Investor appetite is changing as private debt matures as an asset class

Looking to the future has rarely been fraught with so much uncertainty for private markets.

Who, after all, would have predicted the scale of the economic, political and social upheavals seen since 2020. Double-digit inflation in a G7 economy? Supply-chain issues that have halted production lines? The threat of nuclear war in Europe? Economic forecasts have been shredded, government budgets torn apart and interest rate predictions revised sharply upwards.

So, our Future of Private Debt Report 2022 comes with something of a disclaimer: times are changing, in private debt as much as in the world around. Little can be predicted with any degree of certainty, but for this special issue we’ve canvassed market opinion to identify five key trends that we think are likely to be talking points at Private Debt Investor events over the next 12 months.

LPs want more flexibility in terms of fund structures

Fund managers report that investor appetite for more flexible open-ended fund structures in private debt is gathering pace. As the maturing of the asset class drives demand for innovation, LPs want greater flexibility and longer terms for private debt funds.

This has resulted in surging demand for evergreen funds that offer all the benefits of private credit alongside enhanced liquidity options, and have the potential to appeal not only to existing large institutional investors, but also to newer investor bases coming to the asset class for the first time.

The specifics of these evergreen funds vary, but LPs are increasingly homing in on the terms of the liquidity offered to investors, the rules around appropriate outflows and the basis upon which performance fees and carried interest can be calculated.

In 2018, Northleaf launched one of the first mid-market focused private credit evergreen programmes, investing 100 percent in private loans and structured with a lock-up period and liquidity provisions that enable investors to redeem their exposure.

David Ross, head of Northleaf’s private credit programme, says: “The demand for the evergreen product has outpaced our expectations, and the broader market acceptance has extended beyond North America to Europe, Asia and Australia.”

The Carlyle Group and Blue Owl Capital’s Owl Rock direct lending arm are among the other prominent names moving into the evergreen space, while Partners Group was also an early promoter of the approach with its €1.4 billion Private Loans Sicav Fund, launched in 2016.

Diversity at fund managers is under the microscope

Institutional investors are becoming increasingly vocal on diversity issues, as the topic becomes a flashpoint for LP board members amid reports of heated discussions on the subject.

In June, the Pennsylvania State Employees’ Retirement System investment committee approved a $125 million commitment to Sentinel Capital Partners despite accusations that the firm misled the pension on its diversity efforts. Affiliate Buyouts reported the investment committee was split 7-3 on the decision after discovering the firm did not in fact have a mentorship programme for women and minorities.

Sasha Jensen, whose firm Jensen Partners has been tracking diversity and inclusion in alternative investment firms, says LPs are getting much more active: “LPs have been making a big push to encourage more diversity on the investment and distribution side. That is both above the radar, with Shawn Wooden in the State of Connecticut reviewing his whole portfolio against D&I metrics, and below the radar where the amount of work being added to due diligence questionnaires and RFPs represents a huge push for more transparency.”

There’s still hope for emerging managers

Capital constraints are making the fundraising environment tougher than ever, especially for emerging managers. But the annual Buyouts Emerging Manager Survey, conducted in partnership with Gen II Fund Services and published in September, has some cheer for first-time funds.

While more than 40 percent of emerging managers say fundraising has become markedly more challenging since covid struck, the good news for the new kids on the block is that savvy investors view emerging managers as a route to superior returns: over half of investor respondents agreed that the risk/return profile for emerging managers versus established managers is attractive.

It’s clear that pedigree counts, however. Almost 80 percent of LP respondents said they were likely or very likely to back a team that had emerged from a larger sponsor, making spinouts the most popular type of emerging manager.

Venture debt demand boom

Challenges bring opportunities. Case in point is venture debt, where a rethink in fundraising plans at growth companies is proving a boon for lenders. Responding to a crunch on valuations, management teams are reviewing their capital-raising plans, with venture debt providers seeing a resulting boom in demand.

Ed Testerman, head of the growth lending platform at credit firm King Street Capital Management, says dealflow picked up in 2022, with activity set to continue into 2023. “A big reason for that is most of these companies are continuing to burn cash due to their business models and require additional capital to fund that burn,” says Testerman.

With the public markets closed and companies not as willing to do an equity round that is highly dilutive to existing shareholders, “venture debt has become a more appealing option relative to preferred equity”, he says.

Testerman says that a one-size-fits-all venture debt structure can be less appealing, so demand is growing for flexible structures that provide a lower cost of capital, less upfront cash burn, act as an accelerant for growth initiatives and maximise valuations.

The digital era is dawning

Fund managers are targeting the retail market via tokenisation. Individual access to private markets took a big step forward this year when KKR, working with digital assets securities firm Securitize, offered tokens in its latest $4 billion healthcare-focused private equity fund. The tokens can be sold on a Securitize-managed secondary market just one year after purchase.

While this was for a private equity fund, PDI editor Andy Thomson says that the implications of this initiative may be even more significant for private debt. Partly that’s because while private equity currently provokes a nervous reaction in some, private credit is seen as offering relative safety with the potential for upside. Moreover, it’s seen as a more liquid option thanks to the yield component.

“Investors may like private equity’s promise of a 20 percent return; but they may find waiting 10 years to get their hands on it rather less enjoyable,” says Thomson.