As published in Private Debt Investor.
Managers who continue to work constructively with their underlying portfolio and are increasingly selective on new investments will emerge from this latest challenge strong, says Keith Miller, global head of private debt at Apex Group.
Inflation! This, particularly in the US, is caused by a tightening of the labour market and supply shortages across the board and is exacerbated by increased energy prices. That is causing significant challenges to the private debt market and is going to be an issue for longer than people had perhaps originally anticipated.
That said, the private debt market is well placed to withstand an increase in inflation compared with other asset classes. This is due to a number of reasons, including the fact that the products are generally based on floating interest rates and on amortising positions, and that they are typically shorter in duration than most debt out there. The naturally higher yields in private debt provide more of a cushion for investors, and there is also often interest rate hedging in place for the underlying companies.
All of that means private debt is relatively well protected, but a lot of what happens going forward will depend on the actual underlying investments, the industries and how aligned those are to inflationary pressures. One of the big factors that will impact the success of private credit funds will be whether or not they are in sectors where inflationary costs can be passed back through to the end client. The investments where that is the case are the ones that are going to weather the storm better.
The US market still massively leads the way globally in terms of private debt fundraising, and the trend over the last few years has been for US managers to raise significantly more capital than the rest of the world in this asset class. Within that, the trend has been for a continued shift towards fewer launches and funds but for those to be much larger in size, as capital has been concentrated in the hands of the most experienced managers. There are two factors that have led to that.
First, in a stressed environment, people are looking for a strong track record, and then at the same time we are also seeing much bigger ticket sizes on the investment side. With difficulties in the public markets, banks have been struggling to allocate capital in the leveraged finance space and so those large fund managers have been able to take market share and lead the way with the pure volume of capital getting allocated.
We can say those large funds are generalist funds, but that is not to overlook the specialist knowledge that exists within them in terms of sector expertise and geographic expertise. As a fund administrator, we are also seeing an increase in smaller, specialist funds successfully coming to market, and that will likely continue. Whether those strategies are in SME lending, receivable financing, infrastructure or sectors like healthcare, the natural benefits of focusing on segments of the market that are more resilient to inflation is not lost on investors.
So, broadly it seems that the larger generalist funds have an advantage, but outside of the mega-funds, there is a definite space for specialists. We are seeing far fewer new pure direct lending funds than we were a few years ago, because the investors in those are generally allocating to the large, experienced managers that are raising considerable amounts of capital.
So, broadly it seems that the larger generalist funds have an advantage, but outside of the mega-funds, there is a definite space for specialists.”
In times of uncertainty such as we are currently experiencing, investors are more focused on track record and experience. They want to work with people that have been through a cycle and are well prepared to deal with a stressed portfolio if that becomes necessary; whether that is operational stress in the underlying companies or more structural stress as they navigate the market as a whole.
We saw through the height of the pandemic that the larger private credit managers weathered the challenges incredibly well, with the asset class as a whole suffering very few defaults. Managers were able to be incredibly supportive with sponsors and borrowers on transactions and there was a lot of constructive engagement, which is what investors like to see.
Outside of that, investors are incredibly savvy and knowledgeable when looking to allocate their resources to specialist funds. They want to see funds that are well protected in the face of macroeconomic uncertainty, so they are looking for individuals that are deeply experienced in key sectors and that can identify businesses that are less exposed.
LPs want to work with direct lenders and credit funds that can handle distressed or stressed situations, and they are now highly sophisticated in their ability to evaluate and identify those capabilities.
There are probably two things to focus on here. First, if you look at existing portfolios, covid has taught us how resilient the private credit market is and the way that managers operated in 2020 can be replicated now to some extent, but for different reasons.
That proactivity of working with borrowers and sponsors to deal with issues, being really constructive and supportive, is going to continue and that approach is what has made the private credit market so successful over the last few years. That ability to identify issues early and react accordingly – whether by giving borrowers covenant relief or payment holidays for example – will continue to be critical in this new period of macroeconomic uncertainty.
Then, when it comes to new investments, managers will naturally need to be more selective, and we are seeing that already. The number of deals done in the first half of 2022 is down and that is because people are being a bit more thoughtful and careful on the investment side, with more due diligence in place and much more focus on inflation protections. That is only going to continue, and that cautious approach will be a key attribute of the managers that will do well in this market.
Where we see a direct impact from the point of view of the services that we provide as a fund administrator, is that people are a lot more interested in data from the underlying portfolio. We are providing a lot more real-time information on portfolio performance and at the investment stage to inform decision-making. The managers that we work for are looking for a lot more scrutiny around their books in order to identify any issues early, and they are seeking to conduct a lot more due diligence when considering going into new transactions.
When you look at a time like this, with more uncertainty and more stress at various levels, your natural response is to assume that the US private credit market will be facing more distressed funds and situations.
Actually, if you look at fundraising over the past year, distressed fundraising has remained relatively low, and that is in part because managers raised a lot of capital for those strategies at the start of the pandemic and have yet to deploy those funds. We will likely see more people stepping into that space, and we will also see more activity from managers that have funds ready and waiting to be allocated into distressed strategies at the right time.
It is also going to be very interesting to see, as we come through this cycle, whether the need for refinancing is to replace public markets and the broadly syndicated loan space with private debt is going to be here to stay. We do not yet know whether that public space will bounce back, or whether the market share gained by private credit funds during this period of volatility will represent a long-term shift. The private funds offer a lot to underlying borrowers and now that those companies have experienced that, they may not move away from private credit.
Investors are also continuing to become more sophisticated and private markets continue to become more accessible, so we expect to continue to see the growth of specialist strategies that respond to investor demand.
Finally, we also see ESG products starting to gain traction in the US market. The debt markets have always been behind private equity on ESG, and the US was also trailing Europe and Asia, but that is starting to change now. We are having a lot more conversations with managers and LPs around impact lending and ESG-focused lending, and there are strong messages coming out of the US government as it intensifies its commitment to environmental priorities. That is naturally going to flow through into private markets, as we are starting to see with some moves on the regulatory front, so while debt funds might have been slow to address ESG, there is a clear uptick in interest.
For all these reasons, the outlook for private debt funds in the US looks really positive right now, as they seize an opportunity to grow at a time when investors and borrowers alike are moving away from the more volatile stock and bond markets. Periods of volatility tend to play to the strengths of private credit, which has been through a challenging few years and emerged in an incredibly strong position.
Fund managers are simply set up to look at things differently to banks, viewing credits from a relationship perspective and working closely with sponsors and borrowers to work through difficulties. The next few years are not going to be any different to what we saw during the pandemic, so we can expect private credit to continue proving its endurance through all cycles.