This article is sponsored by FIRSTavenue Partners
How would you describe the current market in private debt as we near the end of 2022?
In recent years, the benign credit environment of gradually lowering interest rates has gone away and, alongside the aftermath of the covid-19 pandemic and the impact of the Ukraine war, we are seeing a return to higher inflation and rising interest rates. All those dynamics created tremendous dislocation in the underlying credit markets, so the question is where value lies from here.
There are broadly two types of underlying private credit, with the first being senior direct lending, where we are seeing a very benign environment and a tremendous amount of capital allocated as a fixed income surrogate in the last few years. We are seeing a huge proliferation of GPs, in the US and Europe in particular but also increasingly in Asia, and the dispersion of returns between those GPs has been very low.
The direct lending market remains attractive as rates go higher, given it is fundamentally based on a floating-rate product, but there will be a greater dispersion of returns between sectors and GPs as the market environment becomes more complex. The ability of investors to identify alpha by picking the right GP and the right strategy will become increasingly important. There will be some laggards, where returns become more disparate, and being in the third or fourth quartile of performance will matter more going through 2023 than it has done in the last few years.
The other part of the private credit market is everything else, where the focus is on special situations and opportunistic credit. Dislocation is good for those strategies and GPs’ alpha generation skills are critical, which means picking the right GP and asset class becomes much more important.
What impacts are macroeconomic pressures having on opportunities in real estate credit?
In real estate debt, covid changed working patterns tremendously and the role of commercial real estate in particular. The value of those assets changed dramatically based on whether they sit in the city or the suburb and what they provide. At the same time, on the residential side, because people are working from home – whether from a flat in downtown New York or a home in a leafy suburb – what is needed has now changed as a result of those new work-life patterns.
The real estate market is in transition, and the ability to understand that transition, where to reposition assets and where to play in the debt capital stack is even more key. That core real estate skillset is becoming a critical selling point.
The other issue is that leverage levels on a lot of those assets were set when interest rates were much lower and there has since been a sharp interest rate increase, so the impact on the leverage on individual assets will play out in the year ahead. That means in the real estate market we will see a period of dislocation due to rising rates and the changing use of assets.
Investors love secured assets that provide risk mitigation, so when we get through this current period of uncertainty, we believe there will be better performance from secured credit risk than there was before. One way of playing that is in the real estate debt markets, where we now see greater subordination protection and risk-adjusted returns going up as more equity sits below the debt and the value of the assets has gone down.
The last time we saw these dynamics was in the aftermath of the global financial crisis, and that was a great time for real estate debt investors. It all plays into a better cyclical opportunity in terms of timing, with a greater importance placed on the skillset of the GP and their ability to identify the best assets and sources of alpha out there.
Turning to specialty finance, where do you currently see the most opportunities for lenders to put capital to work?
Specialty finance generally involves underlying consumer receivables, while at the moment most credit risk that is available out there is in either corporate or real estate credit. Generally, LPs don’t have direct exposure to consumer debt except when they invest in banks or buy a securitisation product, and those are usually small parts of their portfolios.
The macro context matters a lot when it comes to specialty finance. We have gone through a series of cycles since the global financial crisis, most recently with covid and now the heating crisis in the UK and Europe, and through those we have seen governments step up in support of the consumer.
That ongoing support of governments to consumers is unlikely to go away, but even if it does, these assets have now been repriced to be effectively bulletproof. A great investment in credit is one where, under all scenarios, you can point to the funder of the investment at least getting their money back and generally having generated a small return. When you look at speciality finance assets at the moment, they have repriced to those levels.
How would you characterise investor demand across private credit today?
There are various ways you can measure investor sentiment, and one is to look at the performance of the underlying secondary market. In this cycle, we have nascent infrastructure and private credit secondaries markets for the first time. We have seen venture capital fall off a cliff, private equity is definitely softer, but private credit and infrastructure have for the most part held their own on a secondary basis. There has been some selling but not a collapse, and infrastructure has done fantastically well. That has not gone unnoticed by LPs and will further cement the role of those asset classes in portfolios in the future.
We have seen a surge in the growth of the secondaries market of late. We spent the last few years focused on what that meant for private equity, with the growth of GP-led solutions rather than LP solutions, and that has now completely flipped this year. It has become harder to execute a continuation fund and LP solutions have risen to the forefront, extending into other asset classes like private credit and infrastructure, where there is now size and scale and a roadmap to follow from private equity.
In terms of investor demand today, there is very little for venture capital. In buyout funds, the biggest GPs continue to experience good demand for their offering, but it is down on the buoyant conditions of 24 months ago and some funds have discreetly scaled back their fundraisings. Within buyouts there are some strategies getting more traction, like energy transition and digital transition, where investors are trying to increase exposure.
In private credit, a consolidation of players in direct lending is notable. When an investor puts together a private equity portfolio, they may have 30 GPs all doing different things in different geographies, but in direct lending there is little to distinguish the GPs and so there is limited bandwidth in portfolios for too many managers.
Credit opportunities and special situations can be bifurcated into two strategies: general strategies that generate 10-15 percent IRRs tend to have domestic consumption with US investors backing US funds and the same in Europe, while strategies that generate 15-20 percent or higher command a global reception. Investors are looking for experience, so funds three or upwards are still attracting demand.
Infrastructure demand has generally held up the best. There we see two trends. One is an increasing interest in core infrastructure and increased appetite for permanent capital vehicles. And at the other end there is a convergence of private equity and value-added infrastructure strategies, where a new frontier is being created for investors looking for risk-mitigated private equity-style returns.
Today, everything has to be marketed globally and we have seen a shift in where LP appetite is coming from. Because of the decline in the debt and equity markets, Western pension funds have retreated a bit, with sovereign wealth funds and defined pension plans in the US becoming relatively more important. LPs are assessing both the GP and the fund strategy when making investment decisions, and since covid that first determination around the fiduciary has become more important.
We therefore see the gradual consolidation of GP numbers across all aspects of private funds, and as GPs recognise that, we see them using their brands to sell into adjacent asset classes. In so doing, they become bigger and better and start to look more and more like listed asset managers.
How have recent events shaped allocations for the longer term?
We are in a unique environment – going back over the last 50 years there has only been one year when both debt and equity markets fell together. The fall in the debt markets this year has really proved to be a much bigger issue than the fall in the equity markets. LP balance sheets have come under stress, whether those are pension funds or insurers, and yet there remain opportunities in the credit markets in particular, where assets that give better downside protection and secure yield have come into their own.
When the dust settles, in the first and second quarters of next year, people will determine that they went into this recent mini crisis overexposed to equity, whether through venture capital, private equity or public equity. When they look at the performance of their portfolios they will note that the assets that performed best were infrastructure and private credit, and those will be deserving of greater allocations going forward.
My expectation is that some time in Q1 next year we will hear the end of interest rate increases, at least for now, and that will drive a flurry of increased activity, most notably in the private credit and private infrastructure markets because the main risk point will have been taken away.