Direct lending ‘risks oversupply’

Niche strategies are starting to grow in popularity – a necessary counterbalance to the capital allocations piling up for mid-market direct lending, says Ari Jauho, co-founder and partner at Helsinki-based fund of funds manager Certior Capital.

Q. How would you assess the private debt market overall at this point in 2019? How does it compare with a year ago?  

When it comes to European private debt markets, I would say that they are maturing quite fast. Compared with last year, ever bigger direct lending funds are being raised and rather quickly. In general, more investors are “joining the club”, ie, starting to invest in private credit and granting bigger allocations, usually in plain vanilla, mainstream strategies, such as mid-market direct lending. As a clear consequence, there are now the first signs of “dry powder” starting to pile up, which has not been the case previously during this credit cycle in Europe. To avoid fierce competition in mature markets, some managers are starting to focus on more specialised, niche strategies. 

Q. What would you say are the main concerns for investors right now?  

As more and more money is being raised, there is a risk of oversupply of capital to sponsored direct lending transactions that could worsen the terms and conditions of deals and also possibly have a negative impact on underwriting quality and risk assessment. I have not yet experienced too much evidence of worse underwriting quality and risk assessment – according to our own database on mid-market direct lending transactions, net debt to EBITDA multiples remained consistently slightly below 4.5 times from the beginning of 2016 until the end of last year. What has happened is yield to maturity went down during the same period by around one percentage point. As long as activity levels in the buyout market remain high, I would not worry too much, but if the buyout market cools down, the risk of oversupply would be clear.

Q. What types of innovation are you seeing from managers? What’s at the cutting edge?  

I would be happy to see more innovation from managers than I am seeing. I would say every manager should have a cutting edge that differentiates them from the others and gives them a competitive advantage. It can be a differentiated strategy, but it can also be an operational differentiation, such as focusing on certain industrial sectors or ways of sourcing opportunities. 

One example of an interesting investment area in private debt is revenue-based financing. It is not a new phenomenon in the US, but it is gradually coming to Europe as well for financing new growth companies. We also see some interesting smaller special situations funds that have well defined niche strategies and which can do interesting deals, although we are not now experiencing distressed market conditions.

Q. Is fundraising becoming easier or more difficult? Why?  

Last year, fundraising became easier for mainstream mid-market direct lenders. On the other hand, fundraising is still challenging for smaller first-time funds with niche strategies. The reason for this polarised development is that mid-market direct lending is today an accepted asset class for institutional investors, which make sizeable allocations per fund from their fixed-income allocations. It is more difficult and time-consuming to invest in smaller first-time funds with niche strategies, and you cannot invest “big tickets” in small funds. I would say, in general, that small funds are struggling with fundraising, whereas for established mid-market direct lenders fundraising is relatively easy.

Q. What might we be talking about in a year’s time that isn’t yet on the radar?  

This is really a tricky question and if I knew, I would not tell anybody! Hopefully we will be talking about more and more institutions focusing on other – smaller – sub-segments of private debt than mid-market direct lending, such as SME direct lending and niche strategies. n