in a downturn. The events of the past year offered a backdrop that provides the answer – or at least part of it. “The market has demonstrated its resilience through the pandemic,” says Marcel Schindler, Partner and Head of Private Debt at Stepstone. “Many LPs had feared the strong performance seen in private debt through the GFC would not be repeated, especially as many firms in existence today had not been through a crisis before. That fear hasn’t materialised.”
This view is echoed by many other LPs, although they point to central bank and state-backed intervention as masking some of the challenges faced by borrowers. With government stimulus packages up to ten times the level seen in some countries, including Germany, France and the UK, according to McKinsey estimates from June 2020, the pandemic’s economic hit has certainly been dampened.
“At the onset of the pandemic, we were initially very concerned and conducted downside stress testing on the portfolio,” says Oliver Duff, Senior Managing Director and Global Head of Private Credit Investments at The Public Sector Pension Investment Board, which makes direct and fund investments in private credit. “But our portfolio has been surprisingly resilient and our operational forecasts in many cases turned out to be too pessimistic.”
He adds: “The combination of government support and strong liquidity overseen by central banks and regulators meant that the banks were forgiving of lenders that had short-term liquidity and sometimes covenant issues. Many lenders either gave covenant waivers or allowed borrowers flexibility to buy time for recovery. There was a very short period of dislocation in the March to May 2020 period, followed by a strong and quick recovery.”
Yet it’s what happens in 2021 and beyond that LPs have their eye on – and many are circumspect. “The second order effects have not yet been digested,” says Schindler. “Markets seem to be back to normal - leverage and loan to value ratios are back to pre-crisis levels and credit spreads are at record levels - but traces of the pandemic’s effects remain. We’re seeing higher dispersion of returns among GPs as well as higher dispersion of deployment rates.”
This point is echoed by Filippo Casagrande, Head of Insurance Portfolios Investment Strategy at Assicurazioni Generali. “It could be easy to conclude that private debt is a safe haven, but it’s just too early to say,” he says. “The 2020 crisis provided a first test for a private debt industry that has grown exponentially over the past decade. That said, central bank interventions have had a significant effect on public markets and so I see a lot of swings and volatility to come in the future. As for how this impacts private credit performance, it’s currently unclear. This will become more visible through 2021 and 2022, with performance numbers affected by what fund managers did in the run-up to the pandemic.”
This may ultimately impact LP decisions on whether to commit to individual funds, but not, it seems, around appetite for the asset class, which now occupies a permanent spot in many institutional investors’ portfolios.
The variety of strategies on offer with differing risk, return and investment horizon characteristics, is one of private debt’s main attractions, with insurance companies in particular opting for a combination of direct and fund investing.
“Whenever we have a great fit with our liability structure, we focus on building internal direct capabilities - infrastructure lending with long maturities is a prime example,” explains Sebastian Schroff, Global Head of Private Debt, Allianz Investment Management. “But we also allocate at scale to experienced GPs that have an edge in their respective areas. For example, in the US mid-market lending space we have built a balanced and resilient portfolio with external partners, also including niche strategies, such as non-sponsored transactions, or dedicated sector strategies, such as healthcare. Overall, the smaller the market segment and the underlying loans, the more fund structures are helpful to get granular and efficient access. Large scalable strategies, with typical ticket sizes of more than US$500mn for individual transactions, we hold directly.”
This variety within private debt – ranging from direct lending to more specialist segments, such as specialty finance and asset-based lending, allows investors to allocate according to need and preference. “We like short-dated loan exposure – around three years,” says Brandon Laughren, CIO of family office The Laughren Group. “We target parts of the market where you can achieve double-digit returns with no leverage on the underlying portfolio. We’re not looking for seven to 10-year lock-ups.”
Among the increasing number of investment strategies in the private debt space is the newly emerged secondaries market – a development that offers LPs liquidity as well as an additional way of accessing opportunities. It may have some way to go before it matches the scale of its private equity cousin, but it’s a corner of private debt that is becoming ever more active. “We’ve closed 30 transactions in the past two to three years,” says Toni Vainio, Partner at Pantheon. “There’s a large and growing market out there, from BDCs, to LP trades to tail-ends. It’s a way for LPs to manage their exposure and for GPs to rebalance their portfolios.”
The fact that private debt secondaries are still in early development can make them an attractive place to be, given low levels of competition for deals.
“Intermediaries have a tough time finding easily replicable transactions in the private credit secondary market,” says Jeff Hammer, Senior Managing Director and Global Co-Head of Secondaries, Manulife Investment Management. “Transactions are highly customised according to seller motivations. It’s an artisanal market. In addition to LPs, private credit secondary market sellers include direct lending funds, BDCs, insurance companies and banks. They each abide by a different set of regulations, which drives a diverse set of motivations. Negotiations are more important than auctions in this part of the market.”
He adds: “When you invest in a private credit secondary transaction, you are likely to get a better return for the same risk. Even if the underlying investments are senior secured performing loans, secondary market deal dynamics and the transaction structure are generally able to drive premium returns.”
Growing investment options and access points, combined with the growth of the market over recent years, means that, while investors are looking out for signs of trouble ahead, they also see opportunities. Marco Natoli, Head of Lower Mid-Market – Northern, Eastern and Southern Europe at the European Investment Fund, naturally sees the European mid-market as offering some of the most attractive investment options over the coming period. He points to lower competition and higher quality documentation here than in the larger deal space. “The lower mid-market funds have more influence over company direction,” he says. “They are often sole or main lenders and they are well positioned to intervene early in difficult situations – this was one of the big lessons learned from the GFC.”
He agrees that the pandemic’s full effects have not yet been absorbed by the market, yet is optimistic about the coming period. “It is reasonable to expect there will be a correction 12 to 18 months from now, but there will also be
the potential for a lot of opportunity when the public measures supporting liquidity end,” says Natoli. “Companies will really need finance when interventions are withdrawn; at that point in time, it will be crucial for GPs to distinguish between fundamentally strong companies and those that can’t recover. The players that can really do this will be able to exploit attractive opportunities, but they won’t be in plain vanilla debt, they will typically be bespoke.”
So while there may be some pain to come, the European private debt market looks set to grow still further. There is demand on the LP side, particularly as interest rates seem destined to remain low for some time to come. And there is demand from companies, which will increasingly turn to more flexible forms of finance as banks continue their retrenchment from the market. As Natoli says: “Private debt is around 50% of lending today in Europe, so there is scope for further growth. The coming period will test the resilience of lending models, but the fundamental drivers of growth in the European asset class are there. It will emerge out of the crisis even more robust.”
