As 2018 draws to a close, debt fund managers and investors will be considering what the coming year has in store.
Recent years have provided private debt with significant tailwinds, including tightening up of bank lending, poor performance in other fixed income assets and a relatively benign economic environment. However, with the US public equity market now officially entering bear territory, interest rates on the rise worldwide, the spectre of a trade war between the world’s two biggest economies and political turmoil in the European Union, 2019 is likely to set a very different tone.
Among the most central issues is that of the economy and trying to predict where we are in the credit cycle. Most industry professionals now agree that we are in a late cycle period and should start preparing for the eventual downturn.
Ted Goldthorpe, partner at BC Partners Credit, said: “The next five years will start to differentiate between the good and less good underwriters and it will be interesting to see how managers perform through a cycle.
“I think this will be a different type of cycle, with a lot more dislocations and debt swaps but not a huge default wave like we’ve seen in the past.”
Many managers believe the next cycle will start to separate out more experienced credit teams from those players who are new to the business and have tried to ride the recent wave of private debt popularity.
“The established firms with dry powder, experience of cycles and discipline….will fare well. The newer entrants who have striven for quick growth in the last 18 months, with a small team and without the experience of a full credit cycle, will do less well and may be holed below the waterline,” said Howard Sharp, partner at Park Square.
One of the possible triggers for a change in economic fortunes could be the final end of quantitative easing. While the US and UK have already ended their support programmes, the European Central Bank has persisted in buying bonds through quantitative easing up until the end of 2018. The end of quantitative easing and potential future interest rate rises will dramatically change markets have seen record low rates for most of the past decade.
Sharp believes this will be an important development, and said: “Economically, the end of Quantitative Easing and its effects on markets is an area we have been closely monitoring and preparing for. There are clear signs of weakness in credit markets in the US at the moment and European loan markets are always slow to react. In our view, a correction in terms, in the favour of lenders, is overdue.”
One major downside of the buoyant loan market of recent years has been a slow erosion of terms and covenants for lenders. If the current borrowers market dissipates, it could turn the tables in favour of debt fund who will be able to obtain betters terms and provider their investors with vital protection.
Asset selection will also be key, and with a glut of private equity money in the market, there is likely to be sufficient deal flow for lenders to be able to pick and choose the best credits, though competition for these loans is likely to remain fierce, meaning managers will have to be nimble enough to seal the deal quickly.
However, industry professionals, particularly those in Europe, should not forget the threat of regulation. While regulatory clampdowns on the banks have been a positive development which has helped private debt become established, as the asset class grows and becomes a bigger share of the loan market it is inevitable that regulators will start looking at the industry, according to Cheyne Capital partner and Alternative Credit Council chairman Stuart Fiertz.
“In 2019 we need to make the case as an industry that the development of non-bank lending reducing systemic risk, rather than adding to it. We have to make the argument to regulators that we are less levered than banks and better aligned with borrowers,” he explained.
The approaching year seems filled with uncertainty, but private debt is in a good position to capitalise on this. With the industry insulated from the volatility hitting public markets and able to continue offering superior returns to investors, the real focus will be on sourcing quality deals and working hard to get favourable terms and conditions.