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Consultant warns on changing risks in private debt sector

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Some private debt funds have become riskier as managers chase yield to meet investor demand, according to consultant bfinance.

Yields on senior direct lending funds – the most popular form of private debt among institutional investors – have been compressed in recent years following a surge of demand, bfinance said in a new report on the asset class, published today.

The consultancy firm said: “We are frequently asked: ‘Is now a good time to invest?’ While 
the answer may still be ‘yes’, a deep understanding of what’s under the bonnet will be key to successful implementation.”

Although private debt funds raised less money in 2016 than the previous year according to Preqin data, unused capital hit a record high of more than $220bn (€206bn).

bfinance said it worked on private debt mandates worth more than $1.25bn last year, more than double the volume of 2015. Roughly three quarters of this was corporate lending.

“We expect significant performance dispersion between upper and lower quartile managers in this more competitive environment,” the consultant said.

Analysis by bfinance showed most European private debt fund managers still expected returns of around 8% from senior funds. However, the consultancy claimed, “portfolios with large proportions of traditional senior secured loans cannot drive such expectations”.

“Core senior debt in Europe now produces returns of 5-6% with average cash yields at around or slightly below 4%,” bfinance said. “This signifies noticeable spread compression since 2012.”

As a result, the consultancy said investors should “focus on the nature of the senior debt” in funds they are considering, as well as the proportion invested in subordinated (higher risk) debt. Some managers had raised their limits for investment in riskier debt above 20% in senior funds.

In addition to falling yields, bfinance warned of managers using more leverage than in previous years, and of covenants being eroded – known as “cov-lite”.

Cov-lite structures “may, in theory, hold
 the potential for increased credit risk”, bfinance said. The lender – and therefore the asset owner – has less visibility on the borrower, for example.

However, bfinance said some funds had introduced other forms of oversight to mitigate the loss of traditional covenant protections, such as a seat on the board of the borrowing company.

On costs, the consultancy reported there was “considerable flexibility” for fee negotiation around the industry norm of a 1% management charge with a 15% carry for senior funds.

“Hurdle rates, catch-ups, and administrative charges prove critical to overall leakage and should be handled with care,” bfinance added.

The trade off between risk and reward in private debt was still “highly attractive in relative terms”, bfinance said, but it was also “somewhat less favourable than it was four years ago”.

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