Debating debt: Beneath the surface at PDI New York

The growing popularity of private debt could be measured simply by the numbers as around 250 attendees gathered at the Convene Conference Center on Third Avenue for PDI’s New York Forum 2016, more than 70 of whom represented limited partner organisations.

Or it could have been ascertained from the opening audience poll of the day, which found that 90 percent of LPs in the room were already allocating to the asset class. Of these, 43 percent said their private debt allocation had been enabled by switching out of fixed income; and 57 percent said their return expectation was somewhere in the range of 8-12 percent. But…

Do these investors know what they are investing in?

It may sound like a strange question, but one panel, dedicated to “Decoding strategies”, was an exploration of whether labels really matter. Erik Falk, global head of private credit at fund manager KKR, admitted to being little concerned about terminology. “We did a unitranche and half of people said it was unitranche and half said it was something else,” he said.

“What’s important is what’s in the documentation. You need to understand what happens in different scenarios. The key thing is not ‘what is this called’; it’s the next layer of questions about what’s in the documentation and what kinds of protection I have.”

“Each deal is its own special story,” added Arthur Penn, founder and managing partner at investment firm PennantPark. “You need to tailor a solution for both the borrower and the lender and, in doing so, you need to understand what’s underneath the surface.”

Greg Spick, a director at pension fund manager UPS Trust Group, said: “From the LP side, I find some of the terms quite ambiguous. Unitranche is not a new concept – we were seeing it in 2006-07 in real estate – but maybe it’s new to private companies. The key thing is: what are you trying to do? If you’re aiming for 8-12 percent, you will have to accept structural or asset level leverage to get there. You have to have a plan and identify what kind of risk you find acceptable.”

James McMullan, senior vice-president, fixed income, in the corporate markets team at Caisse de dépôt et placement du Québec, said investors need a full understanding of what the GP is trying to do in order to persuade people internally that they will achieve the expected return. He said that, for example, they would be challenged on the necessity of adding extra levels of leverage.

Given CDPQ’s ability to invest directly, he added that “the cost of an external manager and the degree of control that we retain” would also be issues to address. Questions demanding answers would include: “Are there specific investment parameters?” and “What rights do we have to terminate and replace the GP?”

What does adding value really mean?

While some delegates appeared to be agnostic about what to call a given strategy, the “Creativity in pursuit of high returns” panel saw Kelli O’Connell, head of the asset management team at fund manager NXT Capital, insist that “the ability to define the strategy is important”. With core team members going back 25 years, O’Connell said NXT had been successful in explaining its focus in the mid-market loan space.

Another mid-market specialist, Ted Koenig, president and chief executive at Monroe Capital, said his firm was operating in a “defensible niche”, targeting companies with EBITDA between around $5 million and $30 million. He said private debt was becoming more like private equity in terms of evolving a broad range of strategic approaches.

Arguably, this kind of approach was best exemplified by the presence on the panel of Manuel Henriquez, founder, chairman and chief executive at Hercules Capital. Hercules is a venture debt provider focused on venture capital-backed companies in the technology, life sciences and the sustainable and renewable technology industries.

“Nearly all our companies have zero revenues when we invest, which is an interesting underwrite,” said Henriquez. He added that the firm only takes forward around 8-10 percent of the deals that it sees, focusing on companies with disruptive technologies.

Despite what some may see as a high-risk approach, Henriquez said the firm has sustained a loss rate of just 2 percent.

Has the death of BDCs been exaggerated?

It’s been a hard ride for business development companies lately, particularly those with significant energy exposures. But panellists exploring the concept of “BDCs 3.0” argued that well-managed vehicles still offer investors numerous enticing characteristics such as efficient deployment of capital, diversification, solid governance and tax advantages.

Joshua Easterly, co-chief executive at TPG Speciality Lending, insisted that evaluating BDCs based solely on premium to NAV was “a rough instrument” and stressed the importance of good governance and treating shareholders well.

Brad Marshall, a senior managing director with GSO Capital Partners, said an important consideration with BDCs was whether a firm trusted managers to provide it with accurate valuations, with some prone to fully value and others inclined towards more conservative approaches.

However, Howard Levkowitz, a co-founder and managing partner of Tennenbaum Capital Partners, said transparency was a relative strong point of BDCs, contrasting the granular data provided on exposures with the “aggregated data” approach of other investment classes.

Can only larger funds be trusted through a cycle?

In a panel on investor priorities, Mark Katz, director in the alternative investments group at Ontario Teachers’ Pension Plan, discussed his organisation’s shift towards deeper relationships with fewer managers as the asset class matures. OTPP’s average ticket size, he said, was now up to around $250 million, meaning it was typically looking at funds around the $1.5 billion mark.

Bigger funds, Katz pointed out, are more likely to have the resources necessary to be seen as credible substitutes for the banks. “Direct lending GPs are perceived as a bank alternative. And that’s fine, but you need to be as good as the banks in terms of your platform, your infrastructure, your team, and your ability to structure and monitor deals,” he said. “This tends to take you in the direction of the bigger platforms.”

He added that larger funds also tended to have more experience in stressed and distressed cycles, something which many of the new private debt funds lack.

GSO’s GOODMAN WARNS ON ‘PARADIGM SHIFT’

During an onstage interview, GSO Capital Partners co-founder and Blackstone senior managing director Bennett Goodman cited retail as an area of potential market weakness due to the “paradigm shift” brought about by the internet.

“The impact of Amazon has been profound,” he said. “For big box retailers it’s hard to have a differentiated value-add offering.”

Goodman also referenced disruption in the hotel sector due to Airbnb and in the auto sector from developments such as driverless technology and apps like Uber.

He added that he has a favourable view of energy, interpreting its troubles as cyclical rather than secular. Where the principal is well protected by a company’s secure energy resources, he said his firm would be willing to underwrite a recovery five years from now.

However, he added that the company would need to have sufficient liquidity to deliver the upside from a recovery in oil prices, and that it’s impossible to know exactly when the recovery will happen.

Goodman said the attractiveness of private debt would be maintained on a relative basis in an environment in which returns were coming down across all asset classes. The key for investors, he said, was to identify the best risk-adjusted returns; even dropping a percentage point or two, private debt would still be well compensated for the patience of the capital and for not requiring liquidity.

He pointed to GSO’s scale as a “huge competitive advantage” given “the ability to do what others can’t do” and praised the ability to utilise Blackstone’s private equity expertise, its boots on the ground in Europe and the ability of the firm’s operating partners to provide detailed analysis of business models.

Goodman also urged investors not to “get caught up in fads” and to be highly sceptical. “We see the glass as half empty. We are doubters and that makes us good underwriters,” he noted.