Loan Note: Preferred return under scrutiny; US property ‘fragile’ says Moody’s

Callan's findings from its inaugural study of private debt fees. Plus: Moody's highlights the fragility of US real estate markets; and France's Eiffel Investment adds to its sustainability toolkit. Here's today's brief for our valued subscribers only. 

They said it

“Aggregate EBITDA and FCF [free cashflow] margin forecasts for a global cohort of 1,875 corporate issuers are moderately less optimistic than six months ago”

This is despite the aggregate revenue forecast being revised modestly upwards following better-than-expected 1H23 results, says a report from Fitch Ratings.

First look

Fees in a new era: rising rates are putting pressure on preferred returns (Source: Getty)

Study finds pressure on preferred return
In the era of ultra-low interest rates, private credit managers were able to push the preferred return – the minimum return to be achieved before the payment of carried interest is permitted – down to between 6 and 7 percent from a prior level of 8 percent.

In the new era of rising interest rates – from which managers stand to benefit from floating rates in many cases – there is increasing pressure from limited partners to move back to the 8 percent level, according to an inaugural study of fees in private credit from investment consultants Callan. The median preferred return moved up to 7 percent last year from 6 percent in 2021. Carried interest in private credit is typically around 15 percent.

The study, which covered 330 funds and had an 86 percent bias to North American and global strategies and a 62 percent bias to direct lending, found that the median management fee during a fund’s investment period was 1.15 percent between 2016 and 2022. The median stood at 1 percent in 2016, rising to 1.25 percent last year.

The highest median management fees were found in opportunistic, distressed, multi-strategy and asset-based lending funds while the lowest were in direct lending (partly due to the fees being charged on a larger capital base) as well as real assets and niche strategies where funds were often newer and smaller and needed to price competitively to attract new capital.

The study also identified moves to tiered pricing depending on fund leverage and commitment amounts, and the increasing popularity of first-close discounts. Sixty percent of managers made a GP commitment to the fund of between 1 percent and 1.49 percent.

Moody’s calls US property markets fragile
Moody’s Investors Service has published its quarterly assessment of US property markets, also known as its Red-Yellow-Green scores, and the overall credit worthiness of those markets has fallen three points, from Q4 2022 to Q1 2023.

The RYG is a 100-point scale in which the middle zone (yellow) occupies the range above 33 and below 67. In less quantitative terms, yellow is defined as “on the cusp of imbalance and therefore fragile”. The overall score, 67 in Q4, fell to 64 in Q1.

Retail and industrial property both remain green (at 85 and 67, respectively). The other segments of the property market fall at various points within yellow terrain: multifamily, 66; hotels, 64; central business district offices, 40; and suburban offices, 37.

The multifamily score sustained a full six-point drop, from 72 to 66, and this comes as a follow-up to a greater drop from Q3 to Q4. Indeed, multifamily (like industrial) has now fallen in each of four consecutive quarters, with both markets hit by high vacancy rates.

The office sector has taken notable hits in recent years. The pandemic forced the closure of many offices and since then work-from-home arrangements, in industries where such arrangements are most feasible, have undermined the demand for office leases. In recent quarters the office score has stabilised in the low yellow range. It may drop further, into red, as longer-term leases come up for renewal.

Eiffel adds to sustainability toolkit
Paris-based fund manager Eiffel Investment has partnered with climate-focused data solutions provider Carbon4 Finance to introduce a new evaluation methodology that it says will allow it to enhance the investment, governance and climate strategies of companies.

“This methodology will help us make investment decisions that are even more enlightened and to direct our capital towards companies that have made a firm commitment to sustainability,” said Antoine Maspétiol, head of the private debt strategy at Eiffel.

Founded in 2019 and viewed as a pioneer of impact debt investment in Europe, Eiffel has incorporated around 150 “Covenants d’Impact” into its deals – covenants that move the interest rate paid up or down depending on a portfolio company’s success or otherwise at meeting environmental and/or social targets.

The firm is currently raising its Impact Debt 2 fund, an SFDR Article 9 vehicle that aims to contribute to the transition to a low greenhouse gas economy. The fund has so far raised almost €650 million on its way to an €800 million target. 


Fund leaders survey: we’d love to hear from you!
This year’s Fund Leaders survey is up and running and we want to hear from you! Submit your form to us by 17 July and you will get a complimentary copy of the results when they are published at the end of July, as well as entry into a prize draw to win a $250 Yeti Cooler.

Topics covered in this year’s survey are as follows:

  • Fundraising (market sentiment, factors impacting performance, performance predictions).
  • Sources of capital (private wealth capital, digital fundraising platforms, geographic distribution of investors, continuation funds).
  • Headcount and AI (changes in headcount, priority areas for increasing headcount, AI implementation across firms).
  • ESG and DE&I (factors driving ESG adoption, link between ESG and performance/value creation, DE&I in portfolio companies).
  • GP stakes (GP stakes interest, objectives and considerations in selecting buyers).

Man Group to buy Varagon, leave investment team in place
Man Group has agreed to buy a controlling interest in Varagon Capital Partners, for cash payments of $183 million, in a deal expected to close in the third quarter of 2023.

Varagon, a mid-market private credit manager founded in 2014, has completed $24.5 billion of financings in over 300 companies and 138 sponsors. It has $11.8 billion in assets under management and $15.4 billion in total client commitments.

This acquisition comes at a time of transition for Man Group. Luke Ellis is retiring and Robyn Grew is onboarding as the new chief executive officer. In a statement on the Varagon acquisition, Grew called it: “Indicative of our commitment to diversifying our client offering and our strategic expansion ambitions in the US. Varagon has built a high-quality investment platform and shares our vision to deliver outperformance for clients. Our extensive distribution network and operational expertise will support Varagon with its continued growth and delivery for clients, and we very much look forward to working with such a strong team.”

Man Group will pay the $183 million to interest holders Aflac, Corebridge, AIG and former members of Varagon’s management team.

Varagon’s investment team and processes will not be changed, the statement said. The firm was founded in 2014 with the aim of looking to the top of the capital structure of its portfolio companies. It targets cash generation from non-cyclical industries, often serving as a lead or co-lead lender.

A London-based multinational with a history stretching back to the 1780s, Man Group began with James Man’s contract to supply the Royal Navy with rum. As of the end of the first quarter of 2023, Man Group had assets under management of $144.7 billion.

New mid-market firm raises $245m
Philadelphia-based Hidden River Strategic Capital has closed on $245 million of committed capital – which the firm said was “significantly above our initial target” – for its Fund I, which is focused on non-control debt and equity solutions.

Hidden River was formed to address the funding gap that it believes exists between the “often rigid” investment approaches of traditional credit funds and the “overly dilutive, controlling” approaches of growth equity and buyout funds.

The firm targets owner-operators looking for a capital partner that will allow management to continue to own and run their businesses. Investment tickets range from $5 million to $25 million per company.

Hidden River says it is often the first, and most meaningful capital partner for positive cashflow businesses generating at least $10 million in revenue. Capital is commonly used for growth, acquisitions, inactive shareholder recapitalisations and other strategic initiatives.

The team comprises self-described “lower middle-market veterans” including partners Steve Gord, Todd Morrissey and Kevin Condon. Gord and Condon were previously at junior capital specialist Boathouse Capital.

LP watch

Institution: Texas County and District Retirement System
Headquarters: Austin, US
AUM: $42.7 billion
Allocation to private debt: 28.76%

The Texas County and District Retirement System has confirmed a commitment to Silver Point Capital.

The Austin-based US public pension fund confirmed a $250 million commitment was made to Silver Point Distressed Opportunity Institutional Partners II. The fund invests in distressed corporate debt in North America. In March, the vehicle reached a first close at $1.17 billion.

This marks the second distressed debt commitment TCDRS has made this year. It recently made a $50 million commitment to distressed real estate fund Taconic Credit Dislocation Fund IV.

Platinum subscribers may click here for the investor’s full profile, including key contacts, allocation strategy and fund investments

Today’s letter was prepared by Andy Thomson with John Bakie, Christopher Faille and Robin Blumenthal contributing