Investors’ approach to private credit has changed over time, with more and more investors seeking increasingly sophisticated solutions to meet their investment goals. This evolution is due in part to institutional investors’ growing interest and participation in the asset class, particularly since the financial crisis of 2008-09.
It hasn’t always been clear to investors where private credit fits in an investment portfolio. Recently, however, the prolonged period of low yields has left many investors seeking both yield and non-correlated returns from their private credit allocations. As follows, given the current low-yield environment, private credit appears to be serving two primary purposes:
1. Enhancing returns as part of a fixed income allocation;
2. Diversifying and adding a lower-volatility investment to an alternatives allocation.
No matter the bucket in which investors choose to group private credit, the investment options offered have continued to grow and now span traditional senior secured loans to mezzanine and unitranche options. As the asset class matures, it offers more choices than ever but also makes the decisions of which strategy to utilise and which manager to hire more complicated.
SEEKING RELATIVE VALUE
While the North American private credit market has long offered a broad and deep universe of potential investment options, today’s investors have begun looking increasingly toward expanding and diversifying their private credit allocation to other markets and strategies. In particular, investors in many cases are requiring smarter approaches to capitalising on relative value opportunities across the capital structure and geographies.
Opportunities across the Capital Structure
Within the broad private credit universe, there are multiple ways to finance deals, which in turn creates a wide range of investment opportunities for investors with varying risk and return requirements.
Senior secured loans, which sit at the top of the capital structure, offer investors the most seniority and security. These loans have recently offered yields ranging from 6 percent to 8 percent1, and because they sit at the lower end of the risk/return spectrum, have the potential to provide stable cash flows over time.
Investors can also find attractive opportunities in mezzanine debt. By definition, mezzanine is more junior in the capital structure and is therefore higher on the risk spectrum. Given the subordinated position of mezzanine debt, investors are compensated with higher yields, which on recent transactions have been in the 13 to 15 percent range.
In recent years, issuers in the US and Europe in particular have opted to issue unitranche debt, which combines features from senior secured and mezzanine debt into one investment vehicle. Unitranche typically offers higher yields than standard senior debt, and although leverage is higher, the investment is still secured by a first lien.
Opportunities across geographies
Private credit offers opportunities across geographies, with each region exhibiting different characteristics. While we see opportunities across North America, Europe, Australia/New Zealand and developed Asia, the overall attractiveness of each market tends to ebb and flow over time.
Supply and demand factors also differ from region to region, which can lead to differences in how transactions are priced and structured. As such, diversifying across these regions may better position active, global managers to seek relative value as loan spreads tighten or widen from region to region.
Given investors’ growing interest in maximising relative value opportunities, the flexibility to pivot to the most attractive regions and products at any given time has also become important to many investors. For instance, while senior secured loans may look attractive during the later stages of the credit cycle, investors may become more interested in junior or more opportunistic transactions as the cycle evolves.
Similarly, as spreads in one geography tighten there may be an opportunity to pivot to another geography where valuations are more attractive. In order to capitalise on such opportunities, investors can benefit from partnering with managers that have experience across the capital structure and geographies and the ability to provide differentiated and customised investment vehicles.
FLEXIBLE, CUSTOMISED SOLUTIONS REQUIRED
Non-banks are well-entrenched in the North American private credit market, having dominated the space since the early 2000s. However, the type of non-bank capital available since the financial crisis has changed, leading to the creation of multiple platforms that allow institutional investors access to private credit. With these changes, there has also been a growing differentiation between managers. Given the increasingly broad spectrum of private credit managers, it is critical that investors understand the culture and motivation of any manager with whom they consider partnering.
Understanding a firm’s business model and ownership, in particular, can shed light on that firm’s incentives. Investors can benefit from understanding up front, for instance, the differences between a firm focused on short-term profits vs. a firm with longer-term horizons or one that invests proprietary capital alongside its clients. In a buy-and-hold asset class like private credit, longevity is critical as investors want to be sure that managers have invested through many cycles and will be there to see them through the end of their investment.
DIFFERENTIATING BETWEEN PRIVATE CREDIT MANAGERS
Origination is key
Origination capabilities and relationships with private equity sponsors and other market participants, are paramount when investing in private credit. Established lenders with long track records and established partnerships have an advantage over newer entrants in the market, in that they tend to see the largest pipeline of deals. This access is key when it comes to sourcing a large number of potential opportunities and avoiding adverse deal selection.
It is also important that managers have local origination teams in the countries where they invest, as regulatory frameworks and other dynamics vary from country to country and region to region.
Deal structures can and do change
There can be advantages to working with private credit managers that have the ability to provide solutions across the capital structure. Many private credit managers focus on just one area, such as senior loans. While that focused approach may be beneficial to some, the reality is that deal structures can and do change over time.
In the several months it typically takes to close a deal, changes in market conditions or a company’s unique situation can change what the optimal deal structure looks like. In such a situation, managers that can execute up and down the capital structure may be more effective than those that specialise in only one or two areas.
This flexibility is particularly important given the illiquid nature of private credit and the difficulty of replacing deals. It takes a tremendous amount of time and effort to source and structure transactions in private credit. In fact, at Barings, we only close roughly 4 to 6 percent of the transactions we review. As such, if we were unable to provide a certain deal structure to a company that we assess to have an attractive risk/return profile, we may have to analyse scores of other borrowers to find a comparable opportunity.
Managers with a presence across the capital structure, from senior loans to unitranche and mezzanine, are best positioned to provide flexible debt capital solutions to borrowers, in our opinion. This breadth often leads to greater deal-sourcing opportunities with private equity sponsors which tend to prefer working with capital partners that have the ability to be flexible depending on what type of financing a specific situation calls for.
Reliability and certainty in the market
Reliability and certainty in the market are also key differentiating factors among private credit managers. Many factors, including supply and demand and overall market conditions, can materially impact the ability of lenders to meet the financing needs of middle-market companies.
In North America, for example, current market dynamics have reminded sponsors of the importance of reliability, not only with new deals but also when it comes to continued support for the ongoing financing needs of their portfolio companies. Due to increased post-financial crisis regulations, banks have become less able to provide middle-market financing.
Some smaller business development companies (BDCs) have also found it more difficult to remain active in the middle market, and as a result, private equity sponsors and corporate borrowers have turned increasingly toward what they view as reliable, long-term sources of capital as funding needs arise, leading to greater deal-sourcing opportunities for such lenders.
Risk management is paramount
One of the most important roles that a private credit manager can fulfill is that of risk manager, as private credit returns are earned by avoiding the pitfalls rather than by reaching for high levels of growth. It’s important to remember that this is an illiquid asset class, so investors are unable to sell positions easily. Additionally, like any credit investment there is the risk of adverse changes in value and even default.
Risk management is therefore paramount, and one of the most important steps in managing risks and achieving attractive returns for investors comes at the portfolio construction stage, when managers must clearly understand the risk parameters under which they are operating.
Managers must also understand the volatility of cash flows generated by each company and the degree of cushion in the amount of cash flows needed to pay interest and repay principal. Much of this understanding can be gleaned from on-site meetings with management, in-depth analysis of each company’s balance sheet and competitive positioning, as well as through partnerships with private equity sponsors, which can add significant value at the due diligence stage.
Despite the fact that private credit is considered a “buy and hold” asset class, portfolio monitoring is critical. In addition to closely tracking portfolio companies’ performance vs. maintenance covenants, a sophisticated portfolio monitoring process is necessary to ensure the portfolio is performing in-line with expectations. As such, investors may want to consider partnering with firms that have a robust risk management system and advanced portfolio monitoring and reporting capabilities.
Investors’ approach to private credit has become more sophisticated over time as they increasingly seek smarter solutions to meet their investment goals. While the North American private credit market has long offered a wide range of potential investment options, today’s investors have begun diversifying their private credit allocation to other markets and strategies. In particular, investors in many cases are looking to capitalise on relative value opportunities across the capital structure and geographies.
The type of non-bank capital available since the financial crisis has also evolved, leading to the creation of multiple platforms through which institutional investors can now access private credit. Given the growing differentiation between private credit managers, investors must understand the culture and motivation of any manager with whom they consider partnering. Some of the key differentiating factors investors may look for when selecting a private credit manager include:
Ability to provide solutions across geographies and the capital structure;
Reliability and certainty in the market;
A robust risk management process.
Private credit has the potential to provide attractive risk-adjusted returns relative to other fixed income instruments. In order to access the broadest selection of private credit investment opportunities, investors can benefit from partnering with experienced managers that have long-standing relationships with key market participants, access to a large and diverse pipeline of opportunities, and the ability to appropriately structure, price and monitor investments.
Ian Fowler is co-head of North American private finance at Barings
Proprietary capital: In our capacity as a principal investor for our parent company MassMutual, Barings invests our own capital alongside our clients, aligning our interests with those of our investors.
Scale and resources: Barings' scale across geographies and public and private market asset classes allows us to better understand and price risk, and puts us in position to provide effective solutions up and down the capital structure.
Origination: Barings has been investing in private credit for more than 20 years and over time has formed strong partnerships with financial sponsors, intermediaries and portfolio companies across North America, Europe, Australia/New Zealand and developed Asia. Our direct origination capabilities allowed us to review 1,240 deals in 2015. Of the deals reviewed, we closed approximately 6 percent.
Team: Barings' large, global team consists of more than 60 private finance professionals located in seven offices across four continents. Our team has over 20 years of experience investing in private credit, and also benefits from the compliance, legal and systems support of a large, global asset manager.
This article is sponsored by Barings. It was published in the US Special supplement of PDI’s September 2016 edition