Reaching for the top

Limited partners are committing large amounts of capital high in the capital structure by investing in senior debt before the credit markets go low – as if keeping time with Ella Fitzgerald's jazz standard “When I Get Low, I Get High”.


The strategy has a strong selling point of providing decent yield with the safety of being higher in the repayment pecking order at a time when we are late in the credit cycle, a trend evident both in PDI's fundraising data and conversations with industry experts.


“The reason people are putting money into fixed income or private credit is because they know a correction will be coming,” says Fraser van Rensburg, a managing partner at London- and New York-based placement agent Asante Capital Group. “There is downside protection – they know they'll get their coupon” regardless of the economic environment, he adds.


If limited partners invested in senior debt don't receive their “guaranteed” return, those investors will be first in line to get paid in a bankruptcy or out-of-court restructuring scenario, often being paid in full or receiving a minimal haircut on their claim.


In the first quarter of this year, 42 percent, or $13.1 billion, of the $31.19 billion raised for private credit was for senior debt, according to PDI data. Two of the three largest funds that held final closes in the first three months of 2017 embraced that part of the capital structure: $4.6 billion for Alcentra's European Direct Lending Fund II and $3.85 billion for Hayfin Capital Management's Direct Lending Fund II.


The wave of senior debt fundraising has continued into the second quarter, at least anecdotally. Barings was scheduled to hold a close at the end of April on around $1 billion on its North America Private Loan Fund and KKR disclosed it had raised over $400 million so far for Lending Partners III.


“Investors realise that even with the recent increases in rates they need to be more creative in looking for yield,” says Howard Levkowitz, chief executive of Tennenbaum Capital. “Many investors buy syndicated loans and increasingly more are investing in privately originated debt.”


The Iowa Public Employees' Retirement System is offering a $250 million corporate credit account, primarily on senior loans. The Kentucky Retirement System is also looking to make a private credit investment, also probably $250 million, and has heard presentations from the likes of Benefit Street for the credit manager's Fund IV, which focuses primarily on senior secured debt.


“The larger pools of capital are coming from fixed-income allocations within insurance companies and pension funds,” van Rensburg says. “We don't see a material influx from endowments, family offices or sovereign wealth funds.”


Pension funds and insurance companies like senior debt because they need liquidity to meet retirees' benefits and customers' claims. Private credit, and senior debt specifically, gives them quarterly distributions, leaving LPs with a predictable 6-8 percent return.


Conversely, endowments, pension funds and sovereign wealth funds sometimes have higher return expectations, thus leaving more of their assets under management in public and private equity investments.


“[Senior debt] is becoming increasingly popular with LPs,” Levkowitz says. “They need yield and it's the safest part of the capital structure. The vast majority of our directly originated debt is senior secured.”


Nithin Johnson, Americas head of Citi's international fund distribution division, is seeing the same trend.


“It has largely been pension funds and some insurers that appear to be most active in private debt so far in 2017 and interest appears to be in senior funds and global funds, likely as they can deploy capital in scale,” he says. “However, differentiated junior debt strategies are also given consideration.”

Going global


Global funds sought 33 percent of all capital in market, across all strategies in the first quarter, PDI's numbers show.


“For institutional investors, global managers can offer a relative value play by shifting investment between North America and Europe (and developed Asia) depending on the manager's assessment of optimal risk-adjusted returns at a given point in time,” Johnson says. “As a result, institutional investors are combining global funds and regional funds as part of a more sophisticated asset allocation strategy within the space.”


North America is a popular destination for capital as well, according to PDI data. Funds in market with that geographic focus raised one out of every three dollars in the first quarter.


“North America is more attractive for a couple of reasons,” says Shahab Rashid, a co-founder of Adams Street Partners' private credit group. “I think there's a lot of money raised in Europe and there's just not enough dealflow right now to soak up the capital. The supply-demand imbalance is much larger in North America.”


There, the dealflow might actually be to absorb all that senior debt capital.


“At a high level, if you look at an LBO cap structure it always accounts for a majority of the capital and an even higher percentage recently given the prevalence of unitranche [and] stretch deals and where we are in the cycle,” says Rashid.


For the fourth quarter of 2016, average equity contributions for institutional mid-market leveraged buyouts stood at 39.1 percent, while the figure for private mid-market LBOs stood at 54.4 percent, according to Thomson Reuters. Mid-market senior leverage stood at 3.43x during that same period.


“When I look at the demand-supply imbalance, on one hand [there is] dry powder available in private debt funds and [on the other, there are] expected loan maturities for leveraged debt, as well as new debt to finance LBO transactions by private equity funds. Demand currently dwarfs supply, so I think there's a long runway.”

Numbers heading north


Looking at private equity data provides a clearer picture of this. A report by consulting firm Bain & Co showed $534 billion in dry powder for buyouts at the end of 2016. That figure is a record, according to the report, even above the $433 billion in 2007 and the $477 billion in 2008.


In addition, total private equity capital raised over the first quarter was $124 billion, according to data from PDI sister title Private Equity International .


Total equity funds in market were seeking $604.53 billion – across buyout and secondaries funds as well as mezzanine vehicles – with $222.38 billion of that for buyout funds.


Rich purchase-price multiples to EBITDA could deter some private debt providers from transactions. Transactions are being done at 10.9x, also higher than the 9.7x of 2007 and 9.1x of 2008, according to the Bain report.


Tighter credit spreads are also a factor. For a first-lien loan with covenants, credit spreads stood at 2.71 percent over the benchmark interest rate in March whereas that number came in at 4.49 percent in August, according to Debtwire.


Those deterrents aside, given the downside protection afforded by senior debt and the massive amount of potential dealflow due to a record haul of buyout-focused dry powder, senior debt appears to be a strategy with the fundamentals
in place to continue its runaway popularity. n