In a low investment rate environment, there are few options that appear to help institutional clients achieve their financial objectives. Marrying enough risk to provide a sufficient level of income and return in such a volatile world is challenging.
But is it possible that private debt provides the answer?
Steve Sterling and Stephan Caron of BlackRock, the global investment management firm, believe that private debt does. They have come together to share their thoughts on the subject with Private Debt Investor at BlackRock’s London offices and their view is that this asset class is a rising destination for long term, institutional client capital and will prove to become a larger percentage of client portfolios.
Sterling, head of BlackRock US Private Capital, speaks with enthusiasm of private debt’s potential to provide institutional clients, such as insurance companies and pension funds, long-dated, stable contracted cash flows driven by local economics, with relatively low correlation to the public markets; as well as the value of direct diligence and degree of protection afforded by financial covenants.
He talks also about the potential in the US to pick up material incremental yield for first-lien risk, relative to broadly syndicated investments, and how a market rally in the first half of the year saw substantial yield pick-up within second-lien middle-market investments relative to public high yield. In particular, he cites the middle-market opportunity as “quite compelling”.
Caron, head of BlackRock European Middle Market Private Debt, reinforces the case for private debt, adding that, in Europe, “the risk-adjusted net return is attractive and higher than what clients can expect from their allocations to liquid fixed income, and in Europe, middle-market private debt investments offer additional yield. Varying by country and depending on the complexity of the transaction, institutional clients can achieve compelling returns and income without leverage at the fund level.”
Caron observes that Europe is behind the US when it comes to the development of private debt. But the market has been gaining momentum recently, amid the regulatory reform of banking and the need to deleverage, following the global financial crisis. As a result, private companies are increasingly turning to alternative sources of financing, creating significant growth opportunities for the asset class.
“There are about 50 funds active in Europe today with around €50 billion of committed capital. But that’s modest compared with the amount of debt that needs to be refinanced, which is estimated between €2.7 and €3.1 trillion, over the next five years. The asset class has a lot of room to grow.” He believes this is particularly the case in the sponsorless market, which has already more or less doubled in size from around 12 percent of the total European market in 2012 to circa 25 percent today.
Sterling has already witnessed considerable growth in US private debt, manifested by the growing number of clients considering initiating or increasing their allocation to the asset class. “Because of regulatory reform in the US, we have seen a growing interest in middle-market private debt from institutional clients who are more suited to owning the exposure,” he says.
“US clients have, over the years, become more knowledgeable about the asset class,” he continues, “and the driver has been their need for current income and willingness to allocate to private debt, especially in the middle market. They have had positive experience with the asset class and, given the latter stage of the business cycle, have indicated interest in moving up the capital stack to first lien where the risk/return profiles are more attractive, the market has additional depth, and there is constant deployment into quality assets”.
Of course, there are limits to growth in any asset class and quantity should never be at the expense of quality. “There is a fair amount of capital inflow at the moment,” concedes Sterling. “A high-growth asset class will naturally settle to find equilibrium, with expectations for some consolidation amongst fund managers and segmentation into niche strategies. The sophistication of managing credit has already increased significantly and you will continue to see higher levels of economic rationality and evolving ways of investing.”
Caron notes the presence of many new entrants that have arrived on the scene in Europe in recent years, as companies have become more aware of the opportunity to obtain financing on flexible terms from institutional investors and investment funds. But he notes, “the market has not been through a downturn yet and investment managers’ private debt expertise will be tested and the question will be whether they have the right resources to conduct due diligence and systems to monitor investments.”
This leads to a consideration of which qualities are required to ensure that you will survive and flourish in a market that offers the potential for strong returns but where creating value relies on such things as having the right people on your staff roster, depth of analytics, and the market presence and reputation needed to foster introductions and a regular pipeline of deals.
Asked to nominate the most important traits for any private debt fund manager today, Caron reflects: “The quality of deal sourcing is absolutely vital. In Europe you have to invest in boots on the ground with investment professionals in each of the key markets around the region. There is too much competition to secure introductions and land deals with teams based out of London alone.”
Developing “multiple deal channels” as a result of having a widely spread and deep team of investment professionals is important to avoid focusing all your efforts on areas of the market that have become overly competitive and where price or the total debt quantum may be the sole differentiator.
“We are seeing segmentation, with some of the larger debt funds moving into the upper mid-market where they end up competing with CLOs and the lower end of the high yield bond market,” says Caron. “We are also seeing more and more country-specific strategies which play in a narrow segment.” In his view, “you’ve got to leverage your network to identify where there is less competition, and be open to the idea of a regional approach”.
PLUGGING THE NETWORK
Caron also cites the importance of support within the wider organisation, highlighting the network within BlackRock. This includes a capital markets team whose relationships with brokers provide a frequent source of referred deals and investment opportunities. Through sector-focused credit analysts, he also believes this network gives the private debt operation a vital information edge: “There is a tremendous amount of information across the investment teams giving us insights into things such as Brexit, foreign exchange and interest rates.”
Sterling, meanwhile, focuses on reputational aspects. “Your reputation is critical,” he emphasises. “More than ever, middle-market companies care about who is in their capital structures. BlackRock’s reputation within the global asset management industry instils confidence, reliability and predictability that is important to their selection decision.”
He also highlights that relationships give the firm an advantage when it comes to sourcing investment opportunities and evaluating fundamental risks. BlackRock’s breadth and depth can provide further comprehension of business, industry or regional trends.
“As a large independent asset manager, we can use our relationships with company management teams to identify quality prospective investments,” he stresses.
Another relationship that is vitally important, reflects Sterling, is with the management team of a portfolio company. “You need a quality relationship with the company that means there will be a good rapport when things don’t go well,” he says. “We require monthly reporting which allows us close contact on an ongoing basis. As you evaluate performance, you can make some judgements about future cash flows and anticipate what will happen over time.”
Caron points out that offering genuine added value can help to deepen relationships. These growing middle-market companies are looking for robust partners who can be constructive on a number of fronts. “In Italy we worked with a business that wanted to go public and, as it was not backed by a private equity firm, it needed some helpful advice. These are the kind of situations where you can bring knowledge and insight and it’s not all about the capital that we invest on behalf of our clients.”
If a company does face a bump in the road, then the depth of the relationship with management will become more important than ever. “When things are not going to plan, don’t assume things will get better,” says Sterling. “You need to engage around the issues so everyone is on the same page; and dealing with the issues early enables a process of collaboration to eventually find a resolution.” A relationship built on partnership and information transparency may lead to a better set of possible outcomes – for both companies and investors – when a company faces a challenge.
He goes on to stress the importance of being well equipped to deal with the fallout from problems that prove insurmountable. “You work together to solve problems, but sometimes options become exhausted and a change of control is required, and that drives important decisions to protect client capital, which is a whole different skill set. You’ve got to understand that process really well.”
Indeed, the concept of attempting to protect capital referred to by Sterling is an important one in private debt and underlines the significance of both investing well in the first place and then being responsive to any difficulties. As Caron explains: “Some funds are taking big-ticket credit risk with individual investments. That can work well in private equity where it’s accepted that you get big winners and big losers, but in private credit it’s very difficult to compensate for big losses.”
He continues: “For that reason, you need diversification; an understanding of sectors, technology, regulatory trends, the supply chain and price dynamics; and you need people who have experience and can do very labour-intensive workouts if they need to.”
Having outlined the qualities and characteristics needed for a successful private debt operation, Sterling and Caron reflect on whether institutional clients, such as insurance companies and pension funds, are familiar with these requirements and whether they are digging deep enough into what asset managers bring to the table.
“Good due diligence and investment structuring is all about nuance and detail,” says Sterling. “It’s about getting behind a sourcing model and understanding how firms attack the opportunity strategically through different channels. When firms say they are multi-channel, are they really? It’s also quite common to claim an information edge, but you need to ask for specific examples and test the efficacy of that claim.”
“Further, it is about investment discipline and risk culture; the proprietor model defined by one or two decision makers is dead and, now, it is about creating a high-performing team.”
He also says the short history of private debt as an asset class means that there is even more onus on investors to examine processes that firms have in the here and now.
“People are right to ask for track record but any track record in this space is quite short. It’s good for ticking a box, but you need to know how investments are created and will be managed through stress, distress and, if necessary, change of control. Don’t get fixated on track records built in a bull market,” Sterling cautions.
There is, in the BlackRock duo’s eyes, a significant opportunity in private debt in the years ahead. But they would caution against assuming that a rising tide will lift all boats – best, they would no doubt suggest, to examine whether the boat has any potential leaks.
This article is sponsored by BlackRock