We haven’t had a real recession for a long time,” reflected Daniel Leger, managing director at US fund manager MGG Investment Group, on the opening panel at the PDI Germany Forum in Munich, writes Andy Thomson. But now, with interest rates on the rise, Leger foresees the possibility of a recession akin to that of 2001-02, in the wake of the Y2K scare and the 9/11 terrorist attacks.
With deals being done at equity levels of 15x and debt at 7x, “it’s going to get challenging”, said Leger. “It raises questions about the ability of borrowers to service the debt. The quality of underwriting will become evident over the next year or two.”
Howard Sharp, head of origination in direct lending at fund manager Alcentra, added: “Some people have never lent in an environment where base rates are much above zero.” He too said recession was possible, given the likes of raw material price increases and supply chain disruption on top of rate rises. However, he also noted that the firm’s unitranche portfolio had loan-to-values around 37 percent on average, with a “good equity cushion” providing protection.
Moreover, Sharp was optimistic about the type of businesses private debt firms are now able to lend to. “There has been a concentration of lending into high-quality B2B. Managers are funding more resilient businesses in terms of consumer demand and their ability to pass on rising costs. It used to be the case that private debt picked up the deals that the banks didn’t want to do,” he said, but now managers have more ability to pick and choose the deals they want.
Stephan Caron, head of European private debt at BlackRock, cautioned that: “You would expect the private markets to reprice in this environment and they haven’t yet, whereas the public markets have.” But, with public markets subdued, sponsors are “turning to private debt to unlock their deals”. He noted the strong appetite for unitranche deals in the $1 billion to $2 billion range.
Sharp highlighted the amount of control sole lenders have – a status Alcentra enjoys in around 70 percent of its deals. But he sees more of a club market developing, where managers will struggle to exert control as part of a group, “especially if there are fewer covenant protections and in some of Europe’s less creditor-friendly markets”.
Alexander Ott, a managing director at Partners Group, noted limited partner capital migrating into private debt from both equity – with investors looking for safer havens – and traditional fixed income. “With inflation and a higher yield curve, investors are increasingly moving to floating-rate exposure, either through syndicated loans or direct lending,” he said.
ESG no luxury
Another talking point – unsurprisingly – was ESG. But is it a luxury or “first-world problem”, given the profound economic and geopolitical issues confronting the world today? This was the question posed by James Newsome, managing partner at advisory firm Arbour Partners, who was moderating a panel.
He quickly answered his own question in the negative. Environmental, social and governance is part of the most important long-term issue facing the asset class: how can private debt help pension savers to make a positive impact in the wider economy?
A more pressing question perhaps is whether ESG action really is being carried out in the right way, given the regular claims of greenwashing in the asset management industry. Newsome asked whether we may see LPs taking legal action against fund managers that have not lived up to their stated ESG commitments.
“At the moment, it’s too early to see such cases but greenwashing is a hot topic and in a few years’ time we may start to see this happening,” said Jin Hyuk-Jang, international counsel at law firm Debevoise & Plimpton. “Also, it may not just be LPs suing GPs but regulators coming after you as well. As a GP, the message is don’t promise too much and be careful what you put in the private placement memorandum.”
Also on the panel was Priscilla Schnepper, diversified debt funds investment manager at the European Investment Fund, a major supporter of emerging private debt funds in Europe. She was asked whether an EIF commitment to a manager could be taken as proof of that manager’s ESG credentials, given the organisation was such a strong proponent of green strategies.
“Other LPs might look at us and take note because we want to ensure that key performance indicators are clear, that there is no greenwashing and there is real additionality,” said Schnepper. “I wouldn’t say we validate managers, but we try to go in in detail and challenge the approaches that are taken.”
Luz Martinez is a sustainability manager at ILX, a fund manager that in January launched an SDG-focused emerging market credit fund with a $750 million commitment from APG. The fund invests in private sector loans originated by multilateral development banks and development financial institutions.
Martinez said the perceived risk of investing in developing markets was “way higher” than the actual risk. “The loans are very comparable in terms of credit margin to the high yield and leveraged loan markets but with much lower losses.”