News Analysis: Navigating a new asset class

Growth in the private debt market is driving demand from investors for fund of funds-type instruments to help them navigate through the thicket of new vehicles. Magda Ali looks at the challenges such a model presents, and how a handful of managers are tailoring their products in response. 

 One bellwether of a developing asset class is the presence of funds of funds targeting it. Such vehicles require not only investor demand for the manager selection services they provide, but also a deep enough pool of managers to choose from. So the launch of several funds of private debt funds in recent months is an important landmark in the development of the industry.

The market for dedicated funds of private debt funds is relatively small, but is slowly gaining momentum. Fund of fund managers Golding Capital, Access Capital Partners, WP Global, and even Morgan Stanley are beginning to see a surge in investors outsourcing decision-making to managers who understand the nuances of investing in debt.

One of the pioneers of funds of debt funds (FoDF) is Frankfurt-based fund manager Golding Capital. The firm currently manages more than €1.8 billion in assets, and though debt funds account for a comparatively diminutive segment of that total, its FoDF strategies are gaining traction with German investors.

“The underlying growth of the asset class has led to dedicated private debt funds assuming the role banks and CLOs played in the past,” says Jeremy Golding, founding partner at Golding Capital. The increased appetite in the market for private debt will also lead to the growth of dedicated fund of (private debt) funds, and could see larger asset managers developing tailored product offerings to their investors, he adds.

There is rising interest by institutional investors in the private debt asset class in general through broader credit opportunities funds, but also for specific sub-segments such as distressed debt, mezzanine or dedicated senior loan funds, explains Golding.

“The ways in which to access the asset class differ by type as well as size of investor,” adds Golding. “Larger institutions invest directly into funds or even have in-house teams to do deals directly [like Allianz, which is building an infrastructure debt team]. Small to medium-sized institutions either invest directly into funds or via funds of funds; there is also a trend among these types of investors to go through individual segregated (managed) accounts.”

Golding Capital currently manages a €150 million fund of debt funds – smaller than some of its private equity-focused vehicles. “Overall, the market – particularly in Europe – is still relatively small. The additional layers of fees are an unattractive component of FoFs in the debt fund space. It definitely needs to be justified by market performance through better fund selection,” Golding admits.

Funds of funds who allocate to the larger debt managers may end up doubling down on the same underlying debt investments because these managers are in the same deals. “The more diverse and often stronger strategies are developed by the smaller funds,” says Jeremy Newsome, managing partner at fund placement and advisory group Avebury Capital Partners. “Through the expertise gained by using FoF, and although they have initially outsourced their own decision-making to fund managers, they are able later to allocate their own internal teams to select managers.”

Newsome explains: “The emphasis by private debt fund managers should be on allocating to real opportunities, and not just mega buyouts – a fund of funds in the debt space works when a big fund invests in a pool of small fund managers who then invest in companies with high growth prospects.”

“There is a strong shift in demand from investors for high yielding assets,” says Theo Dickens, partner at UK-based debt fund manager Prefequity.”Fund of funds have been very heavily discussed this year and most managers are trying to figure how to extract yields, but with all the layers involved in the process, it is proving a difficult task.”

Fund selection is the key skill required, explains Golding; “Volatility of fund returns is still pretty high and therefore selecting the right managers and avoiding the losers is crucial to achieving above-market returns.”

Due to the cyclicality of credit markets, most people agree it is necessary to build a diversified and well-balanced portfolio combining different investments strategies, including senior loans, mezzanine, credit opportunities and distressed debt.

“On the private equity side, the fund of funds model is dying. This is due to the fact that FoF strategies have been overplayed in the private equity space, and the numbers have reached their peak,” says Dickens. “In the private debt fund space, it’s a whole new ballgame, and with the emergence of new debt funds, we expect many investors to opt for employing a fund of fund manager to do debt selection for them.”

The main question for private debt managers in the US and Europe is whether to decide on outsourcing capabilities or having dedicated teams in-house and invest directly in funds. “Dedicated fund of fund managers as well as larger asset managers need to have an established platforms, an established investor base and a proven track record [to be successful],” says Golding.

Philippe Poggioli, managing partner at French fund of funds manager Access Capital Partners, says his firm had seen uptake from investors for funds that invest across mezzanine, junior and senior debt. As a result, it’s broadened the remit for its second fund of debt funds beyond the mezzanine-only strategy of its maiden 2007 vehicle. “We are broadening our scope. The strategy allows us to invest across Europe. It gives us the mandate to cover larger segments of the debt market, and we are less dependent on mezzanine dealflow into this fund,” explains Poggioli.

The firm secured its first commitment for its €250 million fund of debt funds this month. Addressing the issue of fees, Poggioli says that co-investing alongside the funds Access backs would allow the firm to reduce management fees and improve performance.

Access Capital hopes to receive investment from institutional investors, pension funds, and insurance companies. “Our coverage is broader, and so is our target [audience]. We expect to see interest from a wider range of investors. Having a niche is really important, but so is covering a breadth of sectors and regions.”

Besides traditional fund of fund structures, a trend is developing towards individual solutions such as managed accounts, where investors determine geographies and segments, and outsource decision-making regarding allocation to a fund manager. 

Rather than marketing a fund of funds, Morgan Stanley’s managed accounts division is looking to invest in real estate-related debt instruments on behalf of investors. “Investors are starting to realise that now is a good time to be building debt exposure,” explains a source close to the bank. “The window to access the debt side of real estate will stay open for at least another three years,” the source adds.

For an asset class that is still, relatively-speaking, in its infancy, funds of funds could prove an attractive proposition for investors eager to access this developing opportunity. The key for the providers and managers of such funds will of course be the fee issue – structuring their products so as to still deliver attractive returns after twin layers of fees have been deducted remains the most pressing issue.