Debt yields opportunity for credit providers

A period of “binge” lending has turned into a debt “hangover”, according to Partners Group.

A dearth of available debt for leveraged buyouts, particularly in Europe, is expected to create attractive investment opportunities for credit funds and other “non-traditional” providers of private debt, such as pension funds and insurance companies, according to research from the Swiss private markets manager.

One of the supply constraints for debt comes from a shortage of the collateralized loan obligation product, a traditional source of capital for leveraged buyouts in recent years. 

“Basically, European CLO’s are dying out and no new ones are being raised,” Juri Jenkner, co-head of private debt at Partners Group, told Private Equity International. Between 2011 and 2014, the supply of CLOs in Europe will fall by roughly 80 percent, according to the report.

At the same time, large European banks are reducing their lending activities as part of a larger process of deleveraging. During the next 18 months Morgan Stanley expects European banks to scale back their lending businesses and shrink their balance sheets by between $1.5 trillion and $2.5 trillion.

Contrasting the low supply of debt is the fact that global private equity investment activity is expected to remain strong during the next 18 months, according to Partners Group, with an estimated $400 billion of dry powder in private equity funds that will need to be combined with roughly $500 billion of debt financing when invested.
 
The lack of “traditional” financing for these deals will provide attractive opportunities for investors who previously have had little or no exposure to debt investing.

“One of the likely new sources of capital going forward will be the large institutional investors,” the report said.

Because of reduced competition from traditional debt providers like banks and other institutions, many buyout transactions today contain lower leverage ratios and higher proportions of equity, making lending into such deals even more attractive.

“We have the highest equity contributions that we have seen throughout the last 10 years,” Jenkner said. “At the moment, our judgment is that [investors] are clearly on the lower end of the risk scale because of reasonable leverage and very high equity in the deals.”

While high yield debt is expected to play a strong role in leveraged buyouts during the next few years, according to Partners Group, appetite for high yield, a more volatile product, is unlikely to be strong enough to fill the financing gap.

In addition to the demand for debt in buyouts, European businesses hold a combined €64.3 billion of loans that will need to be refinanced between 2012 and 2015, according to Partners Group.

“We’re not predicting that the world will fall apart because of this driver,” Jenkner said. “Some of them will be solved by amend and extend, but there you need willing lenders.”