What is your current assessment of the market environment?
Brent Humphries: We continue to believe that private direct lending provides an attractive investment opportunity. Although at this stage in the cycle, and given the current market environment, we also think that manager expertise, platform design and properly aligned incentives are increasingly important.
If you just look at the broader markets, the liquid capital markets including fixed income, it feels like we are in the later innings of an expansionary cycle. Prices appear to be bid to perfection. Spreads in the levered fixed-income markets, such as high-yield bonds and broadly syndicated loans, are tight. Even as it relates to the private debt sector we are seeing spread compression and terms becoming more borrower friendly.
Additional capital has clearly entered private credit. Every week, every month a new private credit fund is formed, and that’s cause for concern. Now, it’s important to understand measurements of capital inflows and fund formation do not provide a full picture of the supply of capital. This is because it is very difficult to quantify the amount of dollars that have exited the system in the form of banks de-emphasising middle market credit. There is nevertheless an overarching theme of more capital coming into the market and there is no denying that the spreads have gotten tighter.
What’s the benefit of private debt against that backdrop?
BH: So notwithstanding more challenging market fundamentals, we believe the merits of this asset class hold in all markets, including the environment we see today.
First and foremost, we think there is a material and persistent illiquidity premium that investors can capture if they are prepared to commit capital to the asset class for a reasonable period of time. The closer investor commitments match the underlying tenor of the loan assets, the better likelihood to realise the illiquidity premium.
Middle market loans continue to provide significantly better downside protection in the form of covenants, senior ranking in the capital stack and collateral, relative to high-yield bonds, for example.
And the asset class provides a natural hedge to interest rate risk as the vast majority of loans are floating rate instruments. We’re starting to see rates such as LIBOR increase and middle market loans offer a nice way to benefit from this.
Lastly, for an investor’s portfolio, private debt is a very diversifying allocation. It’s not highly correlated with public equities or traditional fixed-income asset classes, so it’s a nice component of a balanced portfolio, in our view.
I also mentioned platform design being a key element at the start of this conversation. To really exploit the full benefits that private credit offers, allocators need to partner with managers that not only have solid underwriting capabilities, but also the right access to a diversified pool of long-term, fully-committed capital – both equity, as well as leverage to finance portfolios. Having access to committed capital is critical to take advantage of market dislocations. We further believe that managers with a flexible investing mandate and broad product suite have the best tool kit to navigate changing market environments, including periods of distress.
After being involved with the ground up development of several platforms, my colleagues and I have learned a lot of lessons when it comes to the importance of thoughtfully structuring a direct lending organisation. We built AB Private Credit Investors from a blank sheet of paper and used our prior experience to design a purpose-built platform intended to take full advantage of the asset class.
How is the trend for looser covenants impacting the downside protection that private debt is ideally supposed to offer?
BH: We are at all-time highs in terms of the covenant-lite composition of the broadly syndicated market. Cov-lite structures are also becoming common in upper middle market transactions involving companies with $35 million to $50 million EBITDA. By comparison, we focus on companies between $10 million – and maybe a little smaller depending on the business model and sector – and $35 million of EBITDA. Despite the current pressure on documentation terms, covenants remain available in this core segment of the middle market and are an important element of the overall value proposition, especially as we reach the later stages of the credit cycle.
What are you seeing in the market that gives you cause for concern?
BH: First, let’s step back and think about market psychology and characterise it in terms of fear versus greed, or conversely, risk-on versus risk-off. The market today is much more heavily tilted toward greed and risk-on. There is plenty of blame to go around with both investors and managers sharing responsibility for driving this dynamic.
How is it playing out for investors?
BH: From an investor perspective, there’s a strong sense of urgency to enter the space and not get left behind. I think you can see the herd running in the same direction and it’s arguably becoming a stampede that is picking up speed. That’s always cause for concern. And one of the main ways we see this manifest itself is by investors really pushing for shorter ramp periods and rewarding deployment at the expense of prioritising strong, long-term investment performance.
This has a predictable effect on how managers react. With shorter time periods to put dollars to work, managers will be less discerning when selecting credits. As a result, we are seeing leverage increase and pricing fall. We are also seeing pressure on documentation terms, as previously discussed. The proliferation of cov-lite loans has been enabled in part by banks and CLO investors that finance these assets for lenders. Additionally, some managers are simply lending to weaker businesses or taking on excessive single-name concentrations to meet deployment targets.
How is the tendency toward greed and risk-on market psychology affecting managers?
BH: In reaction to this push by investors to deploy assets, many managers are becoming market-share players rather than focusing on finding the best risk-adjusted return opportunities. This is a departure from how the asset class was initially envisioned. Essentially, we are seeing alternative lenders approach the market more akin to sell-side investment banks rather than true buy-and-hold private credit investors.
This can manifest itself with a misalignment of incentives commonly referred to as the principal-versus-agent conflict. This is most prevalent when a significant portion of the manager’s income is driven by transaction-related volume, such as underwriting income, instead of incentive fees tied to performance.
Investors really need to ask themselves when they see that situation: “Am I aligned with the manager? Or is the manager more focused on doing the deal to drive volume to grow market share and generate underwriting income versus doing the deal to generate attractive risk-adjusted returns?”
What prevents a manager from substantially underpricing a deal if their economics are tied principally to transaction volume, for example?
In the face of these observations, what is your outlook for private debt as a whole?
BH: At the end of the day we think there are a lot of great attributes to this business. We still think direct lending is a very good place for investors to commit capital given its attractiveness compared to traditional fixed income and other yield-oriented options.
We also believe, however, that we are entering a phase where the expertise and discipline of the manager is going to be much more important. Platform design and alignment of incentives are also areas we think deserve more focus by investors.
Skilled private debt managers with well-designed platforms and properly aligned incentives can produce attractive returns for investors, notwithstanding some of the current pressures on yield and terms.
This article is sponsored by AB Private Credit Investors. It appeared in the US Report published with the September 2017 issue of Private Debt Investor.