Senior debt: Pricing proves a bit of a stretch

There’s a common utterance among debt managers: we’re in a borrowers’ market. New entrants to the private debt space have put increasing pricing pressure on loans, particularly those at the top of the capital structure.

As a result, managers are increasingly looking at ways of ‘stretching the senior’ – taking steps to enhance the returns generated by senior debt funds. In doing so, however, they may be creating demand for entirely senior-focused offerings as investors shift to prioritising safety over returns.

James Greenwood, chief executive of Permira Debt Managers, says the number of managers raising private credit funds over the last few years has increased competition and caused some compression in pricing. To maintain returns, however, funds do try to keep pricing steady as much as possible.

“There may be some pricing pressure on individual deals, but this remains relatively minor and is usually no more than circa 25 basis points,” says Greenwood. “In the context of alternative credit, we continue to believe that direct lending offers extremely attractive returns to investors.

“Investors in direct lending funds expect a minimum level of return to compensate for the inherent illiquidity of the asset class. As a result, managers tend to be quite disciplined when it comes to maintaining pricing.”

Despite a desire to defend pricing and meet investors’ expectations, other managers note growing commitments to private debt are driving prices down, particularly in the senior loan space.

“Pricing is certainly affected to some extent by the inflow of capital into the private debt space,” Jeremy Golding, founder of Golding Capital Partners, tells PDI. “The eagerness of banks to defend market share and the general risk appetite in capital markets play a significant role, too.”

Certainly, the presence of banks causes some issues for debt funds looking to provide senior financing. “The banks themselves are always able to be more price competitive,” says Shaun O’Callaghan, partner at Grant Thornton.

With this pressure on pricing, managers operating senior debt funds are maintaining flexibility in their senior offerings.

A recent study from bFinance noted most senior debt funds looked down the capital structure for investments. For the majority of funds marketed as senior, between 30-80 percent of the portfolio could be made up by unitranche debt, the study notes, while up to 30 percent could be held in subordinated debt.

Managers are adding these loans to the mix to meet investor expectations in an increasingly competitive environment. The same report says investors in Europe, on average, anticipate a return from senior offerings of around 8 percent. In reality, core senior debt is returning 5-6 percent, with a cash yield below 4 percent, the study notes.

One reason investors might have these return expectations is because of the nature of early iterations of senior debt funds. According to Niels Bodenheim, director at bFinance, early senior debt funds wanted flexibility to allocate down the capital structure, allowing them to take advantage of attractive financing opportunities.

“The first couple of funds were always opportunistic with their risk allocation,” he says. The early investors in these funds may have also had their expectations fixed by such managers. “If you have a lot of fund managers coming across your doorstep offering certain returns then you start to accept those,” Bodenheim adds.

Being opportunistic has its advantages, but managers may regret investing outside the parameters of a fund’s original risk target. “Managers should stick to the investment strategy they have initially sold to LPs in fundraising and control the risk level,” Golding says. “They should stay disciplined and either adjust their investment pace withstanding the pressure to invest, or accept lower market pricing. Chasing returns and thus increasing leverage or business risk in transactions at a late stage of the credit cycle has usually not ended well.”

Debt fund managers can also try to boost returns by opting for niche strategies or targeting businesses which aren’t as suitable for bank financing. Bodenheim notes, for example, his firm is starting to see more funds targeting lower-mid-market companies.

Defining unitranche

While bFinance’s report notes the potential amount of unitranche debt being utilised in senior funds, some managers would still consider these investments as meeting the senior definition. There are many varieties of unitranche debt, Bodenheim says. Certain managers will market a primarily unitranche-focused product as senior should the multiples on the debt warrant this description.

“In most of our direct lending deals, we are the sole lender, delivering one tranche of senior secured debt,” Greenwood says. “In that sense it is a ‘unitrache’ loan. However, this terminology is used to cover a whole range of different situations. In our deals, the owners of businesses are typically providing 40 percent to 50 percent of the enterprise value as equity. Therefore, we do not believe we are taking a combination of senior and mezzanine risk.”

Paradoxically, as senior debt funds show more flexibility, demand is rising for pure-play senior debt exposure. “We’ll start to see pure-play senior debt funds coming up,” Bodenheim says. He notes investors are getting to the stage where they would be willing to accept lower returns for a greater sense of security.

This demand is being played out, to some extent, in the business development company space. John Cole Scott, chief investment officer at Closed End Fund Advisors, tells PDI recent times have seen a focus on lower-yield assets, perhaps costing dividend pay-outs but ensuring the net asset value of a BDC is looked after.

“There has been a general move to increase the level of securitisation,” says Scott. “They’ve said we’re going higher-quality – the yield has to come down.”

For O’Callaghan, however, the idea debt funds can introduce pure-play senior offerings is unlikely given the presence and pricing power of banks. “In the non-sponsored space, if you want to do non-leveraged senior debt, the banks are always going to be more competitive,” he says.

David Brooke contributed to the article.