Europe votes no to UK

Among the talking points at this week’s Capital Structure Forum was greater scepticism from continental investors towards the region’s largest private debt market.

This week saw an impressive attendance for the fifth version of our Capital Structure Forum in London. Here are the key issues raised.

Anarchy in the UK?

Hardly … but there are certainly concerns. The UK has traditionally been Europe’s largest private debt market by a comfortable margin, accounting for 40-50 percent of activity. In the face of Brexit, the feeling is that UK investors are keeping the faith and happy for UK exposure to continue at current levels. Elsewhere in Europe, however, investors are rather less accepting of the status quo and keen for exposure to be reduced.
Panellists felt that if the threshold for maximum UK exposure in a pan-European fund were set at 30-40 percent, few problems would be posed. If, however, the threshold came down to 20 percent or lower, then capital deployment could become a major issue.

In a downturn, there’s no easy way out

Private debt was described by one panellist as “extraordinarily illiquid” given the lack of a secondary market of any scale. Make sure your credit selections are spot on, or prepare to repent at leisure. Furthermore, in funds where there is the option to invest in both performing and non-performing credits, problems in what should be the performing portfolio will create a distraction from the origination of non-performing deals – which is where the action will be when a downturn takes hold, and hence where you want your resources to be focused.

Reasons to worry about structures, and a reason not to

“Borrower-friendly terms will hurt investor value over the long term,” said one panellist, adding that competition was forcing lenders into some clearly unfavourable concessions. Examples include looser covenants, greater flexibility around borrowers’ ability to expand their debt facilities, and a smaller chance of lenders having someone at the table in work-out situations.
Set against that, comfort is being taken from the relatively conservative amount of leverage being used in deals. One panellist noted the revival of PIK financing as a potentially worrying development that’s more benign when seen in context. Pre-GFC, amid a very different interest rate environment, the equity component in deals was generally small. Today the equity cushion is much larger, and PIK financing is being used as an equity rather than debt substitute.

The emerging markets case is increasingly compelling

Relative to other asset classes, private debt currently has a strong bias to North America and Western Europe, with emerging markets barely getting a look in. It’s a situation that may be on the cusp of change. While ‘risk’ is the first word that springs to mind, delegates were asked to consider which is riskier today – investing in a German government bond or a best-in-class emerging markets manager.
India was the subject of some excited chatter, thanks to a benign competitive environment and new bankruptcy code. Turkey’s retail sector and African infrastructure also had their supporters. In a tightening competitive environment in the West, it’s time for visions to broaden.

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