1. Deal terms
The erosion of deal terms has been a major discussion point. It is particularly pronounced in the syndicated loan market, where investors have increasingly had covenant-loose documentation imposed on them in a borrower-friendly environment. According to a report from debt and high-yield specialist Debt Explained, by the last quarter of 2018, around 89 percent of European deals saw some form of change being made to documents or pricing, compared with 77 percent for the whole of 2017.
A similar trend exists in the US, with participants at our annual New York Forum in September saying sponsors have been pushing covenant-light deals with more borrower-friendly terms in the large-cap space. However, there has also been pushback – especially in the lower mid-market and the asset-based lending space, where less competition has allowed managers to negotiate on better terms.
2. Dry powder
To the casual observer, the above phenomenon is partly a symptom of the fact there is more competition for deals. While talk has often been of too much capital chasing too few deals, the reality is more complex. According to the Financing the Economy 2018 report by law firm Dechert and industry body The Alternative Credit Council, at the end of last year dry powder as a percentage of global private credit assets under management stood at 37 percent – below the 18-year average of just over 40 percent.
What this suggests is that there is no wave of private debt capital poised to be unleashed, inflating valuations in the process. However, while the proportion of dry powder is lower now, the asset class’s global AUM is higher than ever in absolute terms. What the low dry powder figure does show is that fund managers appear to be having little trouble in putting the capital to work.
If anything, financial regulation with regards to private debt has been benign; after all, it was post-crisis regulation that caused banks to retrench from the debt space, creating the market we know today. That said, the possibility that this may change in the future has increased. A private debt survey conducted at the start of 2018 by Intertrust revealed that investors saw regulation as the biggest challenge faced by private debt funds, with 61 percent believing regulation will be a major challenge in the near future.
In Europe, some fear that the growing market could attract the attention of EU regulators. A new report by the Alternative Credit Council observes that the non-bank lending sector is still small in comparison to traditional forms of lending. However, further growth of the sector would require policymakers to adopt a proportionate approach towards regulating it.
4. Macroeconomic risk
The spectre of a trade war between the world’s two biggest economies – China and the US – and ongoing political turmoil in the EU has weighed heavy on the minds of investors over the past year. On top of that, most industry professionals now agree that we are in a late-cycle period and should start preparing for the eventual downturn. Many believe the next cycle will start to separate more experienced credit teams from newcomers that have tried to ride the recent wave of private debt popularity.
One of the possible triggers for a change in economic fortunes could be the end of quantitative easing; the US and UK have ended their support programmes, and the European Central Bank halted its own at the end of 2018. However, while the year seems filled with uncertainty, private debt is in a good position to capitalise on macro headwinds. With the industry insulated from the volatility hitting public markets, it will be able to continue offering superior returns to investors provided the real focus will be on sourcing quality deals and working hard to get favourable terms and conditions.
A recurring topic for private debt investors in 2018 was the creeping influence of technology on the asset class. At PDI’s Munich gathering last June, Matthias Kirchgaessner, an external advisor at Plexus Investments, made a compelling case for technology when he said managers who are not at least examining the potential impacts of technology and data science on their business now are “already behind the curve”.
But technological disruption doesn’t just manifest as an opportunity, it can also appear as a threat. Many managers remain underprepared in the face of increasingly sophisticated cyber-attacks. Preparedness for the possibility of data leaks became even more prescient in 2018 with the introduction of the EU’s General Data Protection Regulation. Not only does GDPR carry heavy fines for those unable to respond appropriately to a data breech, but the SEC Division of Enforcement is also paying closer attention to the issue, having recently established a new Cyber Unit.