As the private debt asset class emerges from a global covid lockdown that hit emerging managers hard, investor appetite for new entrants is high and innovative GPs can look forward to accessing a growing range of institutional backers.

Jess Larsen, CEO and founder of specialist placement agent Briarcliffe Credit Partners, says: “We are now in a situation where private debt accounts for $1 trillion in assets, there are more than 2,000 GPs active, and about 650 private credit funds in the market raising funds right now. That’s a historically large number, almost double what it was last year, so how do you establish yourself as a new manager in that environment?”

He points to four boxes that new managers need to tick if they are to get off the ground: a proven track record, seed capital, a niche strategy and, ideally, some attachment to a larger private markets platform. Those are tough criteria, however, creating a danger that the asset class is stymying the very innovation it thrives on.

And covid certainly hasn’t helped. “Pre-covid, over the last 10 years, on average the top 50 private credit GPs raised about 70 percent of all assets on an annual basis,” says Larsen. “If you weren’t in the top 50, you were fighting over that remaining 30 percent. Then covid hit, LPs weren’t able to meet new managers and establish new relationships, so the concentration of capital among the top 50 went up from 70 percent to almost 90 percent.”

The good news is that the institutional investor community is apparently alive to the fact that it is now overallocated to the largest managers and is not only more receptive to new managers but is actively seeking differentiated approaches.

Klaus Petersen managed to break through before the pandemic when he launched Apera Asset Management at the end of 2019. Petersen set up the business after leaving BlueBay Asset Management, where he was head of German direct lending, and raised €750 million for Apera Capital Private Debt Fund I, which provides senior secured loans to lower mid-market companies in northwestern Europe. He launched a second fund in 2020.

Petersen says the biggest challenges for emerging managers relate to track record, infrastructure and team, all of which require patient capital to get started. “You can be very experienced,” he says. “But unless you have an infrastructure comparable to existing players, how can you expect to convince people to give you significant amounts of money to manage on their behalf?”

The fourth element is differentiation. “We were differentiated because as funds have grown massively and started doing much larger deals, they are leaving behind a market segment that is the biggest by numbers, because it doesn’t make sense to do €60 million tickets with a €10 billion fund,” says Petersen. “That market segment is underserved, with banks also rotating out of that space.

“There is now clear differentiation between the upper end of the market and the lower end, which wasn’t clear before – the truth is they are different markets with different characteristics. The lower end is where banks never offered non-amortising loans, there are stronger covenants, lower loan-to-value, and pricing is also different. The big guys are focused elsewhere and that just creates a massive opportunity.”

Emerging managers

It is an opportunity that institutional investors are increasingly aware of. The big question now is whether LPs will continue to concentrate capital with the largest players or whether we can expect a post-covid wave of entrepreneurialism driven by emerging managers.

Kevin Neubauer is a partner at US law firm Seward & Kissel, which recently published its 2021 Alternative Investment Allocator Survey. That found an overwhelming majority of investors – four out of five – allocating to emerging managers, with all the funds of funds questioned allocating to managers founded less than two years ago, and half of pension funds doing the same.

“Institutional investors are still broadly
under-allocated to private credit versus where they should be”

Jeffrey Griffiths
Campbell Lutyens

Neubauer says: “In 2020, managers who had existing relationships were much more successful at raising capital than emerging managers. A lot of emerging managers pushed ahead and did their best, but maybe their fundraising results were not as good as they had expected. By and large, those that opted to sit it out have been proven correct.

“At the start of 2021 there was a recognition from institutional investors that if they did not get comfortable with remote meetings they were going to miss out on good opportunities with emerging managers. We have seen an uptick and there is certainly still institutional investor appetite for new managers. That may be because of more attractive economics offered by those that are hungry for capital, but also because investors that allocate to dozens, or even hundreds, of funds are always interested in something new.”

Jeffrey Griffiths is a partner and co-head of global private credit at placement agent Campbell Lutyens. He says plenty of emerging managers are coming through to target the lower end of the mid-market left behind by the more established players.

“We also see new management focusing on particular themes, such as ESG or impact credit,” says Griffiths. “We don’t see new managers coming into upper mid-market direct lending, which is well-established and where breaking in is particularly difficult. But not all investors are looking for large funds operating in a well-trafficked space – some are looking to achieve specific objectives or already have exposure to that larger, more competitive space and are happy to support groups that can achieve diversification for them.”

At Briarcliffe, Larsen identifies four strategies that are growing as LPs look for routes that complement the larger funds in their portfolios: real asset credit; speciality finance; structured credit; and a new breed of corporate credit, with a very narrow sector focus or in areas where there are high barriers to entry and larger funds cannot participate with smaller tickets.

Larsen says: “We are certainly seeing a broader offering of more niche and sector-specific strategies, and we are seeing institutional demand for them, which is very encouraging.”

New kids on the block

As existing investors continue to up their exposure to private debt, there are also new investors coming in with sophisticated strategies of their own.

Petersen says of raising his first fund: “It was difficult because you have to convince investors that despite the fact that it would be easier for them to invest with established players, there’s true value in investing with you. You deal with people that are very experienced and need to diversify their platforms, and they are supportive. But what’s happening also is there are quite a few sophisticated advisers and investors who haven’t had exposure to private debt yet and are looking at the market with the benefit of much better data and analytics, taking a view on each segment.

“We see new investors that are seasoned investors elsewhere but not in alternative debt, and they are building portfolios, looking at the upper and lower ends of the mid-market and picking and choosing guys that they find interesting.”

Griffiths also sees the investor base expanding: “In Europe, there are still pension funds coming into the asset class, especially in places like Germany and Sweden where we continue to see new entrants, and in the UK with local government pension schemes that have recently pooled.

“In the US, we are seeing an interesting development with fixed-income pools that are now looking to private credit through securitisation structures. We are seeing private credit funds being securitised like CLOs, which is allowing a new pool of investors an access point into the market.”

High-net-worth individuals continue to seek exposure to private debt, driving further innovation. Private credit offers these investors five- or six-year funds compared with the typical 10-year fund in private equity, and typically pays a quarterly dividend.

Larsen says: “We are seeing aggregating platforms that allow smaller wealth managers and independent financial advisers into institutional funds. That’s important because five years ago a single investment into these funds could be $5 million-$10 million minimum, but with these platforms you can open up a $15 trillion pool of new capital from smaller institutions, family offices and private investors.”

At Seward & Kissel, Neubauer says he has observed a growth in the number of hybrid funds being raised to target that same pool. “A manager is managing a private debt fund, originating loans to mid-market companies but giving investors the ability to control the timing of their liquidity to some degree,” he says. “They can invest not just in one fundraising period but on a monthly or quarterly basis for the life of the fund, allowing the manager to continue to raise capital and offering investors some level of liquidity. The biggest challenge is how you provide liquidity to investors in an illiquid asset class.”

Under-allocation

With sovereign wealth funds also increasing their allocations, and huge potential growth expected from Asian LPs, GPs with the right strategies can expect more capital to flow.

Griffiths concludes: “Institutional investors are still broadly under-allocated to private credit versus where they should be. The average allocation today is 3 to 5 percent across pension funds and insurance companies, and it probably should be nearer 8 to 10 percent. We are seeing average allocations increasing slowly over time and I think we will see the market grow into that, because the returns profile on offer of anywhere between 5 and 9 percent in your plain vanilla private credit fund is the sweet spot for these institutional investors to meet their liabilities.

“Longer term, those institutions will likely be doing less higher-return private equity and less lower-return publicly traded fixed-income, and instead focusing on private credit in the middle. We will see more specialist funds, more regional strategies, more opportunity to deploy capital in Asia, and a gradual move away from private equity lending towards non-sponsored lending to family-owned and privately owned businesses. But the thing about private credit is this is not going to happen fast.”

While covid may have put the brakes on innovation in the past 18 months, expect a rebound on the horizon.