This article is sponsored by Apex Group
With the private debt product continuing its expansion and diversification into new industries, how can technology help managers stay on top of the bespoke nature of their reporting and responsibilities?
Eddie Kelly: Technology has opened the door to the asset class becoming more mainstream. Where technology has spent many years catching up for secondary market traded loans, the focus has now shifted to private debt, making it more accessible to new jurisdictions and industries.
We are always moving forward from a technology perspective and increasingly focusing on products that can support managers and open new opportunities for investors. Whether the target is real estate and infrastructure debt, trade finance or other industries, there is going to be a requirement for much more detail on the underlying assets and technology can provide those solutions.
The focus for us and other service providers has shifted to capturing all of this data and giving managers access so that they can avoid that investment themselves which makes them quicker to market and increases their profit margin.
With more and more private debt structures launching around the globe, what challenges will managers face when it comes to valuation of their portfolio?
EK: Access to accurate and up-to-date information is going to be extremely important for all managers going forward, whether using external valuation agents or internal valuation committees. But the requirements for LPs and investors are only going to increase and they will be looking for increasingly more granular insights on the portfolio and where the risk lies.
The pandemic highlighted the importance of that flow of information and accurately valuing the portfolio – if you have all the information in front of you, you have a far better chance of making informed decisions. However, the more diverse the borrower pool, the harder it will be to automate this type of information, therefore those who can find a way for this to be accessible to all will reap the benefits.
Agnes Mazurek: There is an increasing need for transparency on a number of levels. When it comes to ESG, for example, the importance of data access and being able to monitor the performance of an asset in more ways than were relevant before is a challenge. That need for transparency from an investor perspective goes straight to the point of valuation, and the ability to have data processed in a quick and professional manner is a core strength for managers in the current environment.
How has the pandemic affected fundraising in the private debt space and what are the nuances in the way different strategies have reacted?
AM: We’ve seen private debt emerge as a new asset class in the wake of the global financial crisis and last year it proved its worth in a volatile year. From a volume perspective, AUM for private debt has increased to close to $900 billion as of June 2020, according to Preqin, making it the largest alternative asset class behind private equity and real estate.
As far as specific strategies are concerned, there have been two dynamics at play in allocation decisions: taking advantage of the dislocation brought about by the pandemic, and a defensive positioning. Accordingly, the proportion of managers active in distressed and special situations grew in 2020. In terms of market share, distressed debt fund managers gained 5 percentage points in 2020 to reach close to 20 percent of the market, while special situations gained 4 percentage points, again reaching close to 20 percent of the total market.
Those shifts suggest investors and managers sensed an opportunity to fund post-pandemic corporate restructuring. At the same time, direct lending accounted for 43 percent of aggregate capital raised in 2020, reaching a 30 percent market share, suggesting many investors continue to position themselves defensively.
As with any market where demand (investor liquidity) outstrips offer (deals), downward pressure on returns or a temptation for lenders to accept looser structural terms can be feared. In that context, lenders’ discipline and uncompromising due diligence become increasingly important. This is especially true for new products and strategies that claim strong ESG credentials, for example, which call for a data-driven approach to assess and monitor ESG compliance.
What geographic trends do you see at play in the space?
AM: From a geographical perspective, historically fund managers competing for assets in private debt were largely North American private equity funds, but in recent years more mainstream fund groups from across the globe have engaged with this asset class. In line with this trend, while funds focusing on North America constitute 61 percent of total AUM, other regions have gradually expanded their share. This is particularly the case for Europe-focused AUM, which now makes up just under 30 percent of the total, up from just over a quarter five years ago.
This steady growth in demand for European private debt has been aided by an extremely low-rate environment. Furthermore, economic growth in Europe is very dependent on SMEs, which make up the bulk of lending opportunities.
Private debt requires a reasonably sophisticated regulatory environment, with good visibility around insolvency laws, which means Europe and North America can be expected to continue dominating. To put things into perspective, as of January 2021 there were fewer managers in Asia, LatAm, Middle East and Africa and Australia combined than in Europe, which itself was half of North America.
But we certainly see niche opportunities in other regions. There are clearly pockets of investor liquidity, with certain sovereign wealth funds increasingly active in the asset class with regional mandates. But the focus will remain on sourcing opportunities with reasonably predictable returns, making mature markets a natural fit.
How has the unprecedented volume of government intervention affected the dynamics of private credit on the supply side?
AM: We have all heard about the volumes of government support for the economies of Europe and North America, which are the two core markets for private credit. The direct effect of that intervention has been that it enabled companies that went into the crisis on a weak footing to buy time, creating a trail of distressed and special situations opportunities that will materialise in the year to come. Some companies have been artificially kept alive and are in dire need of financial and structural change, which will create transaction volume for those strategies.
The other aspect is that a lot of government intervention has targeted sectors that are part of the energy transition, something that was already in train pre-pandemic but where governments have directed a large volume of funds since. The shift mirrors that in public markets: energy companies represented 7 percent of the S&P500 index in 2015; by 2021 that share had fallen to about 2 percent. That has accelerated the need for direct lending and infrastructure debt and created a large pipeline of opportunities.
With private debt reaching maturity, are we seeing a consolidation of the market with fewer managers and, consequently, no space for new entrants? Or is there still an option for managers to branch out into new strategies or for new entrants to build successful franchises? What are the pitfalls and the key factors of success?
AM: The fundraising market in 2020 was very challenging, partly because of practical challenges around restrictions on travel and face-to-face meetings. That made LP due diligence more complicated and new solutions had to be found for manager selection. The fundraising market was still quite successful for private credit, though first-time managers struggled, and the 10 largest private debt funds accounted for 39 percent of the total capital raised, compared to 31 percent in 2019. A lot of money was raised, but in fewer hands.
The times when ex-bankers who were good at doing deals could be successful at persuading investors they could easily do the job of an asset manager are behind us. With the main private debt strategies having become mainstream, investors are spoilt for choice and they are also clear on what they expect from their managers. As such, we have seen the number of co-investment structures alongside funds on the rise, signalling that investors want to increase their exposure to the asset class in more ways than one, and be more in control over that exposure.
“For any new player, the key thing is differentiation from what is on offer elsewhere”
For any new player, the key thing is differentiation from what is on offer elsewhere, an impeccable team track record – both on deal sourcing and asset management – and a wide web of relationships with service providers and investors. Managers may be very good at technology or the back office, but that is not intuitively where they will stand out on their own. They are, therefore, probably better off teaming up with partners who have developed a technical skillset and the human capital to deliver the requisite technology solutions.
EK: There will always be opportunities for new entrants. As borrowers become more sophisticated and more in tune with the private debt offering, their ability to look for improved terms and even more flexibility to suit their businesses will drive innovation.
We have only touched the surface of the number of industries that are ready to engage with private debt structures, with a long way to go and a lot of opportunities for managers to engage.
It is up to the industry to get the message out, not only to new industries but also to new markets where there remain massive opportunities, like Latin America, Asia and Africa. Technology will have a key role to play in supporting managers through that expansion.
Eddie Kelly is global head of loan services and Agnes Mazurek is private debt consultant at Apex Group. All data quoted in this article is from Preqin