The private debt market continues to grow in size and attractiveness
- Private debt has become too big too ignore as an asset class
- Mid-market lending has become increasingly popular
- Opportunities are available in both the US and Europe
Private debt has become an asset class simply too big and too important to ignore. As a predominantly floating-rate asset class in an environment of rising rates, its appeal can only grow.
For investors, the market can be confusing as not only are there many ways of defining private debt, it also forms a sub-set of a larger class of alternative debt strategies. These have grown in size since the global financial crisis of a decade ago as banks have withdrawn from lending.
In the US, other institutions have been lending directly to the corporate sector for decades but Europe is seeing a more recent transition from the banking sector to non-bank lenders.
Most private-debt opportunities are issued to help finance acquisitions of mid-market companies by private equity firms. These cover three distinct categories. First, liquid senior loans broadly syndicated by banks. Tranches can be in excess of $1bn (€870m) and issued by stable companies. They typically offer relatively low returns but can be used as a cash management tool by fixed-income investors because of their high liquidity.
Investment managers such as Partners Group target smaller investments in large liquid loans as part of their collateralised loan obligation (CLO) and liquid loans business, says Christopher Bone, European head of private debt.
Second, there are direct loans which are typically senior loans originated by a single lender or a small group and are generally illiquid.
Third, there are subordinated loans including second-lien, mezzanine, and hold-company tranches. They lack liquiduity but offer the highest return potential.
For investors, it is not just that floating rate nature that offers advantages. Most debt opportunities are senior secured, which means that they have strong downside protection as recovery rates are high. These performed relatively well compared with other asset classes during the global financial crisis, says Bone. Illiquid debt gives a return premium and there can be a 4% yield premium of second-lien debt over first-lien in the same company.
When it comes to subordinated debt, Partners Group’s strategy is to invest in larger companies with specific characteristics such as stable recurring cash flows and high cash-conversion levels, as they would be better placed to withstand a cyclical downturn.
One of the attractive features of the sector, Bone argues, is that loan-to-value ratios are at about 50% to 60% so there can still be an equity cushion of 40-50% in the companies to which they lend. That level is significant even when possible overvaluations of the equity are taken into account.
The growing attractiveness of the marketplace brings its own dangers. Increasing amounts of capital chasing fewer deals means pricing pressure is lowering returns and increasing risks through weakened debt covenants. Railpen, the €30bn UK multi-employer scheme, sees elevated competition among direct lenders, says Nick Gray, investment manager in RPMI, Railpen’s private markets team. He says there is room for the current large numbers of lenders and borrowers as long as leveraged-buyout activity continues.
Supply and demand for capital appears to be well-balanced at the moment but there are lurking dangers. “The key concerns for our loan book are creeping leverage multiples and weakening covenant packages,” Gray says.
Manager selection is also a key factor. “The key differentiator is origination capability,” Gray says. “We want to avoid lending in highly competitive auction processes and prefer lenders who can generate their own deal flow.”
There are significant differences between the US and Europe, according to Eric Lloyd, head of global private finance at Barings. In Europe, private debt is typically issued as just a single tranche of debt, while in the US it is more usual to have a mezzanine-debt layer or second lien below the first lien. Historically, European mezzanine debt was floating, while the US has had fixed-rate mezzanine debt, which meant that as base rates fell, returns were able to be maintained.
In Europe, private-equity sponsors typically invest alongside a single debt investor in firms generating earnings before interest, tax, depreciation and amortisation (EBITDA) of about €10-50m.
In the US, a sponsor might work with one debt provider initially to finalise pricing terms and the key credit considerations for the deal and then go to two or three other providers of capital alongside the lead.
One of the reasons may be that there are more buy-and-build strategies in the private equity arena in the US than in Europe. A private equity firm will buy an initial platform company for $250m (€219m), representing 10 times EBITDA of $25m and then grow that by acquisition to $60-70m EBITDA. Having multiple providers of capital is beneficial to the equity holders. It means they may outgrow the capacity available from a single provider and that relieves them of the pressures of having to market the deal to a new debt provider.
The US has a deep and well-established private-debt environment. In contrast, Europe’s is of more recent origin but it looks as though it is here to stay. While there may be an oversupply of capital in the larger European mid-market, Kirsten Bode, co-head of European private debt at Muzinich, estimates that there are 100,000 businesses in the European lower mid-market, but fewer lenders.
There are several barriers to entry that many direct lending operators are unable or unwilling to meet. The diversity is challenging as lenders need to find specialist profitable niches in which they can operate. These can vary by country with Germany and Italy, for example, having a greater proportion of industrials, while the UK has more professional services businesses.
For investors, there is a case for having as broad a diversification as possible through global funds. Barings finds offering a global fund enables it to pick and choose sectors depending on the local conditions. Healthcare in the US, for example, is a problematic sector for lenders, says Lloyd. Typical loans have a maturity of five to seven years but every four years, there is a risk of change in healthcare policy. As a result, Barings does not invest in a large amount of US healthcare opportunities as policy changes create uncertainties over credit quality during the life of a loan.
In contrast, healthcare policies in Europe and Australia are far more stable. “In Australia, some of our best deals have been in healthcare,” Lloyd says.
Scale and scope
The private-debt asset class extends way beyond mid-market corporate direct lending. Gregg Disdale, a consultant at Willis Towers Watson, argues that with mid-market lending showing signs of credit deterioration and lower future returns, investors should exploit the full breadth of private-debt markets. That enables them to direct capital to wherever offers the most attractive risk-adjusted returns. These include opportunities such as real estate in Europe, where banks have stepped out of commercial property lending in areas where there are no long leases, no stable income and properties are being converted to new uses.
In the US, he sees opportunities in US residential property, the epicentre of the global financial crisis, where regulations have led to a dramatic decrease in credit available.
Not surprisingly, the interest in private debt has led to the establishment of new boutique firms. These compete with moves into the space by the large traditional fixed-income houses and large private equity firms that already have experience in the mid-market space. Disdale says Willis Towers Watsons prefers specialist boutique firms focusing on particular lines of business. For example, lending against value-added property.
Private debt still has value despite the meaningful capital that has already flowed into the asset class. But investors need to use their precious illiquidity budget to focus on opportunities where the market has attractive tailwinds supporting asset prices. These offer attractive compensation for the risks, rather than relying on manager skill to compensate for an unattractive market beta.
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