This article is sponsored by Northleaf Capital Partners
Northleaf Capital Partners is an independent global private markets investment firm with more than $13 billion in private credit, private equity and infrastructure commitments under management on behalf of public, corporate and multi-employer pension plans, endowments, foundations, financial institutions and family offices. Based in Toronto, Montreal, London, New York, Chicago, Menlo Park and Melbourne, Northleaf’s 140-person team is focused on sourcing, evaluating and managing private markets investments globally, with a focus on mid-market companies.
In 2018 the company launched Northleaf Senior Private Credit, an evergreen fund for mid-market direct lending. David Ross, London-based global head of private credit, expects continued growth of evergreen funds in the sector and increasing commitments from new investor types.
What are the benefits of evergreen funds and which investors like them?
The private credit asset class has been attractive to investors given the strong returns, muted volatility and portfolio diversification it provides. Private credit evergreen funds offer all of the advantages of the asset class with the additional benefits of enhanced liquidity, shorter investment periods, better visibility to capital draws and consistent and ongoing exposure to the strategy.
These characteristics appeal to a broad range of investors, including institutions, family offices, high-net-worth individuals and independent asset managers. The evergreen structure is one with which they are familiar and comfortable, as it more closely resembles a public market fund.
How common will evergreen funds become in private credit?
It is natural that as private credit matures as an asset class, we will see new fund structures develop in response to the increasing demand from both institutional and non-institutional investors. Closed-end funds are likely to remain the most common structure for institutional investors due to the underlying characteristics of most private market investments. We still regard the closed-end fund structure as a very attractive way for investors to access private credit. We see evergreen funds as a growth driver, tapping into incremental investor demand.
How do you manage the tension between investor demand for liquidity and the need to invest in illiquid assets?
We spent a significant amount of time designing the mechanics of our evergreen fund, Northleaf Senior Private Credit. It was incredibly important that the fund’s liquidity provisions were driven by and aligned with the strategy of the fund and the natural liquidity of the underlying assets. It is the relatively shorter weighted average life of the diversified portfolio of loans that underpins and allows for the liquidity provisions of our vehicle.
More specifically, we included a number of design features in our evergreen fund structure to manage the tension between the illiquid underlying assets and the investor desire for liquidity from the fund. The asset class benefits from natural liquidity through the maturation, amortisation and refinancing of the underlying loans, which can be used to help provide investor liquidity.
We have structured Northleaf Senior Private Credit with a three-year ‘lock-up’ period that matches the approximate three-year average duration of the diversified portfolio of underlying loans. We find that while investors are attracted by the flexibility of a liquidity provision, the ability to maintain stable and ongoing exposure to the strategy and asset class is equally important – as is the ability to deliver ‘pure play’ private credit exposure without including public securities or significant cash holdings in the fund’s portfolio.
Our fund facilitates this by reinvesting principal on behalf of investors and by constructing a diversified portfolio of approximately 70 individual loans. Importantly, the fund was structured to provide access to mid-market loans for investors interested in making a strategic allocation to the asset class. While the liquidity provisions enable investors to redeem their exposure over four quarters, the fund is not designed for investors looking for a short-term trade.
We believe that Northleaf Senior Private Credit is the first – and, so far, only – mid-market-focused private credit evergreen fund. Some evergreen funds offer a mix of exposure across both public and private fixed income, but that sort of mix means that investors are not able to benefit fully from the private market return premium. By contrast, Northleaf Senior Private Credit invests 100 percent in private loans.
Looking at barriers to entry for prospective future funds, is it hard to run an evergreen vehicle?
There are significant challenges to launching and efficiently managing evergreen funds. For this reason, we believe that firms with broad operating platforms and depth of credit investment capability will be best positioned to offer evergreen structures.
On the operational side, a fund manager needs to be able to integrate the selection of individual assets with the active management of the entire portfolio. This requires the capability to consistently originate a large pipeline of deals. For Northleaf Senior Private Credit, that means selectively investing in 20 to 30 deals each year, with a target total portfolio that is diversified with 70-plus positions.
In addition, effectively managing such a large and diversified portfolio requires an active risk management process, which begins at the time of credit selection. At Northleaf we have a dedicated portfolio strategy and analytics team that is involved throughout the investment and portfolio management processes.
The team’s mandate is to supplement traditional bottom-up credit analysis with a top-down portfolio diversification and risk management perspective. The added layer of analysis and oversight helps to build an insulated, ‘all-weather’ portfolio that is a key success factor for an evergreen fund.
Do you need to make different kinds of investments for your evergreen fund?
It is crucial to avoid compromising the quality of the investments, or change the underlying investment activity, to achieve the evergreen fund structure. We continue to invest in high quality senior secured deals with attractive terms and returns. Northleaf’s differentiated sourcing platform enables us to remain highly selective while still maintaining a steady investment pace.
Away from evergreen funds, what kind of challenges will lenders face in the future?
We use pattern recognition and trend analysis to frame and focus our investment strategy and enable us to assess future potential risks. In recent years, and over the course of the past decade in particular, borrowers have created efficiencies in their supply chains to cut costs, shorten time lags in the delivery of goods and reduce working capital, but leaving little margin for error or volatility.
One of the biggest threats facing borrowers and lenders is the potential unwinding of some of those efficiency trends, including increases in labour costs, potentially driven by global macro threats such as the trade war between the US and China, Brexit and so on. There are also heightened operational risks with respect to issues such as cybersecurity.
Will investors pay more heed to ESG issues in the future?
ESG considerations are becoming increasingly important to private credit investors. Over the long term, investors will benefit from fund managers integrating ESG considerations, such as climate-related risks, governance structures and social risks, into their investment and portfolio management process.
At Northleaf we recognise that responsible corporate behaviour has a positive influence on long-term financial performance. This belief has underpinned our approach to private markets investing since our inception and we established a formal Responsible Investment Policy in 2011. Northleaf is a signatory to the Principles for Responsible Investment and we are committed to upholding those values and applying the principles of the PRI across all of our investment activities.