PDI Capital Structure Forum

Investors who moved into direct lend- ing in recent years are pleased with the returns, delegates at PDI’s third
European Capital Structure conference in London heard last month.

But sentiment could change if private debt funds don’t maintain discipline.And discipline, or lack thereof, in a more volatile market will determine how great the gap grows between the returns expected and what debt funds can realistically deliver.

There were lively exchanges on whether returns are compressing. During a panel discussion on direct lending, Blair Jacobson, partner at Ares Management, stated with conviction: “We’re still driving returns from this strategy.”

Conference chairman Sanjay Mistry, head of private debt at Mercer, shot back: “Arguably, there’s been some compression” – a point with which Peter Schwanitz, managing director at Portfolio Advisors, agreed.

Delegates wondered if the direct lend- ing opportunity in Europe had been over- sold. If the answer was yes, then managers in Europe were at risk of falling short in meeting US investor expectations.

“Quite a lot of capital is coming from the US and if not handled properly, it could have consequences … and at a time when Europe is not ready for it,” Schwanitz said.

Throwing currency risk into the equation can complicate the issue further. Tony Vainio, a vice-president at Pantheon, noted that this was a priority in investment decisions. If not managed well, it could wipe out returns, he said.

The conference also heard that uni- tranche remains a popular instrument, though returns are not what they once were. Originally, managers could achieve 8-12 percent on the blended deals, but returns are now in the 7-11 percent range, PDI heard.

The gap between what investors seek and what managers are targeting was high- lighted by a poll of investors which showed that 60 percent of limited partners in the room, who made up 30 percent of the audience, were seeking a blended target net return of around 7-9 percent from their overall private debt portfolio.

In contrast, 40 percent of GPs said they were seeking 5-8 percent net returns, while another 40 percent said they were aiming for 8-12 percent. Such returns for high quality mid-market credits remain ambitious in European jurisdictions with competition from strong bank networks. Half of LPs said their highest target net return was over 15 percent. However, none of the GPs polled were targeting such high returns.

Debt providers were cautioned to “keep their discipline”, by Malcolm Hassan, head of funds and asset management sector at Royal Bank of Scotland Commercial & Private Banking.

The warnings were driven by speculation on whether the credit cycle is approaching its peak. During an interview on market cyclicality, Christophe Evain, chief executive officer at Intermediate Capital Group, suggested that fears of
another financial crisis were overhyped. Another recessionary period is plausi- ble, however, and it would have a domino effect, he said.

At the end of the conference, a few brave souls opined that a high default rate was in the offing. PedroTavares, partner at Arbour Partners, said that the mid-market could end up being one of the hardest hit sectors. The rise of covenant-lite and covenant-loose loans in Europe combined with lower liquidity today than before the crisis, would compound the difficulty that would then face private debt managers.

Hassan painted a picture of the scale of the problem at RBS, now 51.5 percent owned by the UK government, after the global financial crisis.The bank’s restructur- ing unit grew from 180 people to 1,200 at its post-crisis height. “You need to be pre- pared and ensure you have enough capacity [to deal with problems],” Hassan warned.

Even if the resulting recession is not on the same scale of post-2007, preparing for downturns is crucial for managers.And in tandem with the doom-orientated discussions, managers and advisors alike emphasised smart deployment again and again.

REMUNERATION

Fees get most GP and LP pulses racing for different reasons and the issue came up more than once over the two-day event.

One of the biggest risks to survival of the private debt industry is the way managers are incentivised to deploy by fee structures that only pay out on invested capital, Nathalie Faure Beaulieu, a regional managing director with European Capital, said.

Evain highlighted that debt managers can stop investing if the market gets overheated. But he and others expressed concern that pro-cyclical behaviour can be driven by fees that incentivise capital deployment over caution. In the worst-case scenario, he noted, managers could be compelled to do deals instead of pausing because they need the income to pay staff.

One way to mitigate this risk is by GPs investing in their own funds, Matthias Unser, founding part- ner and managing director of YIELCO Investments, noted. But other suggestions on how to address the problem are thin on the ground.

It wasn’t all doom and gloom, however. The event, in its third year, was hailed a success, judg- ing by the large number who attended – indicative of an asset class with scope for growth, or an over- crowded market, depending on your point of view. Many agreed that there were pockets of strong opportunity within alternative credit including sponsorless mezzanine, asset-backed lending, growth capital, distressed-to-maturity (as opposed to distressed-for-control) as well as regulatory and secondary trades with banks.

Demand for non-performing and performing loan books is also strong.

Sponsorless lending generated a lot of chatter too and was described as “the holy grail in terms of generating alpha in private debt”, Ted Koenig, president of US firm Monroe Capital, said.

It is one possible solution on offer for private debt funds squeezed out of the sponsor-backed route by falling leveraged loan issuance and more competitors. A strong origination network is vital for such a strategy and the continued success of direct lending, one LP told PDI.

So managers be aware, the large number of investors in the room are watching with eager eyes.