This article is sponsored by Kartesia
What impact has the sustained period of uncertainty seen in 2020-21 had on Europe’s private debt markets?
Laurent Bouvier: When you sum up everything that has occurred over the past 18 months, including Brexit, the covid-19 pandemic and the disruption caused by those events, the volatility that resulted was much less than anticipated. We all had a few weeks or months of real disruption in our businesses, but thanks to the notable levels of government support in Europe, normality at least in terms of liquidity and pricing came back by September.
So, when we look at the net asset values in our portfolios, they were already above December 2019 levels by September 2020. These events provided the first real test of Europe’s private debt markets, which have grown exponentially over the past decade. There was no major disaster in either the debt or the leveraged loan markets, including among pure private debt players like ourselves.
Would you say the markets are now normalising?
LB: It is fair to say that the amount of capital injected by governments has distorted the markets and created additional complexity, so what the new normal will look like following the exit from this unprecedented cycle is hard to predict and is something we are putting a lot of thought into right now.
LPs are more confident than they were a year ago, and have been reassured by the asset class’s performance through the crisis. There has been a lot of money flowing into private equity, so the feared decrease in valuations has not happened. So far, inflation has been controlled, interest rates remain low and prices have increased for assets post-covid, creating a good story around loan-to-value in private debt portfolios. At Kartesia, we have seen a lot of activity, with many exits taking place, so we can say liquidity is back, an outcome I would not have anticipated a year ago.
What challenges and opportunities have you seen in the first six months of this year, and how have you adapted your strategy?
LB: One of the key challenges for some private debt players has been to wrap up fundraisings, because of the delays caused by covid. We were able to close two funds in the first half of this year – we raised €1 billion for our first generation senior debt strategy in March and €1.5 billion for our fifth generation credit opportunities fund in May. In both cases, the fact that we were focused on a particular market segment, only targeting lower mid-market companies with less than €10 million EBITDA, was very critical as that segment is underserved and underrepresented for our investors.
On the dealflow front, there is a massive amount of activity. The challenge there is to keep a cool head, be patient, select the best opportunities and avoid making the mistake of investing too rapidly at a time when part of the dealflow on offer has been to some extent impacted by covid. The question has to be what will be the maintainable level of profitability on which you can structure a deal.
When it comes to opportunities, the asset class is clearly benefitting from a favourable market environment, with sustained low rates and a slow-moving economic recovery. Many of the same conditions that helped private credit to succeed in 2020 are now continuing into 2021. We continue to see bank lending retrenchment and tighter lending criteria from eurozone banks, record levels of dry powder and the hunt for yield still driving demand for private credit among institutional investors.
Finally, we see a growing opportunity in sponsorless deals, which will take time to develop, as a result of a lot less competition in that space. It takes more work to do those deals, because you need to be close to companies from origination and think about customised financing solutions.
Which sector and strategies have emerged strongest from the pandemic?
LB: We have observed a flight to quality that favoured safer credits that performed well through the pandemic, even at tighter pricing and higher leverage, over more speculative transactions on richer terms. In some cases where we had to take control or deal with difficult trading conditions, the fact that we had direct access to borrowers at board level, good governance in place and a local presence in core markets was key.
In terms of strategies, the bulk of the market is now clearly about senior debt, while distressed debt has been constrained due to the very low level of defaults in the market. More and more, subordinated and mezzanine debt are gaining traction, driven by their flexibility and agility to finance operations, particularly at the lower end of the market.
How do you see the EU’s new regulation on sustainable investment impacting Europe’s growing private debt markets?
Coralie De Maesschalck: Despite the additional reporting work generated by these new regulations, and especially the Sustainable Finance Disclosure Regulation, I see them as something very positive for private debt markets. This will allow private debt to catch up on ESG, because engagement started later here than in other asset classes like real estate and private equity. Although private debt is slightly behind, SFDR will improve things.
Until SFDR, there was no consistent view about ESG reporting and best practice in private debt. This is a smaller asset class than private equity and until now, there has certainly been less pressure from investors. Also, private debt players have often been viewed as just assisting private equity players, slightly more in the background, so the reputational risk was much lower until recently. Now, with SFDR, we could say all asset classes are moving at the same pace.
I also believe the new regulation will bring more transparency thanks to the disclosure requirements. Fund managers now need to disclose their sustainability risk policies on their websites as well as consistency between their ESG policies and their remuneration policies, along with some mandatory reporting on pre-defined KPIs at the portfolio level, with more to come. That transparency will decrease the risk of greenwashing, creating more appetite especially for sustainable debt funds.
Finally, SFDR requires all funds to be classified under either article six, eight or nine, broadly meaning those not integrating sustainability into the investment process, promoting ESG characteristics or impact investing, respectively. We expect to see more appetite for funds classified under article eight or nine. As a matter of fact, many of our LPs are already asking about that and are pleased to see we will be classifying our funds as such. Sustainability has always been core to our activities, incorporated at all levels, so SFDR essentially rewards us for those efforts.
What are you noticing in terms of appetite for sustainability-linked loans?
CDM: Since last year we have really seen growing appetite for sustainability-linked loans and a growing number of private debt players launching impact or impact-linked strategies. Those vary a great deal; some might be funds targeting job creation, some are targeting economic development in emerging markets, and others are focused on specific sectors like healthcare or energy, for example.
We are also seeing more funds incorporating an ESG margin ratchet, which is not new but is becoming more common. Overall, we are all working on incorporating more ESG considerations into our investment decisions, or at least starting to think about it because of pressure from investors to align with our peers. Covid accelerated the trend as we all noted the resilience of highly rated ESG funds through the crisis. And, of course, the other reason for increased activity is regulation that gives us a legal framework.
What opportunities and challenges do you see in that part of the market?
CDM: The biggest opportunity that comes out of this is creativity; as I mentioned before, we are already seeing funds with margin ratchets that apply when ESG criteria are met, but we are also starting to see upward as well as downward margin ratchets, with some portfolio companies investing the amount saved in margin in internal projects benefiting the company. So, there is room to be creative.
On the other hand, the challenge is the risk of greenwashing, because even if regulation makes it more difficult, the risk of having a fund launched without making real impact is still there. Another challenge will come in collecting the necessary information as SFDR moves forward in its requirements. SFDR will introduce KPIs and those will be really key in future. One key challenge we see is the small size of our portfolio companies. We need to be sure they are ready to calculate those KPIs accurately on a regular basis. We have already started to work with them on that.
LPs now really want to see mindfulness around ESG factors and how they get incorporated into investment decisions. They are looking for lenders to capture data and standardise their reporting. Some of the top risks that we are seeing concerns about are frequently linked to environmental factors, social factors and cybersecurity.
LPs are more and more interested in analysing the E and the S in ESG, highlighting the growing attractiveness of a well-developed ESG policy to investors in the asset class. Although debt holders by definition do not own companies – and therefore cannot directly influence company behaviour – the market is increasingly recognising the ability of lenders to influence ESG practices through the terms and conditions, and ultimately the pricing, of debt structures.