Out of the shadows

For years, commentators have questioned the longevity of private debt. The argument goes something like this: once interest rates go back up, investor interest will drop; as restrictions on the banks relax, borrowers will turn their backs; having emerged from the embers of the global financial crisis, private debt managers have had the good fortune of operating in a benign credit market but when the real test comes, to paraphrase Warren Buffett, we will see who is swimming naked.

This may go down as the year when the asset class reached a new stage of maturity. Increasingly, private debt funds on both sides of the Atlantic are encroaching on lending territory previously seen as the exclusive domain of the banks, underwriting ever-larger tickets. Antares and Ares led the way on billion-dollar tickets this year, while GSO backed the merger of speciality chemicals firms Polynt and Reichhold with a €625 million unitranche facility.

That is not to say alternative lenders are always in a position to compete with banks. Indeed, the trend has been towards a complementary relationship, with the banks often looking to outsource risk management to funds while providing fund financing services where necessary. “If we don’t work with private debt funds then we will begin to lose market share,” one London-based banker said recently.

Such encouraging developments, however, cannot obscure the difficulties faced by the asset class this year. Despite many fund managers claiming to have shrugged off Brexit, PDI data point to a relatively slow fundraising year with $67.4 billion raised in the first nine months of 2016, compared with $90 billion in the same period last year. Meanwhile, a recent report from Marlborough Partners shows a significant drop in the volume of leveraged loans compared with last year as the wider political uncertainty takes its toll.

With solid assumptions having melted away, this year has prompted a rethink in how to assess political risk, especially in the US and UK as the status quo crumbles under a populist revolt. Political statements now reverberate strongly in the public markets. The plunge in sterling before and after the Brexit vote is likely to have had a material impact on the operating costs of portfolio companies and many are bracing for an expected increase in inflation in the New Year.

In years gone by, the education of institutional investors was essential to promote the benefits of the asset class. Reluctance to invest was guided by a range of concerns about the illiquid nature of the asset class and questions over possibly reckless lending practices.

That wall appears to be have been breached as investors divert capital away from fixed income and equities to private debt. Even the term ‘shadow banking’ may be disappearing (despite the best efforts of the Clinton campaign) as awareness of the asset class grows.

Nevertheless, the shadow of 2008 remains as we enter the next stage of the credit cycle. It’s perhaps wise to reflect on the words of Sir Michael Rake, who at our recent Capital Structure Forum advised fund managers to “remember the lessons of the past, keep things as simple as possible and confusion to a minimum, so that we don’t end up with another crisis”.