Opening up the private debt market

February 2016  |  COVER STORY  |  BANKING & FINANCE

Financier Worldwide Magazine

Although its affirmation as an asset class in its own right is as yet unassigned, what is not in doubt is the private debt market’s status as a bona fide investment vehicle.

In pre-financial crisis days, when the act of lending money was a decidedly less restrictive activity than it is today, the private debt market was deemed to be a shadowy phenomenon by many investors; always there, but really existing somewhat under the radar.

Yet, in this post-financial crisis environment, the banking and finance sector has largely retreating from traditional lending practices. In H1 2015, European and US banks only represented 28 percent and 14 percent of the primary loan market respectively, according to S&P LCD Global Leverage Loan Review, Q2 2015. Against this backdrop, privately owned companies have increasingly turned to alternative, non-traditional sources of capital to access the funds they require to expand their operations.

Investors, of course, have been more than happy to reciprocate this burgeoning level of interest, resulting in plentiful opportunities for private debt investors as the private debt market opens up. Indeed, 2015 was witness to a string of major investments such as KKR & Co’s second direct lending fund at $1.5bn, Goldman Sachs Group’s Mezzanine Partners VI fund at $8bn, and Ares Management LP’s $3.19bn European Loan Program.

Much of the movement away from traditional bank lending practices can be laid at the door of a regulatory environment that has expanded rapidly in the wake of the crisis as a means of keeping the excesses in financial risk-taking firmly in check.

Presently, as we navigate our way through the early months of 2016, the private debt market is witnessing a veritable maelstrom of activity. The alternative assets research group Preqin reports that private debt funds in November 2015 saw more than $73.5bn committed across all strategies, with nearly $30bn allocated in the direct lending segment alone.

A viable investment option

Clearly, the private debt market is thriving and vibrant, with a range of factors driving the upsurge in market activity and its acceptance as a viable investment option. Furthermore, many market analysts are observing a new development in this space, namely, the impact of the private debt gatekeeper – a coordinative role that is taking on an ever greater influence as the private debt market grows.

“The most prominent driver of private debt viability in recent years has undoubtedly been bank disintermediation, grown out of necessity for banks to risk-off in the face of increased regulation and compliance mandates,” suggests Mr Flanders, head of private debt products at Preqin. “The process has essentially created the vacuum to be filled by non-bank lenders, as corporate borrowers with sufficient collateral and legal resources, after some initial reluctance, have focused less scepticism on lending source and more on borrowing terms.”

This repositioning has led to an extremely vibrant market, with investors increasingly realising the potential for exposure to bottom line profitability from private debt, specifically risk weighted returns achieved via senior lending.

According to Keirsten Lawton, co-head of US Private Equity Research at Cambridge Associates, much of the unprecedented vibrancy being seen in the private debt market can be attributed to three factors in particular. Firstly, yields in the private debt market are a beacon for investors lost in the enduring gloom of low interest rates. Secondly, low default rates are inspiring confidence in corporate borrowers. Thirdly, the regulation of traditional lenders has created ‘white space’ for lenders in the private debt market, allowing them to offer capital in imaginative ways whilst reducing borrower interest in accessing traditional lending.

“Before the great financial crisis private debt was not considered its own asset category,” says Keith M. Berlin, director of Global Fixed Income and Credit and senior vice president of the Fund Evaluation Group, LLC. “Today there are scores of private debt managers focusing on many areas, such as direct lending, mezzanine debt and ‘special situations’, which is a fancy term for anything debt-related that has a lock-up structure. The key factor driving investor interest is competitive returns relative to other private strategies such as real assets and private equity.”

On the demand side, the private debt market is indeed being driven by the banking industry’s retreat from traditional lending practices. Newer regulations and risk taking guidelines regarding collateral and transparency, together with pressure to become smaller and clean up legacy problems, have forced banks to re-evaluate less profitable and more unattractive activities.

On the supply side, the evaporation of yield in traditional fixed income markets such as investment grade bonds is leading investors to consider alternatives. In addition to the traditional fixed income risk premium for interest rate, credit and inflation risk, private credit offers additional premia for illiquidity, structuring skills and a favourable supply/demand scenario.

“The appeal of private debt funds is that they provide a contractual return with a running cash yield at low levels of risk,” says Jenny Blinch, a spokeswoman for Partners Group, a global private markets investment manager. “Private debt funds are typically seen by investors as a low-risk strategy offering attractive returns and an alternative to both bonds, which have been offering low to negative yields recently, and equity markets, which are more volatile.”

Also playing a critical role are the private debt gatekeepers who vet private debt managers for clients, a function requiring years of experience to attain the requisite familiarity with all the players in the various niches, in addition to having the nous to create a game plan for how to allocate among them.

Exploring the private debt option

For companies looking to explore non-traditional debt sources, there is a currently a wealth of opportunities to be tapped. Indeed, Ms Lawton believes that borrowers who make the decision to turn to the private debt markets are often surprised as to the number of lenders operating in the space. That said, as one might expect, there are advantages and disadvantages for those choosing to explore the private debt option. “These funds tend to be more creative and flexible, showing a willingness to work collaboratively not just with borrowers but also with other lenders and capital providers,” suggests Ms Lawton. “At the same time, banks’ retreat has allowed direct lenders and opportunity funds to raise prices, so borrowers may find the private debt markets to be more expensive than bank loans. More companies are accessing the private debt markets as bank lending declines. Direct lending was particularly torrid last year.”

Most companies ‘explore’ the private debt option out of need rather than want as they are too small to issue debt in the public markets, according to Mr Berlin. The biggest disadvantage for a small company, he suggests, is a higher cost of capital than a larger company that can issue in the public markets. Companies in need of capital to fund their business activities will, by and large, seek out the lowest cost option for that capital regardless of the source.

For the borrower, the advantage of exploring the private debt option is the longer maturities and more structural customisation to match the financing need compared to bank financing. Private lenders have also earned a reputation for being faster, more flexible and more predictable counterparties than banks. The disadvantage is generally the headline pricing as private loans tend to be more expensive than bank loans.

“Potential borrowers are of course going to be dubious regarding non-traditional debt sources, as the private debt phenomenon has only been relevant in larger communities for a few years, and is still growing,” says Mr Flanders. “That said, if the terms offered by non-traditional lenders are more favourable to the borrower or quicker to close due to increased competition for deal-flow among managers, borrowing companies are financially incentivised to work with a respected and well vetted alternative lender. There should not be a stigma attached to moving away from traditional lending in the name of the financial viability of a business, especially since banks are still heavily involved in other areas as they always have been,” he adds.

Private debt scrutiny

As with any financial or capital market, increasing scrutiny follows exponential growth – and the private debt market is no exception. “Government regulation is the norm, as they, whether it be effectively or not, enact legislation in an attempt to minimise market volatility,” explains Mr Flanders. “In looking at the more micro picture within private debt, when we hit any sort of stressed or higher default rate cycle, the enforceability of the agreements between lender and borrower will be the focus.” Furthermore, the newer, and growing, private debt market in Europe is likely to be a challenging environment when debt funds look to invest in European opportunities, especially when the question arises as to the extent of document enforceability in the event of a workout or recovery.

For highly-skilled private debt market participants, the regulatory landscape is changing, necessitating swifter action to mitigate risks and enhance returns while, at the same time, understanding (and withstanding) the realities of an enhanced level of scrutiny.

Private debt sustainability

For all its lucrative allure, the private debt market is a target for questions pertaining to sustainability, such as whether investor appetite is likely to persist over the long term, what factors may conceivably diminish current capital flows, and, overall, how sustainable the private debt space actually is in comparison with traditional lending practices.

The private debt space is certainly sustainable in the sense that post-crisis regulations have brought private money into the market to take on some of the risk that banks are no longer willing or able to deal with. And, as private debt becomes a more viable asset category for investors and returns outperform public market comparisons – such as the broad high yield indices – over the term of the fund’s life, the market should be quite sustainable. In an alternative scenario, weaker returns than the public market comparisons would be the primary factor that diminishes interest.

“Given proper underwriting and diligence practices by alternative lenders, private debt, in various forms, is a wholly sustainable concept,” argues Mr Flanders. “Economic and credit cycles are the main factors that would dictate capital flows and default rates, and sophisticated investors in these types of funds understand the nature of the assets in which they are invested. As long as skilled managers continue to select deals appropriately and produce favourable long term returns over that which can be attained in public markets on a risk-adjusted basis, there is no reason private debt managers cannot maintain their foothold in the lending arena, especially those underserved without access to the more liquid credit markets.”

Many practitioners are of the opinion that the regulation of traditional lending appears to be a secular trend, suggesting that the private debt market is likely here to stay. Investors with appropriate tax attributes and yield appetites, particularly inflation-protected yield, will continue to be interested in the private debt markets. However, as always, levels of investor interest will depend on the individual investor and on the economic and credit cycles.

And different strategies will perform differently at different times in these cycles. Consequently, changes in the economy or in default rates may diminish current capital flows. Also, lessened regulation could cause banks to return to their historic levels of activity, which would likely crowd out the private debt market.

According to Patrick Stutz, chief investment officer at Bayshore Capital Advisors, LLC, the rise of private debt financing is unlikely to be a short-lived phenomenon; rather, it is expected to become an established part of commercial funding. “We believe that the changes affecting banks are unlikely to reverse quickly,” he says. “History tells us that directional changes in the regulatory scrutiny for banks tend to last for decades. Most of us will spend the rest of our careers in an environment with restrained bank activity. Further, private lending is a very natural extension of the existing landscape of funding.”

Conclusion: the beginning of a new asset class?

Whether or not we are witnessing the beginning of a new asset class, there is now more than a whiff that the private debt market is in a similar position to that of private equity in the late 1990s, when it acquired the status of a real asset class. The private debt space is certainly on the up and up and is projected to expand rapidly in the months and years ahead.

“It’s likely that if more rapid expansion were to take place, it would be focused in emerging markets, although not likely in the near term,” says Mr Flanders. “With considerable opportunities still being uncovered in the US and across Europe, it’s more probable that managers will focus on fulfilling lending capacities in these areas at the current rate, one that suggests that private debt is surely an established asset class.”

For sure, the private debt market has expanded rapidly, with the pace of future expansion – emerging markets or otherwise – depending on the investor appetite for risk, which hinges on the individual investor and the economic and credit cycles. “Anecdotal evidence suggests that the expansion will continue and we are aware of several private debt market players that are expanding operations,” affirms Ms Lawton. “Private debt can be considered on the path to becoming an established asset class, and, as with any asset class, it holds unique opportunities and risks that investors should analyse before moving in.”

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Fraser Tennant