Banking on credit expertise(1)

As the asset class grows in popularity, questions arise as to whether everyone fundraising in private debt has the right skill-set.

Early entrants into the young asset class of private debt, and direct lending in particular, are reaping the benefits, exhibited for instance by ICG’s closing of its second direct lending fund on around $3 billion. And it appears there is still a lot to play for, with the bank disintermediation story set to continue and returns on a risk-adjusted basis said to look more attractive relative to other credit strategies, such as on the public bond markets. However, with volatility creeping into the market during the second half of last year and a wall of money developing after years of quantitative easing, people are wary that there is more risk around than a few years ago and growing increasingly concerned about who is investing in what.

Last week Tom Barrack, executive chairman of real estate manager Colony Capital, told Bloomberg that “everybody is outside of their own asset class”, meaning that there are amateurs all over riskier assets. Recent comments by JP Morgan chief Jamie Dimon also speculated on the potential negative behaviour of private debt fund managers towards borrowers in the next downturn.

In the US, cracks are starting to appear in some business development companies, with the assets of recent casualty MCG Capital gettingbought by rival PennantPark last week. MCG cited a credit-cycle peak for the sale and said it was buying back its stock with asset-sale proceeds. According to Forbes, the company had tried without success to unsaddle legacy assets from poorly performing traditional businesses and market sources said that the firm had made a few poor, isolated bets.

Meanwhile, near-term viability of leveraged buyouts, called into doubt by asset-price inflation, also casts a shadow onto private debt strategies which are still heavily reliant on the success of the former. As a result, the skill-set of private debt practitioners is set to become more important than ever.

The number of funds-in-market has dramatically increased by almost 100 in the past year, from 265 managers to 362, according to data from PDI Research and Analytics in April. As the number of private debt fund managers increases, so market observers have begun to question the expertise and ‘stickability’ of those who have entered the fray.

Trevor Castledine, deputy chief investment officer of UK pension fund Lancashire County Pension Fund, speaking to PDI last month highlighted the importance of manager selection in an asset class where a lot of people are raising money for strategies. He wasn’t convinced that the fees some are charging are commensurate with the grounding that they have in their investment strategies.

Managers say that deal selection will be one of their biggest concerns this year, but for investors, manager selection will no doubt become more of a robust procedure too.

Indeed, PDI hears that former banking professionals with balance sheet and/or underwriting experience are often sought-after people at a private debt fund when investors do their due diligence. Many of the established private debt managers already come from banking backgrounds. And more continue to make the switch – one of the latest examples came last week when former Lloyds and HBOS banker Ian Guthrie was appointed to the advisory council of distressed investor Strategic Value Partners.

Specialists with private equity backgrounds rooted in opportunistic investment philosophies, also continue to enter the direct lending fold, including for instance TPG and Angelo Gordon.

What they will all need to understand are the different ways in which to approach a borrower in crisis from both a primary lending and loan work-out point of view. Experience of working out loans from days during the crisis will help. But private debt fund managers, many with a buy-and-hold strategy, will also need to have a private equity mind-set if assets go awry.

The way in which direct lending in particular is moving, with some targeting lending to corporates without sponsorship from private equity, will emphasise the need for comprehensive know-how even more so. Those managers who have come through the previous crisis and shown that they have what it takes to work out, carry on and even excel, are perhaps best placed to persuade investors that they are deserving of their backing.

@anamcd @News_PDI