Growing gap between expectations and delivery – PDI Forum

Direct lending comes under scrutiny at PDI’s third European conference. There are still pockets of opportunity in private debt however.

Investors who moved into direct lending in recent years are pleased with the returns, participants at PDI’s third European Capital Structure conference in London, heard this week.

But sentiment could change if private debt funds don’t maintain discipline. And that discipline will be key to closing the gap between the returns investors expect and what debt funds can realistically deliver.

There were lively exchanges on whether returns are compressing. During a panel discussion on direct lending, Ares’ Blair Jacobson said: “We’re still driving returns from this strategy.” Jumping into the debate, conference chairman Sanjay Mistry, head of private debt at Mercer, shot back: “Arguably, there’s been some compression.” Later, Peter Schwanitz, managing director, Portfolio Advisors, agreed that there has been pricing compression.

And where managers in Europe are risking falling short is in meeting US investor expectations.

“Quite a lot of capital is coming from the US and if not handled properly, it could have consequences… and at a time when Europe is not ready for it,” Schwanitz said.

Throwing currency risk into the equation can complicate the issue further. Tony Vainio, vice president, Pantheon, noted that this was a priority in investment decisions. If not managed well, it could wipe out returns, he said.

There was evidence to suggest that returns for the unitranche product, albeit still popular, are not what they once were. Originally, managers could achieve between 8 and 12 percent at portfolio level. Returns are slightly lower now at around the 7 to 11 percent range, PDI heard, including some leverage at fund level.

An investor poll showed that 60 percent of LPs in the room (who made up 30 percent of the audience) are seeking a blended target net return of around 7 to 9 percent from private debt. Such returns remain ambitious in certain European jurisdictions with strong bank networks.

A series of poll questions laid out the gap between what investors seek and what managers are targeting. Fifty percent of LPs said their highest target net return was over 15 percent. However, none of the GPs present are targeting such high returns.

More reassuringly, sixty percent of LPs are looking for blended net returns of 7-9 percent from their overall private debt portfolio. Meanwhile, 40 percent of GPs polled said that they are targeting net returns of 5-8 percent. Another 40 percent are aiming for 8-12 percent. The remaining 20 percent of GPs that were present were targeting between 12-15 percent.

REMUNERATION

If a market correction materialises within the next two years, as many Forum participants predicted, mid-market loans could end up being one of the hardest hit sectors, PDI heard. The effect would be compounded by the rise of covenant-lite and loose loans along with lower liquidity today than before the crisis.

Even if the resulting recession is not on the same scale of post-2007, preparing for that downturn will be crucial to manager survival, participants said. Thus deployment was a recurring theme at the conference.

One of the biggest risks to survival of the private debt industry is the way managers are incentivised to deploy by fee structures that only pay out on invested capital, Nathalie Faure Beaulieu, regional managing director, Europe, European Capital, said.

Christophe Evain, chief executive officer at ICG, highlighted that debt managers can stop investing if the market gets overheated. But he and others expressed concerns about how most managers are incentivised to keep deploying capital because of that invested capital fee structure. In some cases, managers might only be able to pay their staff if they continue to invest.

One way to mitigate it is investor alignment in investments, Mattias Unser, YIELCO Investments, noted. But other suggestions on how to address the problem are thin on the ground, delegates heard.

Malcolm Hassan, head of funds and asset management sector, at RBS Commercial & Private Banking, painted a picture of what the potential scale of the problem could look like in the worst case scenario, referring to how the restructuring unit at the UK bank grew from 180 people to 1,200 people after the crisis. “You need to be prepared and ensure you have enough capacity,” he said.

It wasn’t all doom and gloom however. Many agreed that there are pockets of opportunity in the mid-market, including sponsorless mezzanine, special opportunities, asset backed lending, growth capital financing and distressed-to-maturity rather than distressed-for control, regulatory and secondary trades out of banks. Demand for non-performing and performing loan books is also strong.

“This article was updated on 29 October to clarify the flow of the discussion on margin compression.”