This article is sponsored by Ardian
Mark Brenke, head of private debt at Ardian, reflects on the lessons learnt from covid-19; why the future of the European private debt market looks bright despite short- and medium-term challenges; and how ESG should be an important factor in portfolio construction and management.
What lessons from the pandemic need to be borne in mind for European private debt going forward?
Our portfolio has proven resilient and performed strongly through the pandemic. We strengthened our monitoring and undertook detailed financial and covenant analysis to ensure we were doing everything we could to support the portfolio. All in all, I would say the impact of the pandemic to our portfolio has been very limited, and our investment activities continue to be very much in line with pre-covid expectations.
Reflecting on the main reasons for our robust performance through the pandemic, I’d start with the nature of our strategy which focuses on resilient business models, rather than specific sectors. We have always focused on financing companies that are less cyclical with predictable revenues, so our portfolio consists of cash-generative businesses with good visibility on earnings.
I’d certainly highlight the importance of scale – in our view scale matters more than ever in European private debt. With $114 billion of AUM, Ardian is the largest European alternative asset manager and private debt is an important part of that. As an institution that has scale, this allows us to have advantages when it comes to sourcing dealflow, execution and portfolio management – these benefits of scale will become increasingly important. There are also benefits when it comes to fundraising, as we have a large investor relations team that is constantly speaking to investors.
In what other ways does scale make a difference?
Since our strategy is a high control, mid-market focused, direct-lending strategy, the scale benefit of sourcing deals is particularly important. Thanks to our scale, we can afford to make long-term and costly investments into building up our local office network and our teams on the ground. And, for our type of strategy, having a local approach is crucial to sourcing the broadest and deepest dealflow, which ultimately allows us to choose the most attractive opportunities.
It’s also important to have the right size platform relative to the market opportunity, to retain a high degree of selectivity. That, ultimately, is the driver of your longer-term performance. It’s not size for the sake of it – I don’t think that’s a long-term sustainable approach. At Ardian Private Debt, we have always matched our fund size to the underlying market opportunity, so we have never been under undue pressure to deploy. If a platform is too big for the opportunity set, you run the risk of overextending yourself.
In aggressive market environments, it’s easier for private debt managers to significantly increase the size of their funds. But then that forces you to sacrifice deal selectivity for deployment, which can sow the seeds of potential issues in your portfolio in a more challenging market environment, such as the pandemic over the last 18 months.
What are the main mega-trends that will impact European private debt in the years to come?
I think it’s going to be a continuation of what we’ve seen so far. Over the last 10 years, the main fundamental trend has been the secular bank retrenchment in Europe on the back of the 2008-09 crisis. The requirement for European banks to address the quality of their loan books and their loan return on equity, as well as increasing regulation, has led to the continued bank retrenchment. The pandemic hasn’t necessarily accelerated this trend to the same degree we saw 10 years ago, but, in our view, it has amplified it and we expect bank retrenchment to continue.
We also expect ESG to become a greater priority for all private debt fund managers over the coming years, as regulation and rapidly increasing interest from investors drive the need to make ESG central both to the funds’ own operations and to the loans that they provide. Approaches to ESG in private debt will become increasingly sophisticated and those acting now will reap competitive advantage.
How would this impact the demand for private debt?
Demand for the private debt opportunity will continue to be strong longer term. Over the last decade, institutional investors have built up a degree of experience with private debt, and the asset class is now firmly established in their portfolios. There has been a rising demand for private debt, given the perceived attractive risk-reward benefits. But one of the big questions until now was, ‘How will private debt perform in a more challenging market environment?’ That outstanding question has now been resolved.
The performance of private debt on an absolute basis – but also relative to other, more liquid, debt investment products – has been positive. Also, interest rates are likely to continue to stay lower for longer, so the attractive risk-return dynamic in the European private debt market will continue as a result of that. Given all these factors, I expect investor demand for private debt to remain strong.
ESG is a hot topic today. How will the industry – and Ardian in particular – continue to focus on it going forward?
Driven by increasing investor requirements, ESG focus has grown over the last 18 months, and it will continue growing. And private debt managers will have to increasingly incorporate it into their investment approach. As an institution, this is not a new development for us. Going back 12 years now, Ardian incorporated ESG considerations in its investment approach – we were one of the first signatories to the UN Principles for Responsible Investment. Within Ardian Private Debt, we’re drawing on the best practice of our institutional knowledge of ESG compatibility – we have a five-person strong dedicated in-house ESG team to ensure ESG consistency across our various strategies. As such, we have a two-step approach to integrating ESG criteria and as part of our due diligence we carry out ESG analysis of the asset as well of the sponsor.
More broadly, we are seeing increased sophistication when it comes to ESG information gathering. At the moment, most private debt managers who are focused on ESG send questionnaires out to their portfolio companies for ESG KPIs and then look to get as much information back. We, as an institution – and I think this is something that will develop in the market as well – are investing into IT resources to automate the access to this information. As a manager, we understand the importance of investing into these resources – and again there’s a scale requirement to be able to do that.
Mega-trends aside, what are the main short to medium-term opportunities in the European private debt market?
There will be more investor demand for private debt and that opportunity will disproportionately fall on to those managers that have navigated the pandemic well. Validated with increasing demand from investors, these managers will attract more money and raise greater funds. Again, managers still need to ensure that they retain the balance between the size of the fund and the market opportunity, but the overall private debt market is growing on the back of bank retrenchment and increasing penetration of private debt in Europe. On the other hand, those managers that have not navigated the pandemic well will find it more difficult to raise funds. So, over time, we expect to see consolidation in the market.
And what are the challenges for European private debt?
In terms of challenges, they are probably more short-term. The ongoing covid-19 situation, for instance, is not behind us yet so we shouldn’t become complacent. In this sense, private debt managers need to be as proactive as possible, with necessary resources to support the portfolio and dedicated portfolio management teams to navigate ongoing short-term challenges.
In the medium term, there’s still a question around regulation. There’s potential for increased regulation of the European private debt market, but it’s too early to say. Private debt as an asset class has evolved very strongly and resiliently over the last two years relative to other asset classes.
In our view, there’s no reason for private debt to need increasing regulation, as private debt funds – even the larger ones – wouldn’t pose the same systemic risks as a bank. If a bank had issues in its lending portfolio, there could be transmission mechanisms into the retail market payment provision. Whereas private debt funds don’t have the same transmission mechanisms as a bank – it’s just not comparable.
What can private debt funds do to make their portfolios more resilient in the post-covid world?
Your strategy is an important driver to future-proofing your portfolio, in conjunction with what I mentioned previously around the right size of your platform. In this sense, we’ve got the balance between the right size of our private debt platform and the market opportunity in such a way that we retain a high degree of selectivity, whilst obviously being one of the most active players in the market.
Within our private debt strategy – which is a high-control, high-quality private strategy – we are focused on business models that benefit from non-discretionary spend, with very visible revenue, such as subscription-driven business models, which are normally cash-generative. Those businesses particularly prevail in, for example, healthcare, B2B services, IT services and financial services. This has definitely been an important reason why our portfolio has performed so strongly.
Conversely, we’ve not done any new lending activity in consumer retail for more than seven years now. In our view, those types of lending opportunities are more relevant for an opportunistic credit strategy as opposed to a high-quality, high-control private debt strategy such as ours. We tend to do deals with a high degree of control – at a minimum we have a majority stake, and in the vast majority of cases we are a sole lender. We also focus on doing deals where the legal documentation is sufficiently strong.
Those private debt managers that have been disciplined in their credit selection and ensuring the legal documentation has sufficient risk controls, will become increasingly differentiated in a more challenging market environment.