EQT Credit: Ready for anything?

A defensive portfolio will thrive whatever the wider economy has in store, says Paul Johnson, partner at EQT Credit.

This article is sponsored by EQT Credit

What is driving the escalation in LP appetite that we are seeing for private debt strategies?

Paul Johnson

There is a growing acceptance amongst institutional investors that we are now in a perpetual state of low, or even negative, interest rates. Investors are searching for yield and private debt is providing that.

There are also nuances within private debt. Direct lending has become increasingly mainstream and plays a part in the alternatives portfolio of most investors. But, as everyone starts to question where we are in the cycle, opportunistic strategies are now also attracting more attention.

Is there a danger that too much money is being raised? How would you describe competitive dynamics in the market?

The direct lending market, which is where most of the money is being targeted, is competitive – absolutely. But what you are seeing is that while managers are raising larger successor funds, we are no longer seeing the volumes of new entrants that we did a few years ago. Direct lending has become a true alternative to the banks, therefore more sponsors are using direct lenders that historically we would not have seen. Demand has grown.

That means we are still only really competing against the same number of firms. So, while there has been some returns compression and the market is competitive, it has always been competitive and I do not think that competitive intensity is increasing.

How do you approach origination in this competitive environment?

I think it can be easy to rest on the laurels of an ever-increasing volume of deals coming to market. But, of course, these are deals that everyone is seeing, so we do not view this as smart sourcing.

Instead, we focus on building sponsor relationships across multiple direct lending deals. In 80-90 percent of cases, we believe we are only in competition with one or two other funds. Whilst we are still in competition with the banks, the direct lending market continues to take market share year on year.

We still take part in lender education processes, of course, often led by debt advisors who may invite 20 to 30 participants. But if that is the mainstay of your origination strategy, you are not going to end up with the terms you are after. There is no such thing as a perfect deal with no competition, but creative deal sourcing is important.

Which markets do you see as particularly attractive right now?

Not even three years ago, there were 10 times more deals in the UK than in the Nordic region. Fast forward to today and that factor is less than five times. The UK and France remain large and growing markets, but other markets came later to direct lending and so the potential for growth in such markets is higher.

EQT has completed five deals across Finland, Sweden and Norway in the past 18 months. Five years ago, I don’t think there would even have been five deals in total.

“This is an illiquid asset class, so you can’t evolve your risk strategy depending on where you think you may be in the cycle”

What changes are you seeing in terms of pricing, structuring and terms?

Pricing is probably 60 basis points lower than it was a few years ago. This is as a result of competition and there is no avoiding this. But this asset class still represents a pretty compelling proposition when you can generate 7-9 percent returns for senior secured debt.

Terms are certainly weaker today than they were a few years ago. You have to be prepared to walk away if you do not get the protections you are seeking. However, the size of the market is such that you can still maintain selectivity and rigour while remaining active.

What about the level of risk being taken?

This is an illiquid asset class, so you can’t evolve your risk strategy depending on where you think you may be in the cycle. With private debt, you should always be investing in defensive businesses rather than volatile, cyclical assets.

We do see deals that we have passed on for being too risky later being announced by competitors. I should add that most of these deals will end up being fine. If you are lending 50 percent or even less of the value of a company on a senior secured basis, you have ample buffer before you have to take control or lose money on a direct lending deal.

Given that we are arguably on the cusp of a downturn and that European private debt is largely unproven in that environment, how do you expect the asset class to fare when the cycle turns?

Everyone is saying we are on the cusp of a downturn, but the reality is that there have been plenty of pitfalls out there over the past five or 10 years. A lot of businesses have had tough times and many of those have been self-inflicted.

There have been aggressive M&A roll-outs that have produced negative synergies. Businesses have been financed on the basis of ambitious cost savings programmes that just have not come to fruition.

Lots of companies have also tried to increase productivity by changing the sales-force model. This has often resulted in sales teams leaving and it takes a long time to rebuild from there. We have also already started to see some macro-fallout. Clearly, we are not in a downcycle yet. Yet we have seen the impact of Brexit uncertainty, of tariffs and of labour and raw materials’ cost inflation. There have been plenty of challenges out there.

Such challenges will probably increase over time and I actually think it will be useful for investors to observe managers’ ability, not only to restructure a company, but to grow it once it is restructured.

Simply doing a debt-for-equity swap does not, in itself, create value and get you your money back. EQT has the advantage of its private equity heritage and deep operational expertise to help grow these businesses if needs be. We also have a credit opportunities fund, which looks at distressed debt situations.

Do you think private debt firms, in general, have sufficient workout experience to weather a storm?

Some, clearly, have the requisite skill set. Others do not currently but are intending to hire to address that. Others still intend to sell their loans to credit opportunities investors if things do go wrong.

We are certainly getting probing questions from our investors, not only about the health of the portfolio today, but our strategy if one or two were to underperform. I think those questions are absolutely fair. In fact, increased investor sophistication around these issues is one of the biggest changes we have seen in recent years.

What do you see as the biggest opportunities for the private debt market going forward?

On the direct lending side, we welcome the prospect of a turn in the cycle because we know we have built a genuinely defensive portfolio. The opportunity will be winning market share from others who may have more problems brewing, as we believe investor appetite for managers that can prove they are generating risk adjusted returns will continue to grow and grow.

Opportunities are also likely to increase for our distressed debt business, meanwhile. For the past 11 years, that business has generated top quartile returns across vintages and so is well positioned to take advantage of whatever may come our way, be that a continued benign environment or, indeed, an economic downturn.