Unwelcome publicity for private debt

Unwelcome publicity for private debt

A combination of increased competition for traditional investment opportunities and growing investor enthusiasm has prompted a growing number of asset managers to spend more time looking at the potential of private debt deals. 

Private debt fundraising levels are on track to at least match last year’s figure, with 300 funds currently in the market seeking an aggregate $146bn in targeted capital, according to data from Preqin.

Industry assets reached $595bn as of the end of June 2016 despite $95bn being returned to investors in 2015 and a further $58bn returned in the first half of last year. 

The firm’s survey of private debt fund managers found that 61% were reviewing a greater number of potential investments than a year earlier and 90% said investor appetite for private debt had risen.

This tallies with the firm’s investor research, which found that 68% of investors held a positive view of the asset class. An almost fourfold increase in the size of its flagship Montello Real Estate Opportunity Fund over the last 18 months is evidence of growing investor awareness of direct lending, according to Carl Giannotta, director of LendInvest Capital.

THE SEARCH FOR YIELD

Interest rate yields on cash and government securities as well as the need for further diversification are two of the main factors that ensure continued growth into the second half of 2017.

“Investors continue to seek consistent income-producing strategies not correlated with public markets and we have benefitted from the attractiveness of UK real estate,” says Giannotta. “We are the senior lender on almost all of the loans that we originate and our investors appreciate the downside protection that this brings.”

However, high levels of deployable capital and a growing number of sophisticated industry participants prompted 43% of the managers surveyed by Preqin to suggest that it had become more difficult to find attractive investment opportunities compared to the same period in 2016.

In some cases this has prompted funds to partner with banks to get access into the large non-sponsored market. 

The managers surveyed by Preqin collectively stated that direct lending/ senior debt strategies is the most promising strategy for the next 12 months, although support for mezzanine and subordinated debt has also risen strongly. More than half plan to offer co-investments over the next 12 months, a sign that investors are increasingly interested in alternative investment structures.

More than half plan to offer co-investments over the next 12 months, a sign that investors are increasingly interested in alternative investment structures.

Demand for unitranche (combined senior and subordinated debt) and more subordinated structures can be explained by the fact that most of the capital being raised is still looking for 7-9% returns and is therefore not comparable to bank financing says Mike Anderson, head of investor relations at Pemberton.

This presents a problem for managers since bfinance research indicates that portfolios with large proportions of traditional senior secured loans are increasingly unable to meet such return expectations. 

The firm has found that core senior or non-unitranche debt in Europe now produces returns of 5-6% with average cash yields around or slightly below 4%.

Senior debt remains the primary strategy for the bulk of direct lending funds, with 81% of vehicles closed since the start of 2015 using a senior debt approach explains Ryan Flanders, head of private debt products at Preqin.

“However, we have seen more vehicles closed focusing on direct lending strategies within specific sectors such as healthcare, energy, technology and property,” he says. “This marks a shift from the diversified approach that direct lending funds have historically taken and indicates the market is broadening.”

MATURING MARKET

Christopher McChesney, senior vice president, alternative fund services at Brown Brothers Harriman, observes that some managers are specialising in specific strategies such as emerging markets, senior loans or unitranche deals, while others are coming to market with second or third funds that are moving up and down the capital structure.

On average the funds serviced by BBH are getting bigger and are doing larger deals, he says. “Deal identification is becoming increasingly competitive. 

Many managers have collaborative relationships with banks for sourcing deals and they often work together to meet a borrower’s needs for a total financing solution that could include, for example, a revolving credit line and senior loan from a bank and a subordinated loan from a fund.”

Insight Investment portfolio manager Ranbir Lakhpuri cautions that the weight of money in the market means that spreads have been tightening, arguably too much in some sectors given the risks. “It is therefore important to pick and choose sectors and investments carefully, particularly given the significantly lower liquidity in the direct lending market,” he says.

Given the crowded nature of direct SME lending, Insight Investment has looked to differentiate its proposition by leveraging off its strengths in secured finance with solutions in the asset-backed sector, adds Lakhpuri.

He suggests that not only is this field less crowded – which provides for better execution – but also that there is diversity among opportunities and some better-rated investments are available in asset-backed deals.

“We have seen aircraft leasing, ship leasing and many more new strategies being deployed,” says Pemberton’s Anderson.

“It is the natural evolution of the market to think about different areas within the credit environment. The challenge for a lot of those areas is that they haven’t scaled sufficiently yet. 

The big question is whether they are speciality niche strategies – or are they mainstream and scalable like the corporate lending funds have proved themselves to be?” 

 

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