Loan Note: Insights into the state of direct lending; valuations start to become clearer

How is the direct lending market shaping up? We asked LPs for their thoughts. Plus, how some consistency is returning to valuations and the latest private credit return figures. Here's today's brief for our valued subscribers only.

She said it

“The historic focus on the trade-off between ‘growth versus sustainability’ in alternatives is giving way to a mindset of ‘growing sustainably’.”

Teresa O’Flynn, global head of sustainable investing for alternatives at BlackRock, taken from the firm’s virtual press briefing for Q4.

First look

What do LPs make of direct lenders’ prospects? 

Direct lending has experienced enormous growth since the global financial crisis, filling a gap that retrenching banks left behind. It has also been a market driven forward by tailwinds while constantly bracing itself for an inevitable downturn. Now that one is here, what is the outlook for direct lending? In the forthcoming November issue of Private Debt Investor, we ask LPs around the world for their thoughts. Here are a few insights taken from a handful of those conversations:

One investor found that almost one-quarter of its private debt portfolio companies were subject to high impact from covid-19. Unsurprisingly, many of these were in vulnerable sectors such as retail, hospitality and travel. Eyes are on the operational models that GPs talked about when they raised their funds and whether those models will live up to their billing. Some think this is an environment where the private debt arms of private equity firms – despite concerns over possible conflicts of interest – may come into their own because of the ability to tap PE colleagues’ operational nous.

From around 2010-13 a net return of around 8-10 percent was considered par for the course for direct lending. Since then, competition has compressed returns and made that target range more like 6-8 percent. How returns fare in the period ahead depends on the level of defaults – everyone knows they’re going higher, no one knows exactly how high. Just one loss in a portfolio could take returns down to 5 percent at the most, although some funds are still able to access carry at this level.

Since the health crisis emerged, documentation has been getting slightly more favourable for lenders (see our Friday Letter on the topic here). Some sponsors are recognising that certain EBITDA addbacks cannot be justified in such an uncertain economic environment, and also that cash should not be leaked out of businesses that may need to keep hold of that cash for the next year or two. However, there is still a lot of competition for deals in sectors perceived to be covid-resilient and, in these cases, bidders are fighting over the terms as well as the price.

While a lot of capital has been raised for distressed debt by global mega-funds, observers have noted a number of new emerging distressed debt managers in Europe targeting niche opportunities – including the possibility of purchases from direct lenders. This would be a relatively new phenomenon in a market that hasn’t seen many secondary trades to date.

How to solve the valuations riddle

One of the key themes of recent times in private markets has been investors pushing for greater transparency and more regularity of reporting. At a time of crisis, this is of course all the more important for investors but all the more difficult for fund managers.

This article from John Czapla of VRC provides some fascinating insights into how GPs, amid the chaos of the health crisis, have been grappling with different methodologies to try and accurately reflect the impact of covid-19 on portfolio companies. Initially it was a thankless and seemingly near-impossible task. By the end of Q2, however, some consistency in approach appeared to be emerging.

Data snapshot

Returns take a dip. Performance figures from the Institutional Limited Partners Association show negative short-term returns for private credit and distressed funds on a pooled net internal rate of return basis. Distressed only outperforms private credit over a 10-year time frame.

Essentials

CVC prices latest CLO

CVC Credit Partners has priced Apidos XXXIV, a collateralised loan obligation fund totalling $402.5 million. It is the second CLO fund CVC Credit has priced in the past month, following Cordatus XVIII in late September, and marks its fourth CLO priced this year.

Together the vehicles total around $850 million of new issuance and will increase CVC Credit’s global CLO funds raised in 2020 to approximately $1.6 billion. CVC Credit’s global CLO assets under management now stand at approximately $17 billion.

Distress signals for small UK firms

One in three (35 percent) of small and medium-sized enterprises – and 43 percent of medium-sized enterprises – do not expect to be in business beyond a year, according to a new report by Fladgate, a law firm serving the SME market.

Canvassing leadership teams at more than 500 SMEs across the UK, the Restart Capital report paints a concerning outlook for the backbone of the UK economy. A fifth (20 percent) of SMEs consider their business to already be in distress, with a further 64 percent just about surviving on current support measures as covid-19 disrupts supply chains, causing devastation to sales and soaring debts.

LP watch

Institution: Los Angeles City Employees’ Retirement System
Headquarters: Los Angeles, US
AUM: $17.68 billion
Allocation to alternatives: 21.41%

Los Angeles City Employees’ Retirement System has committed $40 million to Cerberus Institutional Real Estate Partners V, a diversified distressed debt real estate fund that invests in Western Europe and North America, according to a September 2020 meeting agenda.

Other highlights from LACERS’ September 2020 investment committee meeting include:

  • LACERS’ investment with the Cerberus Capital Management fund supports its strategy to “optimise long-term risk-adjusted investment returns”.
  • The private debt asset class makes up 5.7 percent of the system’s investment portfolio.
  • The five-year annualised return for opportunistic credit is 4.1 percent.

LACERS is moving forward with its search for an emerging market debt investment manager and has narrowed down finalists that will be presented to the full board for approval, according to the agenda.


Today’s letter was prepared by Andy Thomson with John BakieRobin Blumenthal and Adalla Kim.

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