Enthusiasm was paired with caution at this year’s PDI Forum in New York, where many investors and consultants described how they were building private debt allocations, often out of LPs’ fixed income buckets.
“Today we’re really looking for private debt strategies as a fixed income replacement,” said Siddique Haq, a private markets research consultant at NEPC.
Brent Humphries, who heads up AB’s private credit investors group, agreed: “Investors are seeing the asset class mature and seeing it as a regular part of a fixed income portfolio.”
This is good news for GPs for two reasons: fixed income buckets are a larger pie to carve from than private equity allocations and credit is now measured against traditional bond returns which are lower than those promised by private debt. This is a much easier sell than being compared with private equity high-flyers.
The fact remains, though, that private debt is more complex than traditional fixed income, and if investors are serious they need to do their homework on underlying strategies, how deals are structured and industry trends.
As well as requiring industry knowledge, private debt is just as subject to macro-economic themes. Equity market volatility, a slowdown in China, political conflicts and high valuations are all leading lenders to be more cautious.
“Are these all indicators that winter is coming?” asked David Golub of Golub Capital.
“If you look at the third quarter the only thing that didn’t go down was Donald Trump’s ratings,” he joked.
What this means in practical terms is that lenders are being a lot more picky about the deals they do at this stage in the cycle. And many are shying away from junior debt.
In a poll on which asset class is the most under pressure today, 62.5 percent of delegates voted for mezzanine.
“I think the audience is dead right,” Golub said. “Junior debt is the most under pressure right now. We closed zero junior debt in the last year. And started moving away two-and-a-half years ago.”
Other speakers warned that business development companies (BDCs), which have raised a lot of capital in recent years, could be stretching for yield and exposing themselves to riskier second lien and mezzanine debt.
And that isn’t the only problem plaguing BDCs. Several delegates raised another issue: stock trading at steep discounts to book value. And those discounts have been increasing.
BDC experts have long held the view that several vehicles have alienated shareholders through dilution and cutting dividends. Speaking at the PDI Forum, Josh Easterly, co-chief executive of TPG Specialty Lending, argued that “some should trade below book”.
The dedicated BDC panel proved lively as Jonathan Bock, senior equity analyst at Wells Fargo Securities, asked the audience how much a BDC manager that has underperformed its peers since inception would be worth, the majority valued this hypothetical entity at zero. Of course, Bock’s question was referring to the planned sale of TICC Capital Corp’s investment manager to Benefit Street Partners (BSP) for $60 million.
It was a loaded question as one of the deal’s biggest market opponents was on the panel – TPG’s Easterly. Since the purchase by BSP was announced, TPG Specialty Lending has made a share offer for the TICC BDC itself (rather than the separate investment manager).
“People are taking advantage of retail shareholders and that’s what causes damage [to the sector],” said Easterly.
The bidding war, which has included mutual criticism by TICC and TPG, is transparent as BDCs are public vehicles. But in the LP/GP relationship there is less visibility on investor treatment by private funds.
If there was a lesson to be learned from the two-day event, it’s that private investors must approach their relationships with the kind of scrutiny that comes with public deals.