Eight years on from the financial crisis, the company-financing landscape has been transformed across the US and Europe. As banks face growing restrictions over lending, so the private debt space has expanded to fill the void.
The recent publication of our PDI 30 report shows just what a shift we have seen: for 2015, the five-year private debt fundraising total reached $462 billion, up from $318 billion in 2014.
In the US, non-bank financing as a proportion of leveraged lending rose from 36.8 percent in 1998 to more than 85 percent in 2013, according to a Brown Brothers Harriman report last year. In Europe, the proportion is lower, at around 20 percent of all lending, according to various estimates, but it has been growing quickly in recent years. This much we know. But what does the future hold for this part of the market?
The effects of Basel III and other regulations will be long term as banks continue to deleverage their balance sheets. This creates further opportunity for private debt, particularly in the mid-market space, as companies and their private equity sponsors seek funding.
Meanwhile, institutional investors are clamouring for yield in a low-growth and continued low-interest rate environment. “The growth of private debt will continue or even accelerate,” says Benoît Durteste, head of European investments at ICG. “Every institution we see is at least thinking about direct lending if they don’t already have allocation to the space as they search for yield. The fact that banks are moving away from the space creates opportunities. It’s a rare case where supply and demand are in sync.”
One trend seen in recent years has been towards larger fund sizes in some areas. This looks set to continue.
“As investors have become more comfortable with private debt, so they are increasing their allocations to the more focused growth debt space,” says Simon Hirtzel, COO of Kreos Capital. “Growth debt funds are seeing increasing opportunities to deploy capital and have been able to accept more capital from investors. As private debt funds increase the size of their deals, so they also need to raise larger funds to avoid concentration risk. This results in a cycle where it allows larger investors to allocate to the asset class.”
With institutional investor demand for private debt ramping up for the foreseeable future, LP allocation models to the asset class will develop.
“As the public credit markets continue to be challenging, we’ll see LPs and fixed income groups gradually carve out pockets for illiquid investments,” says Ben Schryber, principal and head of global credit at placement agent First Avenue. “They will lock up money for downside protection and potential upside, leading them to direct lending and low-risk strategies, while areas such as mezzanine and distressed opportunities will still come from private equity and general alternatives buckets.”
Some will go further.
“We’re already starting to see some institutions build out private credit teams, with some investing directly,” adds Schryber. “The mandate for these groups will be broad, encompassing the spectrum of performing senior, mezzanine and distressed.”
Moves in this direction are already coming from LPs that have direct private equity arms, such as some of the Australian LPs, Canadian pension plans and some US insurers and others may join the trend.
LPs investing directly may mop up some of the opportunities that funds might otherwise have targeted, although this may be more of an issue in the US, where growth in demand from sponsors and companies has less scope to grow than in Europe. It will also take some time to play out, given the need for LPs to build experienced teams capable of direct investments.
The differing needs of LPs will shape the fund landscape. The private debt fund market has already seen a trend towards separately managed accounts to allow investors to target strategies that meet their return profiles. This will continue, says Schryber.
“There will be greater customisation of fund structures,” he says. “This is likely to benefit the big brands that can give investors access to a broad spectrum of opportunities. They will be able to offer investors funds that have the flexibility to go up and down the capital structure.”
In addition, some of these larger players may well build their capabilities across different credit asset classes. “We are seeing some larger, established asset managers looking to build multi-asset credit platforms,” says Tavneet Bakshi, partner at First Avenue. “So investors will have access to opportunities not just across the risk and return spectrum, but also across asset classes, such as infrastructure debt and real estate debt, as well as direct lending.”
The result is likely to be a split in the fund market. “As the market matures, you will see an initial phase of consolidation,” says Durteste. “Size makes a big difference as you need a sizeable fund even in the mid-market space for diversification reasons. So you’ll have large groups that will generally be the more established players, and then you’ll have smaller, specialist funds that target specific geographies, sectors or risk levels.”
There are already some niche strategies starting to emerge. “Leasing is becoming an interesting space in Europe as banks offload portfolios, but there are many others, including litigation finance portfolios, music royalties, film finance and even wedding finance,” says Schryber.
“While some of these may seem fairly esoteric, they are being driven by investors’ need to find yield alternatives.”
Earlier this year, for example, LCM Partners acquired ING’s UK leasing portfolio and Incus bought GE’s Spanish leasing assets.
The prospects for the private debt space in Europe and the US therefore look bright. But what about Asia? Large parts of the region, as well as other emerging markets, have yet to see the development of a private debt industry, but many believe this will come.
As Schryber says: “There are challenges in many of the newer markets, but investors look set to shift some of their emerging markets private equity exposure towards performing, or even distressed, emerging market credit as they react to the lack of exits and growth from their EM PE portfolios.”
MY BEST FRIEND IS A BANK
While banks may have viewed the private debt space with suspicion in the early days, this is changing. Traditional lenders are increasingly coming round to the idea that they can work with the new kids on the block, not just to provide commercial banking services, but also to pool resources and knowledge.
“There will be an increasing amount of collaboration between banks and private debt funds,” says Faisal Ramzan, finance partner at law firm Proskauer. “Banks, after all, have extensive relationships and strong origination capabilities built up over many years. You’ll see more banks, funds and investors market informally together.”
One such example is the RBS tie-up with AIG Asset Management, Hermes Investment Management and M&G Investments announced at the end of 2015 to provide mid-market sponsor-backed lending of up to £100 million.