Brave New World

On an untypically sunny Autumn morning, Private Debt Investor and six industry veterans convened at ICG’s offices in London to discuss the changing face of the debt markets in Europe, and how they and their competitors are addressing the challenges – and more importantly opportunities – those changes have presented.

If it’s hard for most observers to make sense of the debt markets at present, it’s reassuring to hear that even experts are struggling to decipher them. As ICG’s Dagmar Kent-Kershaw understates: “The credit markets are in an interesting place at the moment”.

“If you think about the broader syndicated loans markets, there is a real shortage of new capital coming in. The banks have re-trenched, and it’s becoming increasingly hard for CLOs to make new investments. As a result, new assets are not coming to market,” she adds.

Yet CLO managers are desperate to hold onto their existing portfolio, she argues, citing The Carlyle Group’s recent dividend recapitalisation of the RAC where the structure was re-levered and CLOs stayed on board. “Existing CLOs are keen to stay in a good asset, and are prepared to accept quite aggressive terms to stay in there rather than lose that asset and repay it to investors,” Kent-Kershaw says.

Switching focus to the non-syndicated private debt markets, there’s significant interest from numerous parties – “From corporates who wish to borrow, from investors looking to come into the space, or asset managers who want to manage those sorts of assets… In the club-style transactions of the mid-market, that area of the market is functioning well and there are a number of players from all sectors who are getting involved,” she says.

KKR Asset Management’s Marc Ciancimino notes investors are chasing quality assets, and ignoring anything which falls short. “It’s a very bifurcated environment,” he says. “You see this across a lot of different asset classes, from real estate to leveraged loans. Investors are rushing to things which tick lots of boxes: good cashflow, good performance over the last five years, in a jurisdiction they like. Those deals can get done.”

But unwillingness to get involved in difficult situations or complex credits means a host of deals are failing to progress. “We’ve seen an amazing number of transactions which didn’t cross the line in the last 12 months. It’s a tale of two markets – capital has been rushing towards perceived high quality situations and as a result, leverage has been fairly elevated with terms that are pretty aggressive, whereas on the other hand you have deals that struggle to get done at all.”

Bayside Capital’s Appu Mundassery believes banks would rather refinance existing loans then issue new ones. “To be a little cynical, if there’s an excuse to roll into something and to not have to do new work, there’s a default option there, it’s the path of least resistance. We see that a lot in deals with less scale – they acquire almost an equity diligence aspect.”

That reluctance to back new deals means the lending landscape is changing as private debt funds step into the breach. Traditional banks account for a dwindling portion of acquisition finance, according to Partners Group’s Juri Jenkner.

“Over the last 10 years in the US, 57 percent of primary loan financing was provided by the banks themselves, and now it’s only 16 percent – the rest is institutional investors. Europe is following a similar trend – banks were responsible for 78 percent ten years ago and now it’s only 54 percent,” he says.

All participants agree the market is becoming more institutionalised as far as credit funds are concerned. Opinions differed though as to whether new entrants could fill the funding gap that’s appeared.

“We’re really in an evolutionary phase,” Ciancimino says, “and although we don’t have the luxury of knowing what will happen in the next two years, you can be certain that it will be different to what we’ve seen in the last two. It won’t be more of the same.

“There’s a bit of a stand-off – there’s this gigantic deleveraging required, but if you speak to the well-known high street banks, they’re happy to fund mid-market deals at LIBOR plus 450, whilst at the same time disposing of gigantic portfolios of previous deals. I think everybody’s trying to find their feet in this new environment.

“The direction of travel though is that there’s a huge requirement for capital over the next few years, and there is a dearth of supply. There are sponsors with a lot of equity still to invest. Our small portion of the market is tiny in comparison to the commercial real estate market, the sovereign market, all of these other markets where similar dynamics are playing out. The reality is the environment going forward is going to be different, with a different balance of power. It’s going to be an unpredictable route forward.”

The bumpy regulatory road
One reasons for that unpredictability is the capricious approach of politicians and regulators, who are often accused of pulling banks in different directions. The exasperation at what the participants feel is disjointed thinking from politicians and regulators was palpable.

“The regulatory landscape is very unpredictable, and it can have huge consequences that take time to work through the system,” Ciancimino says. “Good intentions by a politician wanting to deal with one problem can create other, unforeseen problems.”

Kent-Kershaw goes further. “Regulation is a mess. I’m not convinced most of the banks are taking Basel III seriously at the moment. Many have bigger problems and they see it [Basel III] as some distance out. A lot of regulation that’s come in isn’t aligned with other bits of legislation – indeed, it’s often competing. Basel III and Insolvency II are at odds. Solvency II wants insurance companies to hold shorter dated paper. Basel III wants banks to issue longer dated paper.

“In many cases it’s down to politicians or jurisdictions who aren’t close to the capital markets. A lot of the European legislation that’s come in has been voted for and ratified by countries that don’t have capital markets; they don’t have securitisation markets.”

Even at a political level, much of the direction given to the banking sector has been contradictory. “Governments are saying, ‘Please lend more to support small businesses, and oh, by the way, shrink your balance sheet at the same time.’” Says Ciancimino. “If we find banks’ behaviour at times bizarre, is it any wonder when they have so many competing imperatives forced on them?”

But delever they must. But the expected raft of assets has yet to materialise. “In terms of the secondary market, there’s not yet enough stress in the system to have forced major sell-offs,” argues Jenkner. “There’s been some selective portfolio sell-offs from some of the UK, German and Irish banks for instance, but little of significance.”
“It’s a pure cost of capital issue,” Mundassery adds. “Where they’re being forced to be active is where they don’t provide capital. Anything that requires some kind of a reserve, or accounting treatment which is penal, they shy away from, at least for now. That can change. I certainly don’t think the banks are irrelevant, they’re just in a tight spot right now.”

Structural issues
On top of problems of a more transient nature, many of the issues currently afflicting the markets have deeper roots. Paul Rolles, founder of AgFe, explains: “You need to differentiate between things that have occurred because we have structural problems right now, and things that were wrong before the credit crunch. Quite a lot of the stuff that’s going on now relates to people trying to address issues in the debt markets that were fundamentally wrong in the first place.”

But an unusual transformation is taking place, Rolles believes. “In a weird way, it feels a bit like the early 90s again. A lot of current financing techniques are being put together for the first time, and people are going to take a bit of time to get themselves properly organised and work out what they’re going to be doing in the medium term. There’s obviously market dislocation today and lots of interesting opportunities, but a lot of themes – bank disintermediation, investors more actively accessing some of these situations directly for example – are fundamental changes, which may well be permanent.

“There’s a huge wall of capital and a huge wall of opportunities, but the wiring diagram has fallen to pieces and people are just starting to work on the rewiring, basically – the connections need to be made again. If you go back to 1990, there wasn’t a deep securitisation market, there wasn’t a CLO market, and a lot of asset managers had systems which couldn’t manage certain kinds of investments even if they had wanted to. Now we’ve moved forward to 2012 and a lot of those themes are back again.

“When we talk to investors, many of the issues that come up aren’t just about credit, they’re about internal process; operations; regulation; and IT. A lot of this stuff is simply being worked through, and we are very optimistic about the future. There’s a dam breaking, and there’s a big change going on at the moment in terms of where the capital to fund many opportunities is coming from. It’s simply a matter of time,” Rolles concludes.

So how are alternative providers of debt capitalising on banks’ retreat from the market? And more importantly, how are they able to do so despite all the uncertainty around them?

“There’s been a step change in people’s ability to deal with uncertainty,” Ciancimino argues. “A few years ago the sort of stuff we see regularly now in the newspapers would have caused major anxiety, and now it’s just ‘We’ll add that to the list of stuff to deal with’ and life goes on. None of these things are going to get resolved anytime soon. The Eurozone crisis, for example – it’s not a next 6-18 months situation, it’s one that will take years to sort out.”

In such an environment, flexibility and nimbleness are important attributes, and it’s here that the new breed of boutique private debt fund managers excel.

Sanjay Mistry, a director at Mercer, has been tracking the private debt market for a long time. “There are different participants in this space, and that’s what makes it so interesting: CLOs, banks, investors taking different roles. Even amongst asset management groups, there are so many boutiques, each operating in their own niche. However, the fact is that if you can’t deliver successfully in this environment you will really struggle in the future to raise capital. Some may say the market is dysfunctional because people are all doing slightly different things to address the problem, but I think the variety of ideas is healthy and important to create longer term stability.”

Allocating to private debt
But how to sell the opportunity to investors? One challenge is working out where it fits into an investor’s portfolio. Does an allocation to private debt come at the expense of other alternative assets like private equity? Or does it come at the expense of equities, for example?

Even managers aren’t quite sure how best to go about it, Rolles says. “We’ve been talking to a lot of investors about private debt – what bucket does it go in? What part of an institution can do this? Lots of institutions buy into the idea that it’s a good thing to do, but it’s just taking time to work out the best way to do it.”

Ciancimino concurs. “You can’t look at these things in isolation. The old days of being a firm that just does one tiny niche type of financing are gone.”

If an investor does ringfence some capital for private debt, it’s more likely to have come from a pool previously earmarked for high yield or equities, Mistry says. “Assets have been switched out of equities for a number of years, and that’s largely down to schemes de-risking. They’ve been switching into fixed income and alternatives. They’re moving out of riskier assets in favour of liability-matching ones, but those are now yielding such poor levels of return, they’re asking if there’s anything else they can do that can help them move in that direction without compromising too much of that return and de-risking too soon. That’s where private debt comes in – it’s a step towards fixed income. It provides an equity-like return with a fixed income base, it’s a halfway house.”

Many investors were already exposed to private debt – they just didn’t realise it, Rolles believes. “You have to remember that a lot of people who invested in fixed income assets were essentially investing in private debt already, albeit indirectly. They were either buying securitisations, which are basically just ways of bundling certain types of private debt up and making it ‘notionally’ more liquid – and also they’ve been investing in bank and financial institutions’ paper, which is essentially an opaque indirect way of taking exposure to private debt since it is sitting on banks’ balance sheets,” Rolles says.

“The demand for financial institutions paper – such as bank senior debt – is not what it was. People are thinking hard about their sovereign exposures too. This is driving demand for high yield, private debt and other strategies. A lot of the time, institutions are investing in assets that they were invested in already, albeit indirectly, they just didn’t focus on it, or didn’t care, or were basically relying on the ratings. So a lot of what’s going on is essentially connecting real money to assets which were indirectly funded in a more direct, obvious, and transparent fashion.”

Do banks still have a role to play?
“It’s important that they don’t disappear,” Jenkner says. “Absolutely – someone has to do the revolver!” jokes Ciancimino, to laughter from the assembled company. But the point is a valid one. Even if their ability to provide senior debt is limited, banks can still play an important role, offering services that boutiques and new entrants simply can’t provide, as Kent-Kershaw acknowledges.

“There will always be a place for the banks. They can do things that we can’t,” she says. Whether that’s a revolver, trade credit or swaps, they are services that a firm like ICG can’t provide.

“The banks know that to really get the attention of a corporate, they’ll need to continue to lend or provide some sort of lending facility. They won’t completely disappear or step back, but they do want people like us to come in as it will help to protect their relationships,” she adds.

“If you’re a bank who used to write a £75 million ticket to lend to a corporate, but you’re now told by head office that you can only write £15 million to £25 million… what do you do to make up the shortfall? If you invite in the bank next door, they’re going to end up fighting you for the swaps business, for the M&A business, for the corporate relationship. It’s much better to invite one of us along, as we just want to lend – we’re not going to encroach on that bank territory. The banks would much rather invite a friendly lender than a direct competitor,” she explains.

That dynamic can skew returns somewhat. If a bank is going to reap fees from ancillary banking services, it traditionally can afford to price any debt it does issue at a lower rate. For private debt funds, who don’t have fee revenues to draw on, that means their debt will prove pricier.

Banks are less active in subordinated debt, where established mezzanine providers like ICG have long held sway. “For the last three to four years, the banks were pretty much completely disintermediated from the mezzanine business,” Jenkner says. “There are hardly any banks that underwrite mezz these days – maybe JPMorgan, or Goldman. Mezzanine has been a different theme, and a very interesting one from a debt fund’s perspective. It’s been super attractive to our clients and us for the last three years – we’ve completed about 30 high quality mezzanine deals over the last 30 months. It’s a niche market, it’s a small market, but the risk / return profile is very compelling. On the senior debt side, the investment opportunity is equally attractive, but the headline is very different – we still need the banks.”

Many private debt funds are now offering unitranche facilities – a hybrid form of debt which shares characteristics of both senior and mezzanine loans. AXA Private Equity has been particularly active in this segment, for example, providing more than €400 million in unitranche financing facilities to companies including Unither Pharmaceuticals, FDS Group and Biomnis. AXA PE claimed that represented more than two thirds of all unitranche issuance In France in 2011.

And banks are still playing in the senior space, albeit in smaller volumes. Yes, they face problems, but they’re not insurmountable, Rolles believes.

“I just think it’s maybe a question of the banks having to transform themselves a little bit. They have fantastic infrastructure; many departments are superb at lending; and there are certain areas like trade finance which are extraordinarily complex and the banks have many years of expertise there for example. But it comes back to cost of capital, which is maybe now relatively higher for certain banks than it is for some other investors. In these circumstances, some banks could start thinking about being a more of a conduit for external capital, rather than thinking about what they can do just in terms of their own balance sheet. Some institutions are moving in this direction.”

AgFe, for example, is working with a bank on a large deal. The bank is providing no capital – it will syndicate 100 percent of the position.

A relationship game
The importance of relationships may have been forgotten during the boom, but it’s something banks and sponsors alike have remembered, Ciancimino says. “I think if you roll back a few years, sponsors were quite happy to have a fairly diffuse group of rather passive lenders who they didn’t really have to talk to; the syndicate would be organised for them. The larger groups, who have had to get to grips with ‘amend-and-extends’, have realised that it is valuable to have relationships with your key lenders. In a way, things are going back to how they were 10 years ago, when there was a closer dialogue. The whole securitisation thing dulled what was a pretty relationship-driven business and maybe we’re going back, in a new form, to something more like that.”

“More than two thirds of deals that come our way have come direct from the sponsors,” Jenkner says. “It’s absolutely key to globally be close to them these days. That relationship is worth more than anything. Seeing deals early on allows you to be selective.”

Mundassery agrees that good relationships are key to effective origination efforts. “In the distressed sector it really matters. A lot of deals are bilateral deals. All the best opportunities come from referrals from our network of professionals – lawyers, financial advisors and so on – in our target markets.”

Rolles chimes in. “It’s interesting isn’t it? You’ve got relationships being more important, structures much less complicated; you’ve got credit being more visibly important again; you’ve got less reliance on, or trust in, third party agencies. All these things are rather old-fashioned. It’s almost like there’s been a retreat from the last ten years and going back to a much more straightforward market. It’s amazing how much has been forgotten.”

So while there’s plenty to keep market participants on their toes – big picture items like the wavering Eurozone economy, for example, or misguided regulatory measures – the opportunities for canny investors in private debt are compelling. Kent-Kershaw sums up the situation succinctly. “My concern is that the money from new sources comes in more slowly than the money that’s disappearing, creating a funding gap. But there’s a huge opportunity out there. There’s a lot to be done.”