This article is sponsored by Kartesia
How would you describe the European private debt market over the past 12 months?
We all entered 2020 with strong market prospects following a strong year in 2019. Like our peers, we were taken by surprise by the covid-19 outbreak, which halted the market for several months. However, people refocused very quickly, making sure they could operate from home seamlessly and ensuring there were no bottlenecks with any service providers. They also worked relentlessly to consider and to report on the impact the pandemic would have on portfolio companies.
At the beginning of the pandemic, there was lots of dry powder in the European private equity market. Some players were in the middle of dealmaking and so needed financing, while others were using their dry powder to buy companies at a discounted valuation. At the same time, banks started retrenching which created a strong catalyst for direct lenders still open for business.
On the CLOs market front, we have not seen the wave of downgrades we saw during the 2008-09 financial crisis. After a short freeze period, CLOs quickly returned to a normal level of activity.
Despite the disruption, when you look at 2020 market stats, volumes have been comparable with 2019 with more than 90 percent of the deals having been completed cov-lite. We didn’t really see a tightening of lending standards, either on volumes, leverage, pricing or loan documentation.
Has covid-19 had the impact that commentators envisaged at the beginning of the pandemic?
With our two KSO and KCO strategies, we are active in “vanilla” direct lending and special situations across Europe. We thereby benefit from a panoramic view of the European leveraged loan market and believe the full impact of covid-19 is yet to come.
So far, direct lenders haven’t felt the pain of having to top up their investment to support corporate liquidity. Most of that effort has so far been done by banks backed by state guarantees. Yet, this additional debt has effectively financed a vacuum. It has artificially funded a period characterised by a lack of activity and profits, but during which everyone had originally expected to maintain solid financial performance.
These short-term liquidity fixes will have to unfold in the next 12-24 months and be converted into permanent capital. That transition will offer opportunities to the more agile direct lenders while negatively impacting those exposed to the wrong industries and lacking diversification in their portfolios.
Additionally, although we believe the initial fallout from covid-19 is over, the lack of visibility on the exit strategy prevails. Despite vaccination programmes being rolled out all over Europe, many are thinking about re-confinement measures to cope with third waves or virus variants. In France for example, economists had originally forecasted 6-7 percent GDP growth in 2021.
Given uncertainty levels today, we hardly see such a quick recovery being possible. Should such a situation persist, high debt levels will ultimately imbalance certain types of capital structures or borrowers. This is already happening to the industries that have been the most heavily impacted by covid (travel, retail, etc), but the impact of less consumer spending in these sectors will also impact a broader spectrum of companies in an indirect way.
If this is the case, then does that mean that private debt investors, and managers, are facing a new stack of challenges?
The current situation undoubtedly slows down the entry-to-market of newcomers, as investors who are already committed to the direct lending asset class will have made their manager selections. Throughout this period, they’ve not been able to conduct onsite visits which has limited their ability to work with new managers. They have most likely grown their exposure to European private debt through existing managers in their portfolio or to those they had met with and done due diligence on in the past. Interestingly, some LPs have now selectively started doing fully digital onsite due diligence.
For new LPs, the central question lies in manager selection. There will be a flight to quality in the coming months and those with reputable platforms or with strong experience of restructuring in difficult times will be the ones that succeed. The questions for managers from new LPs are likely to focus on performance and agility through the pandemic to provide reassurance on their ability to provide stable returns despite ongoing market disruption: “How have you performed in the pandemic so far?”; “Have you offered dedicated reporting?”; “Was covid-19 properly reflected in your NAV?”; “Have you been able to source relevant deals during covid-19?”.
Lastly, although fairly standard in the more mature private equity market, secondary trading of LP interests in private debt managers could emerge as a direct consequence of covid-19. LPs exposed to the asset class are focusing their attention on the prospects for liquidity in their existing portfolio. There will be some portfolios with difficulties, that’s for sure, and you can already clearly see a growing gap between the top performers and the laggards. That trend could be a strong catalyst for an increase in activity in the secondaries market in the months ahead.
Will private debt’s ‘illiquidity premium’ be sufficiently attractive to investors in the year ahead, compared with what is on offer in liquid alternatives?
The illiquidity premium offered by the private debt asset class has remained very attractive for LPs despite the unprecedented market conditions. By the end of 2020, similar to the liquid space, private debt asset class NAVs had fully recovered to their pre-covid-19 levels. This confirmed that not only were they able to offer less volatility on NAVs throughout the pandemic but that default rates were no different than in the liquid space.
Going forward, much will depend on base rates. Everyone expects them to remain very low if not negative for the foreseeable future. As a consequence, a 4-6 percent illiquidity premium above base rates will continue to be attractive for most institutional investors, be it pension funds or insurance companies.
The second question will be around your cost of risk and management. If they become too high, it will eat a lot of that premium and reduce the attractiveness of the asset class and/or strategy. To remain appealing, you need to keep a clean track record in the top quartile while keeping your cost base as efficient as possible.
Why do you believe prevailing market conditions favour the more experienced managers?
While we think the worst of the impact of covid-19 is behind us, that does not mean that the economy is expected to recover quickly and there will still be painful situations for companies across sectors, despite winners in areas like tech, e-commerce and healthcare.
The flexibility to invest across the capital structure and indeed sometimes to take equity stakes in businesses gives managers like Kartesia access to a broad range of transactions and allows us to maintain a selective investment approach to, ultimately, deliver the best returns for our investors.
This flexibility, when combined with past restructuring experience, often in the wake of previous crises, will also allow private debt managers to enter into more troubled companies which were, pre-coronavirus, enjoying periods of growth and expansion and provide the liquidity and experience that will best position them for future success.
I’m a strong advocate of the benefits of proprietary dealflow, as are many other private debt managers, but in times of crisis this is particularly important as it avoids situations where distressed companies or special situations see their valuations soar as a result of auctions with multiple bidders. Our origination network allows us to maintain this selective and disciplined approach at fair valuations.