While the past decade of private credit has been fuelled by a voracious LP appetite for sponsored direct lending strategies, the next 10 years will see investors dig deeper for differentiated approaches to the corporate credit markets.
In February, Private Debt Investor’s LP Perspectives 2023 Study showed 47 percent of investors planning to increase allocations to direct lending strategies this year, while one in five plan to invest more capital in speciality finance strategies and 7 percent are looking to do more in venture debt.
The non-sponsored opportunity, in particular, is set for growth in the decade ahead. Jeffrey Griffiths, co-head of global private credit at Campbell Lutyens, says the real opportunity is going to be financing businesses that are not private equity owned but need a bit more stretched leverage to achieve their goals than the banks can offer.
“Those family-owned and founder-owned middle market companies don’t always need or ask for the same amount of leverage that private equity companies do,” he says. “So the opportunity is there to get investors exposure to those businesses, potentially with lower returns than they can get from private equity lending but with the implication that the risk level is lower as well. “There is going to be growth in corporate lending and that may not come from the private equity market, because that opportunity has already played out to an extent. What hasn’t really been tapped effectively yet is the core mid-market family-owned businesses that have always been the universe of the banks but where banks are now more constrained.”
The non-sponsored corporate market has long been held up as the future of private credit, but has proved a harder nut to crack that many managers anticipated. Sourcing is especially difficult without the funnel of private equity firm relationships to bring in deals, but sector specialists are starting to break through.
Vista Credit’s niche in supporting technology and software companies, as part of Vista Equity Partners, means that firm sees a big opportunity in non-sponsored growth businesses. David Flannery, president of Vista Credit Partners, says: “Private equity finance is a pretty tight and established market, but beyond that other strategies have yet to reach size and scale. What we see as an expanding area is a form of growth debt for non-sponsored growth companies. You haven’t yet seen large-scale lenders like us writing $200 million loans to some of the bigger companies – that hasn’t really existed yet.”
Flannery says companies used to go public after seven years and the public equity markets would fund that late-stage growth. That is no longer the case. “Over the last few years that late-stage growth has been funded by growth equity, but the size of that market is limited,” he says. “At the same time, the companies themselves are getting smarter and more sophisticated, and founders that have done this before are asking themselves why they are selling dilutive equity to the market when they have zero debt in the business.”
“With non-performing loans, you need to understand the options for working through vast portfolios”
Venture debt is another strategy set for greater things in the next 10 years, supporting early-stage businesses as the funding model for those companies undergoes transformation. Similarly, IP-based lending or other speciality finance strategies like lending to patented, cashflow generating new drugs will increasingly offer LPs returns less correlated to other equity and credit markets.
Robert Molina, managing director and head of origination at Briarcliffe Credit Partners, says asset-backed lending strategies are increasing in popularity as a conservative way to invest in credit. “You are protected by an underlying and tangible asset that has financial value, whether that is accounts receivables or contracted cashflows like music royalties,” he says. “The number of funds coming out with those strategies, and the amount of LP interest, is going to see big growth.
Such strategies used to be heavily bank dominated but are the latest part of the market to benefit from bank retrenchment.
Asset-backed lending falls into the broad camp of speciality finance strategies that offer LPs the benefit of an attractive yield and diversification in their portfolios.
Arrow Global recently held a final close on its second credit opportunities fund, hitting its hard-cap of €2.7 billion. That fund will follow the same strategy as its predecessor, which closed on €1.7 billion in 2021, pursuing proprietary off-market opportunities in niche strategies.
Alexander Slinger, managing director of portfolio management at Arrow Global, says: “The strategies we like at the moment comprise positions where we are receiving very strong margins for resilient assets. There are various segments of the residential real estate market and specialist segments like bridging and agricultural lending where collateral is resilient but spreads have widened attractively.”
He says the strategies that will reward will likely be those capitalising on deep expertise and operational investment from GPs. “In construction development lending, for example, that requires a deep understanding of how the operational development of that site is going to take place, the risks that you could face and how you would deal with those,” says Slinger.
“We are talking about a world – a very big world – where companies are taking a pretty thin layer of debt to make their capital structure a bit more efficient”
“With non-performing loans, you need to understand the options for working through vast portfolios that are often operationally intense and easy to mess up without clear strategies and expertise.”
NAV-based lending, where capital is provided by a lender to a fund owning a diversified portfolio of underlying companies, is also set for bigger things. Briarcliffe’s Molina says NAV-lending is increasingly popular because private equity GPs have started seeing it as an option just as LPs are learning about it as a private lending strategy.
“Ten years from now, direct lending is not going to go away, just like the broadly syndicated loan market is not going away, because lots of borrowers need straightforward corporate loans. But it is the asset-backed lending and the speciality finance areas that are going to see more growth as a great alternative for LPs looking to differentiate between managers and diversify their private credit portfolios.”
The FounderDirect strategy
With software companies staying private for longer, founders are increasingly looking for alternative financing solutions to support growth, finance acquisitions or secure liquidity.
Vista Credit, as the credit arm of Vista Equity Partners, established its FounderDirect strategy five years ago to draw on its deep domain expertise and strong connections to founders to focus on non-sponsored financings in the software space. It has taken off in the last few years, in part as a result of big changes in the Silicon Valley technology funding market.
President at Vista Credit, David Flannery, says: “This is a really interesting long-term trend. If you founded a software company 10 years ago and didn’t use any debt, now you’re doing it again and putting a little bit of debt in to keep more of the equity for yourself.
“We are talking about a world – a very big world – where companies are taking a pretty thin layer of debt to make their capital structure a bit more efficient. That is not the way those companies have previously financed themselves, but we think that’s a really interesting decade-long trend.”
Vista has announced more than $500 million in deployments via FounderDirect so far in 2023, including a $175 million financing for Demandbase, a company specialising in B2B software, and a $125 million financing for Arcadia, a healthcare data analytics platform.