Examining flows of institutional money into private debt funds, you will often find consultants behind the scenes recommending allocations, doing due diligence and ultimately influencing which vehicles investors choose.
Many consulting firms have started building private debt research practices in recent years, especially since the financial crisis when an interest in distressed debt brought private debt managers into focus for investors.
These consultants have been building up their expertise, proactively recommending strategies to clients, adding staff and resources and even influencing fees and terms. For those seeking institutional capital, it’s essential to familiarise themselves with these gatekeepers – what types of clients they work with and which strategies they pursue.
Of course, navigating these firms can be tricky. Private debt is a relatively new catch-all phrase for myriad underlying strategies. Few advisory firms have a head of private debt. Some have adopted the term illiquid credit, while others have tasked their senior private equity, private markets or fixed-income consultants with assessing the asset class. PDI brings you an inside look into some of these consulting firms, their private debt specialists and how their research effort is structured:
THE GLOBAL GIANTS
Head of illiquid credit, Towers Watson
The investment and benefits consulting firm was born from a merger of Towers Perrin and Watson Wyatt in 2009. It now has $2.2 trillion in assets under advisement and has yet another merger underway with London-based Willis Group Holdings.
Given its presence across the US, Europe and Asia, managers are often keen to hear what the Towers Watson research consultants have to say. One of their recent reports argued that investors are under-exposed to alternative credit. Excluding illiquid credit, it represents around 25 percent of the global credit universe, while Towers Watson clients have only invested 8 percent of their credit portfolios in alternative credit and less than 1 percent in illiquid credit.
Gregg Disdale says his firm began to focus on alternative credit around 2006-07 while examining private equity strategies that could take advantage of potential distress in the market. Post-crisis, the illiquid credit universe in Europe expanded beyond distressed debt to more reflect the US, and distressed-for-control type strategies evolved to include non-performing loan (NPL) portfolios and direct lending.
“Private debt in Europe has really evolved since 2009, as has institutional investors’ appreciation for the benefits it brings to a portfolio. There has been the addition of asset-based opportunities, like infrastructure and real estate debt,” Disdale says. In recent years he’s been covering the gamut middle-market lending, real asset lending, distressed and other niche credit strategies.
The firm also has an emerging suite of strategies that Disdale expects to start funding in client portfolios soon. These could include UK mortgages, lending to small and mid-sized enterprises (SME) and regulatory capital arbitrage.
Disdale also says there is an opportunity to own the equity of emerging lending businesses in the consumer and SME space, something the credit team explored alongside their private equity colleagues and led to an investment in a speciality-financed focused private equity fund.
“There are several good reasons to be considering private debt or illiquid credit. The regulatory environment has created nice thematic tailwinds. The asset class offers an attractive illiquidity premium,” Disdale says, although he is mindful of a future downturn and spends time looking at how firms managed through the last cycle. “We spend a lot of time trying to see how investments will perform if we see defaults rise,” he says.
Chief executive officer, Mercer Private Markets
Stefan Hepp joined Mercer via its acquisition of SCM Strategic Capital Management, a private markets advisory and asset management business that he founded. The group was combined with Mercer’s own private markets advisory and discretionary practice this year. Following the acquisition, the firm formed a new global private markets group with Hepp and Mercer’s London-based alternatives chief investment officer Bill Muysken as co-heads.
The group now has 80 people in seven countries across 11 offices. Hepp’s group oversees $21 billion in discretionary and non-discretionary client private markets portfolios globally. The broader Mercer platform, which has $6.7 trillion under advisement, also leans on Hepp’s group for private markets strategy advice and manager research.
Of the $21 billion that Mercer Private Markets oversees, about $650 million is invested in private credit strategies, which Hepp admits is a fairly small portion of the pie.
“As an asset class, it is a child of the financial crisis,” he says, though investors began to tap it more since the 2008 credit crunch.
“Increasingly, our clients look at it as not just part of private equity bucket, but as an alternative to high-yield credit,” adds Hepp.
The two primary credit opportunities in Europe are direct lending and buying portfolios from banks. In the case of the latter, Hepp says sales have not reached the magnitude expected and the banks are still sitting large piles of NPLs. This is in part to manage the impact of the write downs, so the flow has been piecemeal and banks will continue to shed assets more slowly than some anticipated.
Like most advisors in the space, Hepp shies away from proposing a specific percentage for clients to invest in private debt. Decisions are on a case by case basis, he says. But he suggests they take a look at how much of their illiquidity budget they can spend on the strategy. The clients he typically works with are institutions that pursue long-term investment strategies and are better able to shoulder illiquidity. “The general theme is that we advise them to have a harder look at their illiquidity budget,” he says.
When evaluating managers, Hepp looks for firms that are good at sourcing deals as well as restructuring to ensure that they can handle distressed-for-control situations, take over portfolios of assets and negotiate or restructure terms where necessary.
In the US, he says he has seen leverage and covenant-light loans creep up to a worrying extent. “What is staggering in the US is covenant-lite loans and leverage ratios that have come up quite a lot. It’s taking the same amount of risk as in 2007, and we now know that wasn’t a good idea,” he says.
The Mercer private markets arm has five analysts who focus on private credit, though they also work on private equity, real estate and infrastructure. Debt is often on the other side of the equation of private corporate lending or infrastructure and real estate equity transactions, so having both points of view helps round the team. “We like the ability to work in an integrated fashion. We have people who specialise in certain strategies, but we don’t support a culture of isolation and think there is a lot of benefit from having people focused on debt and equity talk to each other,” Hepp says.
THE HEDGE FUND PRO
Head of credit strategies, Aksia
The hedge fund advisory firm was launched by a group Credit Suisse funds of funds executives in 2007 when Adelsbach was advising clients on credit hedge funds. After the financial crisis, Aksia began to focus more on opportunistic, distressed debt funds and Adelsbach tells PDI that it was difficult to research these managers without covering them within a broader context of private debt. “It’s hard to look at the individual opportunities alone. You realise they fall within a broader universe,” he says.
The firm began building a dedicated research group for private debt strategies last year and while most consulting firms that track private debt come from a private equity background Aksia has gone straight for private debt without building private equity.
“Private debt makes sense for us. It’s a similar target return as hedge funds and meeting a similar need,” Adelsbach says. It splits the private credit universe into five categories: corporate lending, real estate lending, real asset lending, consumer debt and distressed debt/special situations.
Timothy Nest manages corporate debt (performing and distressed strategies) and Josh Hemley is responsible for structured credit and real estate investments. Nest tells PDI that he’s been focusing on managers that play in the lower mid-market space ($15 million-$20 million in EBITDA or lower), have low fund level leverage, strong origination capabilities and experience in the last cycle. He also likes firms that do more non-sponsored deals, though is mindful of it being more risky.
Hemley has been looking at commercial real estate strategies, with loan-to-value ratios of around 70 percent and coupons in the high single digits. Aksia is interested in more of a lending mentality, not loan-to-own in real estate.
On fees, Adelsbach says he is seeing a convergence among hedge funds and private equity-style fee breaks, where investors are getting the best of both worlds. Hedge funds normally only charge on invested capital, while private equity has traditionally offered carry over a hurdle rate. Now private credit funds are doing both.
While many managers and investors are concerned about the seemingly late stage of the credit cycle, Adelsbach still thinks it’s possible to play it well. “You could make the argument that you shouldn’t make any investments late in the business cycle, but that isn’t very practical,” he says.
“Our goal is to invest so that principal is well protected and you earn a yield for illiquidity and complexity, but not stretch on safety,” he adds, explaining for example, that many groups that started out as senior lenders later began doing many unitranche deals, selling off the senior piece and getting closer to mezzanine.
THE SKEPTICAL ENTHUSIAST
Head of alternatives research, NEPC
The generalist US pension consulting firm has placed $2.5 billion with private debt managers over the last two years or so and several of its large public pension fund clients have been building sizeable and noticeable allocations in the space. Even so, Neil Sheth thinks private debt is an opportunistic play and that even the more evergreen strategies like direct lending will be out of favour at certain times in the cycle.
“What concerns me is the amount of people getting involved who don’t have track records. I understand the managers wanting to be a permanent part of investors’ allocations, but this is an opportunistic strategy. My concern is that it’s being evaluated in a different light,” Sheth says.
Though that hasn’t dissuaded him from trying to uncover more good managers and moving further and further east. “We don’t think the US is nearly as attractive as it was a few years ago,” he says.
The firm has been building up its private debt credentials since 2010. Around 2011-12, NEPC started moving more money to European managers, as more opportunities for private capital emerged on the back of Basel III. Now Sheth thinks most of the US and European opportunities are passé and he’s doing more work on Asian private lending.
The firm’s research team, the bulk of which is based in Boston, has been spending a lot of time in Asia meeting managers. In one case, Sheth says NEPC found a firm they liked and helped them get started as a fund manager. “They weren’t out raising a fund, but they had the capability. And we told them, ‘You should raise a fund,’ based on the work we had done on the firm and its track record,” Sheth tells PDI.
The firm now runs a hedge fund with a three-year lock-up and makes shorter duration (18 months or so) loans. Eighty percent of the firm’s assets are NEPC clients. Sheth declined to name the manager.
NEPC has also been tough with managers on fees and terms. “The fees we pay are not the ones that the managers have on their cover,” Sheth says. The firm has managed to push most firms to 1 percent on invested capital and a 10 percent carry over a 5-6 percent hurdle.
The consultant has seven people working on private debt research in tandem with fixed-income and private equity research. “We don’t view this as a permanent part of people’s allocations. We’ve never said that should be the case. What if it’s not an attractive area? In the US, it’s not an attractive area, even though many firms are trying to raise funds.”
THE NICHE PLAYER
Director of global fixed income & credit, Fund Evaluation Group
Keith Berlin has been focusing on private credit strategies at Fund Evaluation Group (FEG) since 2006. He has been with the firm covering other credit and fixed-income strategies for 15 years.
FEG has lately recommended a growing number of niche private debt strategies to its foundation and endowment clients. It has funelled capital into CLO co-investment funds, emerging market distressed credit as well as lower mid-market strategies.
While many investors have begun to shun mezzanine funds, Berlin thinks some managers can still find good mezz opportunities in the lower mid-market space. He tends to avoid the mega multi-billion-dollar funds.
Part of the niche approach is that Berlin is usually looking for higher returns, mid-teens and higher net IRR. He tends to structure private credit within clients’ private capital portfolio. “Private debt is competing for shelf space with private equity, so the strategy is being held up not just to fixed-income investments, but also to private equity,” he says. When evaluating debt fund fees, the firm prefers managers to charge fees only on invested capital, though Berlin admits that smaller, newer managers might need to charge on committed to get off the ground and he’ll look at those as opportunities as they present themselves.
Most of his work with clients has been proactive, where FEG is bringing private debt allocation and manager recommendations to clients. “Everybody knows that our client base is predominantly foundations and endowments, so we can make decisions fairly quickly if we like something,” he says.
Looking ahead, with market volatility picking up, Berlin says distressed debt could get more exciting. Energy credit has also been a hot topic, but he thinks it’s still in a wait and see phase for now. “People were very excited about energy credit in the beginning of the year, but now we’re passing on a lot more stuff than we’re saying yes to. We need to see more clarity on where we are in the cycle.”
THE PENSION ADVISOR
Principal, Meketa Investment Group
Meketa, which predominantly advises public, corporate and Taft-Hartley pension funds, has been researching private debt since 2008, when Todd Silverman joined the firm. He focuses on both private equity and debt.
Silverman advises clients to pursue diversified private credit portfolios and thinks scale is necessary for diversification. “We do typically recommend private debt allocations as part of a broadly diversified programme. But we wouldn’t say that there is a one size-fits-all allocation,” he says, explaining that depending on the client’s size, a smaller or larger percentage can move the needle.
The strategies Meketa recommends range across the private debt spectrum including mid-market direct lending, senior, unitranche and junior underlying loans, as well as distressed debt and opportunistic strategies, both in the US and Western Europe.
The firm is currently more cautious around trading-oriented strategies, where there is a non-control distressed debt angle, particularly in large-cap, more liquid parts of the market. “Given where pricing has been over last few years, the opportunity has been less obvious. It’s been hard for larger managers to put money to work in larger more capital liquid structures,” Silverman says.
He admits the firm has been less active in the mezzanine space in recent years. “Pricing has been pressured and you’re seeing higher leverage multiples. These factors have made it more challenging. It’s not a market we’ve completely moved away from but we’re being more cautious.”
When evaluating managers, he looks for firms that have a track record and success in the strategy and team stability. “Ultimately what it comes down to is evidence of strong credit underwriting capabilities. At the end of the day, these strategies have an asymmetric potential return profile and protecting the downside in many cases is the more important indicator of success,” Silverman says.
Managing director, Cambridge Associates
While private debt is a recent buzzword, a number of sub-strategies captured by the phrase, such as distressed debt and mezzanine, are well established. The 2008 financial crisis prodded many consultants to consider distressed funds, Keirsten Lawton says Cambridge has been investing in these funds since the early 1990s, having led clients into one of Oaktree Capital Management’s first funds.
These days, the Boston-headquartered firm has offices all over the world and institutional clients of all stripes, but originally built its business on some of the larger US endowments and foundations, who tend to be more innovative.
The firm now covers credit globally and has a credit research committee with members based in the US, the UK and Singapore. It has 10 credit analysts, who also research private equity and liquid credit.
The firm has lately been looking at senior European direct lending strategies as well as special situations and multi-strategy vehicles. “Some clients want something that’s a little juicier,” Lawton says. Other strategies on Cambridge’s radar include niche opportunities like aviation and royalty funds, which appeal from a diversification standpoint.
In Europe, regulatory requirements and structural factors are limiting new debt issuance creating opportunity with attractive risk/return dynamics, Lawton says. She expects around 8-9 percent returns in this area, while some managers can get to low teens by employing some leverage.
Cambridge prefers managers to only charge fees on invested capital. And it insists that management fees be calculated from equity commitments, not leverage. Lawton also expects to see 6-8 percent hurdle rates on performance fees.
When evaluating managers, she says that experience and reputation are important. In shipping, for instance, she says she has seen many firms rush into the asset class. Shipping requires a real depth and understanding and some firms appear to just be following the herd because the asset class looks cheap.
“It’s clear that some firms are more embedded in the market and some are merely tourists; they’re just getting their bearings and going where others are going,” she says. But the opportunity is certainly there. “Pre-credit crisis, private credit funds were 20 percent of the European market. As we’ve seen the market evolve, we believe they now make up approximately 50 percent of the UK credit market.”
In debt, there are ways to enter through different parts of the capital structure and, in times of company or industry stress, the perceived safety within that structure changes and evolves. Some debt strategies also fall in or out of favour; dynamism that Lawton approves of.