1. MARKETPLACE LENDERS WILL EMERGE AS A NEW ALTERNATIVE
Many people think that the sponsored, deal-led private debt fund model is the only one that will prevail,” says James Newsome, managing partner at Arbour Partners. “They tend to see a people-led business model that has funds making three to four investments a year in companies that are undergoing some form of change through a buyout.” While this will remain an important part of the private debt industry, Newsome argues there is a whole layer of much smaller businesses that require debt funding for much less ambitious projects.
“This is where the fintech revolution comes in,” he says. “Using big data and analytics, marketplace lenders can analyse thou- sands of lending opportunities in increasing granularity – and the machines are really learning here – that means they can assess the real SMEs at the heart of the economy, the high- street hairdressers, key cutters, restaurants, etc, using vertical and horizontal data to determine risk factors, overlaid with predictive analytics, all at the strike of a few keys.” And it is at this point where the marketplace lenders are maturing. Many have been on hiring sprees, both at senior and more junior level to sift through the 10-20 percent of businesses that make it through the automated processes.
“You will have marketplace lenders with hundreds of staff on hand to make quick credit decisions,” says Newsome.
These developments will be accelerated by the increased allocations to marketplace lenders by institutional investors, some of which are already coming on board. Aegon, for example, has just tied up with Funding Circle to provide £160 million ($213 million; €177 million) of loans to UK small businesses. “If marketplace lenders can provide returns of 6-7 percent, that is an attractive story for investors, who will also see this as a more liquid place to deploy their capital than more traditional fund structures – the average life of MPL loans is just two to three years,” says Newsome.
2. BANKS WILL ESTABLISH THEIR OWN PRIVATE DEBT
Until now tie-ups between banks and private debt funds – like in the case of Barclays and BlueBay – have been mutually beneficial. But this may change.
“We’ve recently seen some disagreements between funds and banks on restructuring plans,” says Monica Barton, a partner at Reed Smith. “That’s leading to some funds taking the view they’re better off bypassing banks.”
So how do banks remain relevant? “Banks are finding it hard to compete with private debt funds, particularly as [the funds] have started raising senior debt funds,” adds Barton. “Banks often don’t have the same flexibility and that’s leading to some discussions around somehow establishing their own funds to circumvent some of the more stringent regulations to which they are subject.”
This already looks like a possibility in some European jurisdictions, while in the US the Trump administration is seeking to dismantle the Dodd-Frank Act, which currently stops banks from trading from their own balance sheets, potentially paving the way for US banks to set up their own funds.
But, says Robert Radway, chairman and CEO of NXT Capital, obstacles remain. “Where pre-crisis, banks used to provide 80 percent of mid-market sponsored finance in the US, they now only provide around 20 percent,” he says. “I can’t see that shifting back even if we do see a less conservative view of lending from the regulators. The banks would need to build whole platforms to make way in an already developed private debt market.”
The alternative could be for banks to buy platforms, which some suggest is likely if the market turns sour. “There will be a wobble in the market at some point,” says First Avenue principal Justin Mallis. “You might see banks return to the market or buy up teams to rebuild their capability.”
3. THE LARGE FUNDS WILL ONLY GET BIGGER
With the likes of Park Square Capital and Hayfin Capital Management raising €3 billion and €3.5 billion, respectively, at the start of this year, the indication is that private debt funds will only get larger in future.
“The big players will get bigger. As they get bigger, they’ll get stronger, making it harder for less established players to gain traction in the lending market and with investors,” says First Avenue principal Justin Mallis. “Over the last few years, we’ve seen the emergence of a handful of large players – there is a clear top 15. Below that you have the lower mid-market players that raise between €250 million and €500 million, while those in between will need strong investor bases with an appetite for co-investment and separate accounts.”
Absent any shocks, these top $1 billion-plus funds are expected to continue to attract the lion’s share of institutional capital. “Given the fee and carry structures in private debt – they are rather lower than in private equity, for example – you have to build scale if you want to be very successful,” says Newsome. “That will likely drive some consolidation in the market in addition to the more typical M&A that stems from, for example, owners wanting to monetise their success.”
Added to this is the growing tide of regulation and reporting requirements, says Alex Di Santo, director at Intertrust, pointing to ILPA reporting, FATCA in the US and GDPR in Europe. “Large firms with large teams have the scale to take care of many of these requirements,” he says. “For smaller, more resource-constrained firms, this can be challenging.”
4. MORE MID-MARKET FUNDS WILL GO NICHE
For those not raising giant funds, specialisation will become an increasing necessity. The mid-market has become crowded, making it difficult for many players to differentiate themselves from the next fund, and com- petition for deals has increased. Investors will increasingly turn towards funds that offer the prospect of higher returns than plain vanilla direct lending. And that means finding some kind of secret sauce.
There are already some specialist funds out there – energy has attracted a few, as has financial services, but most are predicting more in areas such as healthcare, while others are finding vertical niches by specialising in strategies such as trade receivables or non-sponsor SME financing. Country funds are also on the rise in Europe, where different market conditions and regulations can give local players an edge.
5. A MARKET CORRECTION WILL CREATE RIPPLES – AND OPPORTUNITIES
We are now in the ninth year since the recession,” says Radway. “And it has become clear that the longer the cycle continues, the less institutional memory there is in the industry. There are a lot of younger entrants to the industry that haven’t been through a cycle and haven’t experienced how an economic downturn can affect borrower performance. There will be a correction at some point, when it will become apparent which managers will be successful – and which won’t.”
Clearly, there will be some losers when this happens – and many of these may be the newer entrants with less experience of workout and restructuring situations. And while a market clear-out may not be rapid, given the closed-end fund structure of private debt funds, most believe it will come.
Yet distressed specialists will find ample opportunity. We have seen many distressed funds reach strong closes in recent times, such as Cerberus Institutional Partners attracting $4 billion this year and Oaktree raising $8.6 billion at the end of 2016, and they may not have to wait too long.
“We’ve seen an increase in restructurings since June,” says Barton. “And while we may not be quite there yet, there will be another financial crisis. The big issue will be the wall of debt that never got repaid – it was simply pushed forward. Many smaller funds won’t have the resources to deal with the wave of restructurings that is likely to come from a downturn.” And this is where the distressed players may come in, buying up portfolios, or there may even be the emergence of a new secondary market for private debt positions.
“The traditional distressed players are certainly waiting in the wings right now,” says Radway.
“And while there will be no portfolios that are unaffected by a future downturn, it will simply be a question of degree. The weakest players will disappear, but there will be others who weather a downturn reasonably well. For those in a strong position – and with dry powder to deploy – there will be a tremendous opportunity for investors as we come out of an eventual trough.”