We proposed private debt to clients in 2009, as an opportunity directly arisen from the financial crisis, given the shortage of financing available to companies. Almost four years later, transactions are now beginning to be realised at the targeted performance levels but more importantly, the opportunity appears to be getting even stronger for investors. Given the state of market developments over the past few years we are now seeing allocations to private debt moving from being opportunistic to longer term strategic plays.
Why do we like it?
Firstly there are the expected net returns to investors, ranging from 6-10 percent for senior debt, 12-15 percent for subordinated debt, with a variety of other lending strategies playing around these levels. Expected performance from 30,000ft certainly seems compelling. However, a key reason a number of our clients have already committed significant amounts of capital to this asset class is related to the significantly improved capital structures behind these return figures. For this a closer dive is required on each individual investment. Since the financial crisis, capital structures have essentially returned to where they were 10 years ago. Leverage levels are notably lower and equity cushions higher. Asset level covenants are also stronger, as are the financial ratios lenders would look to test borrowers against.
To understand why the risk/return trade-off is so improved requires a 20,000ft view on the reasons behind the reduction in bank lending. The impact of changing bank regulation is certainly a factor, as is the fact that banks, European in particular, continue to have highly leveraged balance sheets. This is resulting in a vacuum being created in capital structures as banks reduce their lending facilities. The effect of this is more pronounced in Europe than in the US, given that banks have historically provided around 80 percent of the loan capital in Europe compared with around 20 percent in the US. We therefore see private debt investors being able to fill this vacuum by providing the capital to keep companies afloat and asset structures complete. This is certainly a more socially appealing concept than the otherwise inevitable bankruptcies and asset repossessions.
What about the risks?
Although we believe that an investment in private debt is worthy of consideration in most investment portfolios, investors need to get comfortable with a number of issues before proceeding. Here the view needs to be at ground level. This means fully understanding the pros and cons of the investment’s characteristics, which significantly differ between the private debt spaces of corporate debt, real estate debt and infrastructure debt. In addition there are a number of wider portfolio considerations to also be comfortable with. For example, identifying appropriate strong performing companies to lend to, or assets to lend against, and understanding the motivation of borrowers are equally important factors. Despite some private debt investments having exposure to equity upside, detailed and considered credit analysis is clearly paramount to managing the downside risks. The usual investor approach to track record analysis may also require a re-think, given the majority of lending was previously via bank balance sheets. Firms entering the private debt market may not have direct track records to point to and thus investors will certainly need to dig deeper. The fact that many investors will find some of these issues too difficult to overcome ultimately implies those investors taking the step forward today should find the opportunity attractive for an even longer period of time.
Based on the experience of our client base, investors who take a 30,000ft view of the world and choose to stop and take a closer look at private debt will not be disappointed. The real challenge for those in the private debt market is to identify those investors who are prepared to put on their walking boots, roll up their sleeves and unearth the opportunity.
Sanjay Mistry is director of private equity fund of funds and of private debt at Mercer.