Looser documentation; increased leverage multiples; pressure on pricing: all evidence that we are at the end of the credit cycle, but it does not stop the need for investors to keep putting that money to work.
André Hesselman, founder and co-head of private debt at Yielco, a German fund-of-funds manager, says debt funds are already preparing for increasing distress with many busy recruiting experts in the field. “What we see in our interviews in Europe is that all the investment managers are trying to fill up their teams with restructuring specialists,” he says.
“We ask them if they are seeing a crisis coming up and they say that we are on a high entry multiple level – leverage is not an option. There are some signs that the market is a little bit overheated and that is why they are filling up their teams and trying to prepare themselves.”
Sponsor-backed plain vanilla lending is currently very popular with investors, which explains some of the overheating at the senior end of the market – the degree of downside protection offering some comfort during volatile periods. But those who play further down the capital structure are beginning to fear the worst.
“Providers of unitranche and mezzanine products have a more direct link to the equity and are trying to prepare a little better for the storm.”
And so, too, is Hesselmann. “We see the dark clouds coming and are positioning ourselves for the expected crisis. It is important to establish yourself with turnaround managers, especially those who have a track record delivering a good outcome during more volatile periods,” he says.
The popularity of senior debt strategies means many managers are looking to find a niche, whether it is a geography or sector. And others are looking to enhance their origination capabilities.
“Most of the investment managers in Europe are building up origination teams that try to go to sponsorless deals,” Hesselman says. “We look at sponsored and sponsorless transactions. In Europe, we think sponsored transactions are more attractive and in the US we see more activities in the sponsorless space. It’s just because there are a lack of managers in Europe that operate these strategies.”
The depth of activity in the US is reflected in Yielco’s investment history. According to Hesselmann, since the firm was founded in 2011 it has invested in 24 funds in the US and 13 in Europe – a total of $1.5 billion, predominantly to senior secured investment strategies.
It’s impossible to shield yourself from the inevitable turns of a credit cycle. Pension funds and insurance companies have ongoing liabilities which push them to constantly deploy capital and find the necessary yield. In an environment of low interest rates, investors are not perturbed by the pressures of pricing.
Where once a senior fund could generate a net IRR of between 6 and 7 percent this is no longer possible for a senior secured strategy, says Hesselmann. But with many investors allocating to private debt out of the fixed income bucket, rather than alternatives, then the reduced returns – even during a volatile period – should be enough to nourish hungry investors.