GPs with shallow pockets need deeper resources

The direct lending market has many young management groups battling to try to achieve scale. Until they do, it’s tough to meet growing LP demands for operational strength.

What if Europe has become Japan? That was the question posed by one market source this week, who is beginning to ponder the possibility that the downturn everyone has been anticipating for so long may not happen at all – at least in Europe. Instead, so the theory goes, the continent may bump along close to the bottom for many years, buffeted by the occasional bout of turbulence but never crash landing.

It remains an unorthodox view, however. Assuming that some kind of material correction is indeed around the corner, the question being asked by many in the private debt market is how well placed are managers to cope in the face of headwinds? As the market segment that has attracted most of the attention, as well as most of the capital, direct lending is under particular scrutiny.

The fear of a downturn is prompting investors to pay much more attention to whether the managers they are backing have workout and restructuring skills. Many of the bigger managers not only have this resource, but have it dotted throughout the continent. After all, the restructuring regimes in individual countries are very different from one another and being as close as possible to the action can be vital. Consider a court-run process in France, for example – hard to imagine trying to stay on top of that from London.

But direct lending has swung open the doors to a plethora of new entrants ever since the financial crisis created the opportunity to grab market share from the banks. Many of these still-young GPs have been frantically trying to raise capital and gain the scale to hoist themselves into that exalted sphere where they have enough spare cash to spend on hiring restructuring wizards (among other things, of course). The truth is, most are still operating on shoestring budgets that are being placed under even greater pressure by LPs’ relentless pushback on fees. They couldn’t afford that kind of expertise even if they wanted it.

But whether they want it is a valid question. There is a view that, in the world of humdrum direct lending where return expectations are typically in the mid to high single digits, it would be an admission of failure – or at least an indication of a less-than-watertight underwriting process – to have in the wings a battery of turnaround pros ready and waiting for the worst. Moreover, might private equity firms (in the case of sponsored transactions) be rather nervous at the prospect of a lender aggressively showcasing its ability to snatch the keys of a troubled business? Isn’t that a private equity job, after all?

Whether desirable or not, it seems unlikely that LPs will stop probing GPs for evidence that they will be able to cope well as and when market conditions become less straightforward. Amid a borrower-friendly environment, where covenants have been eroded, it’s hard to argue against the need for having some sort of emergency response in place to deal with issues that may crop up out of nowhere.

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