Graeme Delaney-Smith joined Alcentra in September 2004 and is head of European Direct Lending and Mezzanine Investments. Prior to joining Alcentra, he was an investment director at Intermediate Capital Group where he marketed the firm’s capabilities to private equity firms and originated and invested in numerous European mezzanine financings.
Floris Hovingh leads Deloitte’s Alternative Capital Solutions team and is founder of the Deloitte Alternative Lender Deal Tracker. He focuses on raising alternative capital for private company clients. Prior to joining Deloitte in 2008, he had over seven years’ banking experience with HBoS and NIBC in their respective leveraged finance teams in London.
Sam Metland is head of Alternative Fund Servicing Product at Brown Brothers Harriman which includes banking, administration and technology services for private equity, syndicated and originated debt, real assets and hedge funds. Prior to joining BBH, he was in the product solutions team at JPMorgan Investor Services, focusing on developing bespoke solutions for complex alternatives funds. In 2005, he was part of the team that led a PE-backed management buyout to create Augentius Fund Administration, where he had responsibility for all business systems.
Sanjay Mistry is a senior member of Mercer Private Markets, a specialist unit within Mercer’s investment business and has been leading MPM’s efforts in the area of private debt since 2009. Based in London, he is involved in investing in private debt and private equity on a primary, secondary and co-investment basis on behalf of MPM’s discretionary funds and delegated clients as well as advising across a full range of investment activities.
Adam Wheeler is Barings’ head of European and Asia Pacific Private Finance investments and a member of the firm’s European and Asia Pacific investment committees. He is also a portfolio manager for a number of Barings’ funds and separate accounts in Europe and Asia Pacific, including Gateway Mezzanine Partners I and II, Barings’ Asia Pacific focused mezzanine funds.
Five leading asset class professionals are gathered together at the Shard in London. As they survey the sweeping views of the city that the 95-storey skyscraper affords on this clear morning, it’s a grand setting for a bold question: what is the future of private debt? Of course, it’s not a question that has a simple answer. There are many different opinions on the subject and numerous ways of pondering it. This is precisely why hosts Brown Brothers Harriman (BBH) and Private Debt Investor have set aside a decent chunk of time for a group of private debt experts to debate the subject.
At PDI’s recent Germany Forum in Munich, more than 90 percent of the audience expressed confidence that private debt would prove to be a long-lived phenomenon and not a transitory response to a particular set of temporary circumstances. This view that private debt has a strong and long-lasting future is unsurprisingly held by all round the table.
“We see private debt as permanent, not as some fleeting change,” asserts Graeme Delaney-Smith, head of European direct lending and mezzanine investments at asset management firm Alcentra. “We are at the start of a transformation in the approach to mid-market lending because funds can make good returns for their investors on a relatively unleveraged basis compared with the banks. For investors, a new investment option has opened up that couldn’t be accessed before.”
Sam Metland, head of alternative fund servicing product at BBH, maintains that investors which have traditionally invested in either equity or fixed income are finding in private debt something which bridges the big gap between risk and return. “That demand [from investors] will continue,” he insists.
Embracing this positive view of the asset class’s future does not preclude the possibility that there are also some challenges facing it. As some of the participants point out, investors have to accept some illiquidity.
The view is also expressed that fund structures in the asset class need to match the liquidity, maturity and credit risk profiles of investors and that this has not always been the case.
OVERCOMING CULTURE SHOCK
Floris Hovingh, head of alternative capital solutions in the debt advisory team at Deloitte, says one of the challenges in his view is the lack of understanding of private debt in certain parts of Europe.
“The pace of change is different between countries,” he notes. “The cultural approach of borrowers, and whether they are willing to take on alternative debt, is important. After all, it can be quite expensive at around 6 or 7 percent over LIBOR if you’re used to bank financing at 2 percent margin.”
Hovingh also stresses that private debt can in many cases be worth the extra expense due to its efficiency and flexibility, as well as the ability to create shareholder value by financing M&A and shareholder liquidity events, which alternatively would have been only possible by raising new equity.
Were this message easily absorbed, the future of private debt throughout Europe – rather than in just a handful of countries – would look a lot more assured. As it is, many borrowers have become accustomed to partnering with their local banks and will need a lot of persuading to sever those deeply ingrained relationships.
As Adam Wheeler, head of European and Asia Pacific Private Finance at Barings, says: “Private debt has made more impact in the UK than the rest of Europe; banks are struggling under increased regulation and higher capital requirements.”
“Risk modelling has evolved and that is enabling investors to go down different paths in terms of strategy”
In the long run, however, more borrowers may take note of the point made by Metland: “Funds have more flexibility to design loans in an appropriate way, whereas banks tend to have very rigid criteria and offer rather standardised loans. You have to ask whether borrowers are really happy with that.”
Delaney-Smith believes patience is a virtue in that the merits of private debt will eventually become evident to a much larger number of potential borrowers but, rather like a plant flowering, it’s not necessarily happening at a speed that you can observe with the naked eye. “Managers are making inroads,” he insists. “We’re not going to see a sudden change over a couple of years; it will be a long-term change. But actually that’s good for firms like us because it allows us to build up our resources incrementally.”
One question sometimes pondered by asset class professionals in conversations with PDI is whether an upward movement in interest rates would see the banks reclaim market share. Would this threaten the assumed ascendancy of private debt and see something of a reversal in fortunes?
The view around the table is that this seems unlikely. Even if interest rates do rise, the commonly held opinion is that private debt providers would still be in a strong relative position. “It’s driven by return on capital,” says Wheeler. “Due to regulatory changes, it’s difficult for the banks to lend to sub-investment grade and make money. It’s about the cost of funding, not just interest rates.”
LPS GET WITH THE PROGRAMME
Currently, private debt is mainly the preserve of larger funds, perhaps suggesting a lack of maturity. A couple of the participants point out that smaller funds and thematic plays do exist but capital tends to gravitate to the larger players because, at this point in time, they are an easier sell for the consultants.
“When you’re introducing new LPs to the product, it’s simpler to pitch the top five direct lenders – because everyone knows them. As they become more familiar with the product, these LPs will eventually allocate to more tailor-made and niche strategies but it takes time,” says Hovingh.
Part of the maturing of the asset class can be seen in the approach being taken to it by LPs. Having initially allocated to private debt from either fixed income or alternatives – and having had a limited choice of strategies in which to invest – many now have specific credit allocations and are investing across a broad suite of products. “They are now focused on precisely what they want to achieve and what is the best risk/return for them,” says Wheeler.
“Risk modelling has evolved and that is enabling investors to go down different paths in terms of strategy,” notes Sanjay Mistry, head of private debt at Mercer Private Markets. “The challenge for an illiquid asset is how it interacts with the rest of the portfolio. Where are the returns driven from? What is the underlying premium? It can be difficult to model well.”
Mistry expresses the opinion that many investors, in the continuing hunt for yield, will want to raise their private debt allocations further – even those that already have around 5-10 percent. But he cautions that it should not be taken for granted that the future of the asset class will necessarily be as lucrative as its recent past. “It’s a young asset class. Many investors are happy with the numbers so far and what appears to be good relative value. But the credit markets have been benign and investments not really tested.”
Perhaps this lack of testing in tough times may explain the increasing proliferation of strategies within the private debt universe, as a rising tide has allowed all boats to float. Metland sees this flowering of different approaches as the inevitable result of private debt providers effectively moving into the space where the syndicated loan market used to dominate – but does so no longer. “There’s still scope to grow [more strategies],” he asserts.
Certainly, there has been a trend towards fund managers adding more strings to their bows – and raising funds for each of these different approaches. With the LP base now increasingly sophisticated and able to identify strategic nuance more capably than they have in the past, this may well be a sensible way to proceed.
ORIGINATION IS CRUCIAL
However, expanding rapidly during a benign climate may run the risk of underestimating what it takes to build a sustainable fund management business in the long run. Those around the table are keen to stress the importance of building a network that will enable a credible origination function – and the cost involved in this.
“We run private debt lending out of London but we are on the ground originating all the time,” says Wheeler. “It’s an expensive model to run. You need efficiency in the processes you deploy and you need to invest a lot of capital per transaction.”
Metland suggests that this explains why most deals are of the sponsored variety – in other words, doing deals in the sponsored space [ie, deals backed by private equity firms] tends to be more efficient because of the relative ease of identifying such deals and the fact that they tend to have been subjected to thorough due diligence.
“That’s true,” acknowledges Wheeler, “but it still doesn’t make origination easy. We’re not on a bond desk where you have a flood of deals that you can pick and choose from.”
OPPORTUNITY IN SPONSORLESS
Indeed, while sponsored deals do indeed predominate, one of the growth areas that many in the asset class point to is sponsorless transactions. In the US, sponsorless deals have grown to around 40 percent of the total and there are predictions that a similar percentage may be reached in Europe – where such transactions are currently around 20-25 percent of the total.
The rationale is based around business owners finding it increasingly difficult to obtain bank debt. A study by specialist lender Amicus in May found that almost a third of SMEs canvassed blamed high street banks for the loss of a business deal or opportunity. It also revealed that 16 percent of SME owners seeking finance had been turned down by a mainstream lender, up from 11 percent in 2011. In addition, while the non-bank financing option may be more expensive, borrowers may appreciate its quicker speed of delivery and greater flexibility.
“There is a big opportunity in sponsorless, where funds can form partnerships with family/founder-owned businesses to execute a buy and build strategy,” asserts Hovingh. “These companies often lack equity when making acquisitions and a combination of higher yielding debt with minority equity from alternative lenders could be a solution to unlock transformational growth.”
“There are more sponsorless deals being brought to us by advisors,” acknowledges Delaney-Smith. “However, many sponsorless companies still see the banks as the safety-first option.”
Delaney-Smith has first-hand experience of such situations. One was Mountain Warehouse, the UK outdoor equipment retailer, which “wanted to invest in overseas expansion, including online. Our financing allowed them to take out the last vestige of PE ownership, put control in management hands and let them drive the business plan forward”.
This element of handing management teams control over their own businesses, and allowing them the flexibility to pursue their plans free from hold-ups, gives private debt a vital advantage over banks, in Delaney-Smith’s view.
“We had a deal in Germany where there were previously four bank lenders backing the company,” he recalls. “Every time they wanted to make a bolt-on, the process became quite protracted. We gave them a committed facility that they could draw down at will and it allowed them to proceed more smoothly.”
As Metland observes, this ability for private debt to allow growth companies to fulfil their strategic plans is a positive message within a financial services industry that doesn’t always enjoy a particularly good press. “It’s about giving capital to entrepreneurs to do what they need to do,” as he succinctly puts it.
This would suggest that, in the interests of strong economies buoyed by growth companies with a range of borrowing options, private debt deserves to have a bright future. With investors increasingly swayed by the message that it brings positive characteristics to their portfolios that are not available elsewhere, prospects of just such an outcome would seem to be good.
CLOSING THE GAP BETWEEN BORROWERS AND LENDERS
Private debt providers believe they offer a more flexible and creative product for many businesses than banks are able to. But the universe of businesses that may potentially greet this message with enthusiasm is vast. So how to reach them all?
“You can hold seminars, breakfasts and send news flashes, but a lot of it is about getting out there in Europe and meeting private equity, intermediaries and companies and drumming up business,” says Hovingh.
Perhaps the hardest businesses to reach are the smallest. When it comes to companies with EBITDA of less than £10 million ($12.9 million; €11.6 million), that’s where “the network is really challenged,” suggests Mistry. Wheeler agrees that “the small end is difficult” but Mistry says, that “there’s the prize of differentiation for those that can do it”.
No one is suggesting that closing the gap between borrowers and private debt providers is easy. Those around the table make the point that borrower CFOs are often not well connected to the finance universe and unaware that borrowing from fund managers rather than banks is an option. There is, therefore, a big task ahead for managers and consultants in helping to educate and raise awareness.
Having been asked to gaze into the crystal ball and see how the future of private debt is likely to be shaped, those around the table are asked whether they can also detect the formation of any troubled-looking apparitions in their vision of tomorrow?
Wheeler concludes there’s nothing too much to worry about, but speaks of the perils of failing to keep investors properly informed when an investment runs into difficulty. “Covenant default is just a warning signal, it doesn’t necessarily mean you will lose money,” he says, hinting at the foolishness of attempting to obscure something that may in any case not ultimately be a problem.
Hovingh, meanwhile, points to some smaller managers having too much concentration risk – while larger managers have more positions and hence more diversified risk.
Mistry picks up on Hovingh’s observation by underlining the importance of diversification in private debt. “In private equity, concentrated investments can sometimes have a good effect but, in a credit portfolio, there is limited upside. The vital thing is that you have to get your capital back.”
Delaney-Smith highlights the importance of having a meaningful stake in a portfolio company and hence the ability to have some element of control when things go wrong.
Metland expresses the view that borrowers will remain cautious of direct lenders because of uncertainty over how they will react in a downturn. They may take more comfort from banks because the default processes and actions of banks are better understood, and fear that direct lenders may react more aggressively to a borrower in difficulty – for example, by pulling loans or changing management.
REASONS TO BE OPTIMISTIC ABOUT PRIVATE GROWTH
Regulation encourages growth
Following the financial crisis, regulations such as those arising from Basel III and the Volcker Rule in the US have placed constraints on the banks’ lending activities. But with mid-market companies still needing finance to grow, alternative lenders are stepping into the gap.
Growing pipeline of deals
Deloitte’s Alternative Lender Deal Tracker report for the first quarter of 2016 found that the 46 lenders covered by the survey had completed 63 deals during the first quarter, representing an 8 percent year-on-year increase in dealflow.
This is consistent with the sense that alternative lenders are increasingly on the radar of mid-market business owners. Although owners in some parts of Europe may still have a sceptical view of private debt, many feel that the sponsorless market has room to grow based on the relatively small proportion of sponsorless deals in Europe relative to the US.
Increasing investor allocations
Investors are becoming increasingly educated about the asset class and are more comfortable in making allocations. According to a recent study from advisory firm Elian, 41 percent of institutional investors said they planned to increase their private debt allocations over the next 12 months. Furthermore, almost three-quarters of respondents said the returns generated from their private debt investments had “exceeded expectations”.
Efficient and flexible financing
The economic and political volatility of recent times, which has rocked other asset classes, appears to be making private debt look relatively attractive as a flexible form of financing.
With many predicting a downturn in the UK economy at some point following the vote to exit the EU, consultancy firm bfinance argued in a recent report that it would be asset classes least tied to the effects of low GDP growth and less sensitive to changes in inflation, such as private debt, that would benefit in the long run.