M&G eyes wealth of opportunity

As the private credit markets continue to expand in Europe, William Nicoll, M&G Investments’ head of institutional fixed income, says investors will do well to remember opportunities that exist beyond direct lending.

This article is sponsored by M&G Investments

How do you see the private debt market evolving over the next five years?

William Nicoll

The US financial markets are clearly the most developed in the world and the rest of the world is attempting to catch up to a system that is not totally bank-dominated. We are therefore seeing what could be perceived from the outside as a number of chaotic market shifts, as each continent and jurisdiction works out what is going to be best for them. Europe, in the last decade, has gone from a position that was described as having more than 80 percent of lending done by banks to something closer to 60 percent.

We see the private credit markets continuing to take market share away from the banks, not least because policymakers are quite keen to see a far deeper and more structurally robust set of markets. This means there will be unintended consequences as the regulators act, such as we have seen in the speciality finance area, which will become quite an important market in Europe – possibly more so than in the US – because of the way regulators have moved.

We see the current trend continuing for the next 10 or 20 years as we fundamentally redraw how the markets operate to create deeper and more interesting debt markets. I don’t see the future for Europe looking exactly like the US, simply because other regulatory forces are in play.

That does not mean it will be plain sailing in every market. Clearly, direct lending is now a very crowded market, especially in Europe. That may go through its own mini-cycle as part of the larger cycle that sees us end up with more debt finance coming from asset managers and insurance companies.

What does that mean for the various participants in the market, particularly investors?

The risk is that when people think about private debt they focus too heavily on direct lending, which has become almost synonymous with the asset class. You cannot fit the amount of money that wants to go into private debt solely into direct lending, so the savvy investors are realising that the private credit markets are more complex.

If you go back to 2009 when we did our first direct lending fund, it was very hard to attract investors because it was very new, but there were huge opportunities out there. Now it’s the other way around.

The direct lending space is going to have a credit cycle at some point that will result in losses on those portfolios because that’s the nature of the market. That will cause a hiccup but will shift the spotlight to areas like private asset-backed lending, leasing and trade receivables, which continue to develop as their own markets.

It is also important that when investors talk about private debt they don’t overlook markets like long-lease property and income strips, because each of those other private markets has its own little cycle.

As a general rule, we feel that when a market starts developing, we probably have a couple of years to make attractive investments and then it will go through a cycle, either because it gets too hot or becomes difficult in some way. We advise people to invest quite flexibly so that they can take advantage of new markets that come up and to have the courage to move into the best new investments. We are bottom-up value investors, so if a particular area looks like offering lower returns or worse structures, we will naturally cycle away from that.

The key thing is that private debt is not just one market but lots of different little markets that really do not look at each other. If you’re lending to platform lenders who are lending directly to consumers, for example, you will be affected by the economic cycle in a different way to other credits. The markets are quite separate and unless we have a really bad credit cycle, it is quite likely we will continue to see strong opportunities in some markets most of the time.

“The risk is that when people think about private debt they focus too heavily on direct lending, which has become almost synonymous with the asset class”

What should managers be doing now in anticipation of changes to investor demand for the asset class?

They need to be looking at where the next markets are going to grow, where people want to borrow money and where they can generate good returns. They will need to spend money on research to find the next great markets, which will probably not offer easy access.

The R&D angle is quite important. Simply following other market participants is significantly less attractive in this area than in others. At the moment, there is too much money and as soon as anything emerges as a defined market investors are piling in and you have probably lost most of the return.

From an investor perspective, you defend yourself by having a sensible conversation with your asset manager and by not being wedded to something in a race to get money in the ground. It is better to be patient.

Where do you see the opportunities for investors right now?

We have definitely seen a lot of money available to companies to be able to borrow directly without covenants, so there will be an opportunity at some point for distressed debt. We are starting to see the distressed
players working up.

The other area is some of the more complicated ideas that have been around for a long time, like the way that banks are financing themselves through speciality financing or regulatory capital trades. Those are long, complex transactions to do, because they require a large amount of resourcing, so there are not that many people looking at them and there is still some price discipline.

As an investor you are looking for things that aren’t popular. For many years we had much less competition in private debt but this has changed significantly as it’s become more popular and there have been new entrants to the market in the last five years.

How do you think the asset class will respond in the event of a downturn and how should managers invest in that scenario?

In general, private lending is well placed where there are covenants that allow investors to get in early to help companies or structures in difficulty. The concern is that in some parts of the market there has not been that discipline and covenants have been eroded. We will not have those private assets doing better in a downturn than public assets, as we have come to expect.

There is also an issue of timing. If the corporate environment gets challenging, the public markets will move quite quickly but the private markets will tend to drift more slowly. There will be a very different impact depending on what kind of a downturn we have and what sectors and geographies it hits hardest.

What jurisdictions or strategies should people be looking at to prepare for a change in the economic cycle?

People really need to have open minds an the flexibility to look at private debt more holistically in order to get the value that is out there. We look at all jurisdictions and all asset classes and seek to work out which deals make sense, even in some sectors that might be presumed to be very difficult, like retail.

For us, it comes down to the protections that we can get, because that is really how you prepare for a change in the economic cycle. Investors need to look for protections that work in all reasonable circumstances and make sure that they don’t lend badly.