PDI 50: the cost of consolidation

The drift of capital towards a small cohort of mega-funds remains a theme for private debt, but at what price?

While there has been some interesting movement at the top of the new PDI 50, coupled with some jockeying for position at the lower end of the rankings, one clear trend has continued from previous years: the increasing size of private debt managers. Ares saw the most striking increase in its five-year fundraising total, going from $23.8 billion last year to $37.7 billion in 2018. Even Mesa West Capital, which is propping up the index at number 50, has now raised over $4 billion in the same period, 10 percent more than the $3.6 billion Pacific Coast Capital Partners needed to take the same position in 2017.

Ever-larger managers are an inevitable outcome of private debt’s move from a niche to a more mainstream asset class. It is easy to see the benefits of achieving scale to general partners, but it is unclear if this is wholly positive from a limited partner perspective. Figures quoted at a recent PDI event in London said that 75 percent of LPs either wanted to increase, or stabilise, the number of GP relationships, with less than a quarter looking to see more consolidation among their private debt partnerships.

According to James Newsome, the Berlin-based founder of placement agent Arbour Partners, one major issue relating to the impact of scale in the private debt sector is a decrease in the percentage of non-sponsored deals. In other words, as the private debt world expands, it is increasingly reliant on private equity firms for transactions.

“The proportion of private debt capital raised by the top 10 managers has grown and these larger managers say that the opportunity to expand the market lies in the bigger deals where private debt can be a solution that replaces high yield and syndicated loans. Several managers are fighting to join the group in that $100 million-plus loan market,” he says.

“This makes sense from a GP perspective. You can run a $3 billion fund, with 15 positions, at an average loan size of $200 million with a team of 20. A fund providing 15 secured loans to non-sponsored companies, at $20 million per loan, will only be $300 million in size but will need just as many investment professionals on similar compensation, and potentially more local offices. So, the economics for GPs partly explains the lack of progress in the non-sponsored lending market.”

“The proportion of private debt capital raised by the top 10 managers has grown and these larger managers say that the opportunity to expand the market lies in the bigger deals – where private debt can be a solution that replaces high yield and syndicated loans”
James Newsome

Newsome’s view appears to be borne out by the latest issue of Deloitte’s Alternative Lender Deal Tracker. According to the report, non-sponsored deals made up just 18 percent of private lending deals in Europe, excluding the UK, in the first quarter of 2018, versus 38 percent for the same period in 2016.

Newsome adds that this trend is having a negative impact on the market with the supply of credit to non-sponsored companies falling below the level of demand, particularly at the smaller end of the market. Given the private nature of the market, Newsome concedes it is difficult to pin down precise figures but he says conversations with private debt managers bear this out.

“You will often hear managers in the lower mid-market say, ‘In our sector we face little or no competition for the type of credit we supply.’ Even discounting for an element of marketing-speak, this certainly does seem to be a healthier lending environment than parts of the upper mid-market.”

The impact of increased consolidation on the number of non-sponsored deals backed by private debt is not universally accepted. Indeed, a recent report published by law firm Dechert in conjunction with the Alternative Credit Council, Financing the Economy 2018, argues the opposite. Figures cited by the report, which surveyed around 100 private debt managers, said that sponsored deals, by number, had fallen from 55 percent in 2017 to around 40 percent so far this year.

“This supports the hypothesis that non-sponsored lending is a potential growth area for the industry,” says the report.

Evolution of the market

Gus Black, London-based partner at law firm Dechert, concedes that initial responses to the report have suggested it may have underestimated the amount of sponsored activity actually taking place, but he says it does accurately reflect an evolution of both LPs’ and GPs’ approach to the private debt market.

Black says that as LPs have become more familiar with the sector there is an increased appetite for co-investment with private debt managers, while at the same time GPs have been incentivised to set up direct lending platforms as competition for deals increases and margins gets compressed.

“Some debt managers have been building out direct origination channels, so they can do unsponsored lending bilaterally with corporate borrowers, rather than being reliant on a private equity firm to bring them in the back of an LBO deal.

“This has partly been driven by the volume of dry powder, competition for deals and pressure to deploy capital. This route to market means private debt firms may be able to get their capital deployed more quickly without being beholden to their network of private equity firms. As sponsorless origination requires significant infrastructure on the part of the private debt firm, an increase in sponsorless activity seems a natural consequence of more consolidation in the sector.”

If Black is proved correct it would provide some relief for Arbour’s Newsome, who says that the structural health of the private debt market is threatened by an over-reliance on private equity sponsors, given the cyclical nature of that asset class.

“A market reliant on private equity activity is just that – exposed to the comings and goings of a cyclical borrower sector. If, as many had hoped, large lending platforms with mixed sponsorless and PE-based lenders had proliferated, our market would be a strong prospect throughout a cycle, as LPs participate in perhaps more complex financings in the general economy when M&A or LBO activity is quiet,” he says.

Irrespective of the impact of the private equity cycle, one obvious concern for LPs facing increased consolidation among private debt providers is concentration risk. According to Newsome, this is driving some of the larger investors in the sector to look at ways of diversifying their exposure to private credit via other instruments, a trend which he predicts could happen within the next 12 months.

“Several large allocators – big insurers and pensions – have told me that they need to look at other parts of the credit complex now. We may see trends emerging next year. As well as a search for opportunity funds that will invest through a cycle, LPs are mentioning trade finance, invoice or working capital financing. The big marketplace SME lenders are all attracting attention because they provide the diversity and granularity that insurers for example came in to our market to achieve,” adds Newsome.

The bigger players may be looking to broaden their private credit exposure but, according to Tavneet Bakshi, a London-based partner at placement agent First Avenue Partners, the current market and regulatory dynamics mean for most LPs the trend will be towards the larger players.

“LPs have a far higher bar in terms of the institutional platform that they need, irrespective of the number of people in the individual investment boutique. This is in part a result of coming through the GFC but also due to a more stringent regulatory environment,” she says. “That alone is almost a self-fulfilling cycle such that any GP coming to market now needs to have more substantial working capital and starting AUM and that’s very hard to do.”