When Kreos Capital, the specialist in European and Israeli growth debt, launched its latest fund, Kreos V, it set a goal of raising €400 million – two-thirds more than its previous fund. Kreos V closed in January 2016, and was oversubscribed, a reflection of the heightened interest in both Kreos and the emerging arena of niche debt strategies.
“The focus of investors has evolved,” says Simon Hirtzel, general partner and chief operating officer of Kreos. “Many of them like the idea of a niche strategy like ours.”
In the search for new and effective ways to play the private debt game, investors are finding a home in niche strategy players like Kreos. Often a niche strategy can enhance returns, serve as a substitute for fixed income, or provide a compliment to larger portfolio goals.
Much of the action remains with specialised managers which dedicate their work to a narrow strategy and frequently seek richer and uncorrelated returns. Hirtzel says Kreos aims for 12-15 percent net returns at a time when larger, diversified funds have seen returns drift down into single digits.
Niche funds now encompass a broad range of strategies, from aircraft leasing to music royalties to energy company financing. Larger, more generalised debt managers have dabbled in niches but many of these strategies remain the purview of smaller, highly specialised funds with the ability to focus on sometimes arcane business details. Legal settlement funds, for example, employ attorneys trained in corporate law. Music royalty funds employ veterans of the entertainment industry familiar with the quirks of song rights and their use in other media like films and advertisements.
Energy has been a particularly active niche for debt firms. A new energy debt fund has been opened by Riverstone Holdings, while Carlyle Group runs an active energy mezzanine debt operation. The nosedive in energy prices created particularly tantalising opportunities for distressed debt investors, including a number of hedge funds that specialise in distressed debt. Mudrick Capital Management was among those that raised special funds to invest in energy distressed debt.
Niche strategies have been around for years. But because of their narrow scopes and their small size relative to larger, more general private debt funds, they had limited appeal to institutional investors. That situation is changing as endowments, foundations and pension funds warm up to niche debt strategies, often targeting several specialty funds to gain enough scale to meet their needs.
“I am seeing more appetite right now for quality, proven niche strategies than for generalists,” says Ben Schryber, global head of credit for First Avenue Partners, a global advisory and capital placement firm.
Appetite for change
One reason for their rising appeal is that many institutions have already made commitments to traditional private debt funds, but still have an appetite for more. Having bought into, say, a general distressed fund, a general private debt fund and a broad mid-market direct lending fund, an institution may decide it has reached its goal for large, diversified funds but not for private debt.
“It is difficult to do a second generalist fund, or a third,” Schryber says. “There is not a lot of difference from one to the next.”
Niche funds offer a new way to diversify debt allocations. And because many niche strategies are focused on quirky or unique specialties, they can be a source of returns uncorrelated to other asset classes.
While the demand for niche strategies is growing, that growth has tended to be more modest. Niches by definition are not broadly based opportunities but rather narrow in focus, and so tend to have scale limitations. Niche strategies also tend to require very specific business expertise. These barriers to entry make it hard for general debt fund managers to participate.
Aircraft leasing funds, for example, can typically point to a strong bench of experts drawn from the aircraft industry. Royalties funds offer specialised industry niches revolving around the purchase of royalty streams like healthcare patents, music rights, or oil good rights.
But while royalty funds have drawn considerable interest from investors, their expansion has slowed recently. Data from Private Debt Investor shows that five new royalty funds debuted in 2013 and raised a total of $2.4 billion. Another five funds came on line in 2014 and raised $3.36 billion. But 2015 saw the number drop to three and a total of $1.59 billion. And through the first nine months of 2016, only one fund debuted at $500 million.
Another niche strategy gaining traction is litigation financing, in which private debt managers loan law firms money to pursue cases or run their offices. Burford Capital has been a leader in the field, and as a publicly traded company in the UK, it offers a peek at the finances within this niche. For the first six months of 2016, Burford reported its litigation investment income rose 110 percent from the previous year period to $64.4 million. It’s operating profit for the first half of the year hit a record of $61.7 million, up 117 percent from the previous year’s period.
Those kinds of results encourage others to enter the field. Chicago-based Gerchen Keller Capital, launched in 2013 as an investment firm focused on litigation financing, has quickly expanded into a giant in the field with more than $1.4 billion in assets under management. Its latest fund, a $400 million offering announced in January, has proven attractive to a range of institutional investors, including pension funds.
In some cases, niche players carve out a specialty that is already served by more general private debt funds. Enlightenment Capital recently raised $147 million for its second fund aimed at providing financing to lower mid-market aerospace and defense firms. While a number of debt managers serve the aerospace and defence market, Enlightenment believes it has an edge by specialising in lower-mid-market firms that may not be on the radar of large debt managers.
Devin Talbott, managing partner at Enlightenment, says being a niche player provides an edge both in terms of raising capital and deploying it.
“It is difficult to differentiate yourself in a crowded credit supply market,” he says. “Specialisation, deep roots and track record in our industry lets us distinguish ourselves.”
While there can be numerous reasons investors choose niche lending strategies, the lure of higher returns remains an important motivator. The spread of niche debt strategies is still relatively recent, so performance data comparing niche strategies to general ones is hard to come by.
Schryber says that what keeps stoking investor interest in niche debt strategies is that they offer a promise of generating hard-to-find alpha in the debt field. With more niche funds to choose from, investors have greater opportunity to find combinations that fit with their individual needs.
“There are so many niche funds now that even the largest institutions can scale by making numerous commitments,” Schryber says. “Almost all of them [institutions] are open to niche strategies.”