Mid-market special report: Challenges facing first-time funds

A casual observer may be forgiven for interpreting the recent news that emerging manager AlbaCore has managed to secure a €500 million seed investment from Canada’s PSP Investments as a sign that raising first-time funds in the private debt space is relatively easy. After all, the firm was only established in the summer and has spent the last few months assembling its team. And, given that there is so much demand from investors for private debt, attracting capital can’t be that hard.

Or can it? While it’s certainly true that appetite is high for the asset class among investors – PSP is, itself, new to the private debt space, having launched the strategy in November 2015 with a view to deploying over €3.4 billion to the asset class globally – the fact is that AlbaCore is something of an outlier when it comes to first-time funds.

For a start, it was set up by former CPPIB managing director David Allen, who has deep experience in the credit space. Secondly, its potential size makes it viable for many of the larger limited partners, which are often constrained by having to write large cheques and limited by rules surrounding how much of a percentage their commitments comprise in funds.

The private debt space has clearly grown since the crisis, with many new managers emerging in the intervening years, yet PDI numbers suggest that it’s now harder to get a new venture off the ground than might have been the case a few years ago. In the year to November 2016, just six of the 101 private funds reaching a final close globally were first-time private debt funds, or 5.6 percent of the total. That compares with 10.7 percent in 2015 and 16.4 percent in 2014. And we know that is not due to a shortage of funds in the market: our data suggest that nearly 20 percent of the 458 private funds currently on the road are private debt first-timers.

While some of these first-time funds are Asia-based, where the private debt space is still very much in its infancy, there is a sizeable proportion in the European direct lending area. “Private credit in Europe is still a growing asset class and as such we continue to see new managers emerging,” says Tavneet Bakshi, partner at First Avenue.

“The larger end of mid-market lending has become quite congested, so it is much harder for new groups to gain traction as LPs have already chosen the teams to represent this part of the market for them. As such, as the bar is higher. However, we are now seeing some differentiation in new entrants in terms of size (lower mid-market), regional specialisation and strategy (flexible capital structures) – there are more distressed and special situations managers coming through.”

And it’s this differentiation that can mean the difference between attracting LP capital and a lot of wasted shoe leather. “It’s very tough for first-time direct lending funds,” adds Ben Schryber, head of credit at First Avenue. “Most are not differentiated and so it’s very hard to make the case that investors are better off with you than a well-established group with a track record to point to. Those likely to be successful will be groups that offer investors access to something they can’t already achieve with their existing GP relationships.”

Gregg Disdale, global head of illiquid credit at Willis Towers Watson, agrees. “It’s much harder nowadays for first-time funds to raise capital in more crowded parts of the market, such as direct lending,” he says. “However, we have been comfortable backing first-time funds over recent times that are focused on less scalable and more differentiated opportunities, such as smaller cap real estate debt funds.”

This often means smaller funds – and that, in itself, can create issues in that it effectively cuts out larger investors as a source of capital. “It’s hard for first-time funds to get going if they only require €100 million-€150 million as it’s difficult to attract the main allocators,” says James Newsome, managing partner of Arbour Partners. “That means it’s often down to taxpayer-funded initiatives, such as the British Business Bank or the European Investment Fund, to provide initial funding to act as a catalyst for further private sources of capital.”

After that, he adds, it’s a case of seeking out smaller pension funds and family offices that are more open to backing smaller new funds.

Nevertheless, there are some other sources of capital emerging in the space that may move the market along. Golding Capital Partners and Certior are two of the funds of funds players that target private debt fund opportunities. And in the UK, some of the local authority pension funds are now starting to look more closely at smaller, more targeted strategies. “Some of these investors are now looking at allocating to UK-focused, sterling-denominated credit strategies, where funds are seeking upwards of €150 million,” says Bakshi. “If funds are differentiated enough and they suit an LP’s top-down need, we are seeing some flexibility on the part of investors.”

So, other than offering niche strategies, how can these managers get a foot in the door with LPs, given how crowded the first-time space appears to be? Firstly, make sure your offering is right, says Jakob Lindquist of CORDET Capital Partners. “You need to have the right focus to attract LP interest,” he explains. “You need the right origination process, the right credit underwriting process and the right risk management process that you can demonstrate to LPs. And to support that, you need the right team with credible, complementary, multi-cycle experience.”

Stephen Buchanan, managing partner of US-based Mosaic Capital Partners, says it’s also often down to existing relationships. “When we raised our fund, we first tapped the people we already knew well – many of these were high net worth individuals,” he says. “We also applied for our SBIC licence at the same time. Once we had these in place, we were more able to approach the institutional market – although even here, we had prior relationships we could draw on.”

Contacts are vital, agrees Alfonso Erhardt of Oquendo. “Given that you are likely to raising a smaller fund if you are targeting a niche, start local, as this is where you are most likely to have better networks,” he says. “This is especially important as information sources around smaller investors are very limited. You’re much more likely to hear about local LPs than those based elsewhere.”

And, finally, some managers may well need to think flexibly, particularly if they fail to gain traction in the market. “Some won’t be successful at all,” says Justin Mallis, principal at First Avenue. “For some, however, it may well be worth attempting to raise capital on a deal-by-deal basis to build a track record, while for others there is the prospect of being picked up by a larger platform that is looking to cross-sell new products to investors.”

What can first-time funds offer LPs?

The time taken to assess first-time managers can put many investors off, especially if they have already built a portfolio of established GPs. Yet many argue that first-time funds can bring something different. “There are a number of experienced institutional allocators who know and like the direct lending space, but that now want to steer away from concentration risk in the sponsored core/upper mid-market arena,” says CORDET’s Lindquist. “It has become harder for them to justify adding to what becomes more like an index nowadays. Therefore, they are seeking out managers that can build a proprietary loan portfolio in a specific region, size bracket or industry. With such an allocation approach, investors can benefit from diversification and differentiation.”

Willis Towers Watson’s Disdale says there is plenty of room for new managers with differentiated strategies. “The market has become well covered over the last two years, but there are niches – property development, possibly consumer credit or genuine SME finance in the form of trade receivable finance – that new managers can occupy,” he says. “This type of opportunity can add diversity to an LP’s credit portfolio, giving them access to a different type of borrower that may be subject to a different credit cycle from corporate credit.”

These can also be a good way of boosting returns, he adds. “These spaces are less obvious places for managers to crowd given challenges of scaling and their operational complexity and so low levels of competition means there is less pricing pressure on the products they can offer.”