Don’t go with the flow

As a journalist covering private credit, it seems at times that you receive more pitches from GPs than a public pension fund or insurance company. Most invariably contain some statistic trumpeting the small number of deals they do relative to the total opportunity set, a figure often around 3-5 percent.

What a broad overview of any given credit fund manager often fails to do is drill down on the quality of the pipeline, as measured by the calibre of the borrowing business and credit itself, along with diversity by sector and industry.

Having a good mix of businesses in any given portfolio is one obvious way to provide LPs with inherent downside protection. A well-diversified manager may be able to better ride out difficult market conditions concentrated in one or two sectors than those with over-exposed portfolios.

As we’ve seen with energy funds over the past couple of years, a tumultuous time in one industry can hit an over-exposed portfolio hard. Even otherwise financially sound and well-managed businesses can become collateral damage as private equity and private credit firms take a risk-averse stance to the industry.

For instance, some mid-market lenders, such as Apollo Investment Corporation, made it a priority to reduce energy exposure. Apollo’s oil and gas positions made up 7.4 percent of its book at year’s end, down from 11.6 percent at 30 June 2016.

Investor appetite may also change following tough times as well. Jeff Eaton of placement agent Eaton Partners told PDI sister publication Private Equity International that private equity sponsors are having a harder time rounding up capital to put in the energy sector, even though it has recovered somewhat from the difficult days when the price of oil was below $30 a barrel.

“They needed to go to a different set of LPs. Some of them had to access the high-net-worth channel because the institutional investors were coming back either smaller or not coming back,” he said.

If one sector comprises a large part of a firm’s deal pipeline and investors have become wary of that sector, not only will finding attractive transactions become harder, but fundraising may also be more of a slog.

One business development company manager noted the high level of pre-payment activity has made it difficult to keep those vehicles fully invested.

With more obligations being met in full earlier, a firm’s origination team must keep churning out opportunities at an even quicker pace than usual. Staying invested in attractive deals, of course, is dependent on the ability to drum up good deals that don’t leave the manager investing solely because it needs to deploy capital to generate returns for LPs.

The same may be true for private funds, though it is harder to obtain relatively comprehensive data on the subject.

While private funds have a finite life, limited partners will want their funds invested and generating returns on committed capital. They’ll naturally gravitate towards the managers with the best dealflow pipelines, something that will become obvious over one or two vintages in a fund series and maybe earlier.

Dealflow can be a point of pride for managers and their investors, or a harbinger of pain.

Contact the author at andrew.h@peimedia.com.