As PDI reported in June, European private debt funds are seeing increased pressure on fees, carried interest and other economic terms. Median fees for European direct lending funds had dropped by an average 33 percent since 2015, from 1.5 percent to just 1 percent, according to a bfinance study, with carried interest also falling, from 15 percent to 10 percent and hurdles sitting at 5 percent on average.
Yet what of the US? As a far more mature market for private debt, a casual observer might be forgiven for believing that economic terms have been pretty much settled over the years. And the bfinance study certainly seems to show that US fund managers can command more favourable economics: the median in the US, the study says, is for 1.3 percent management fee, 15 percent carry and a 6 percent hurdle.
Does that mean the more experienced US players are able to maintain higher fee levels than their European counterparts? While the figures may suggest this is the case, the reality on the ground is somewhat different.
The US market has a much broader range of strategies on offer for investors than in Europe, given its greater maturity – funds have had time to develop products that meet different investors’ desires for varying amounts of risk and that provide more flexible funding packages for borrowers. And it’s target returns that, in broad terms, dictate the level of fees and carry investors must pay to play.
“Fees are not really a function of geography, more of target returns, the level of which drive fee structures,” says Stephanie Berdik, partner in the investment funds group in Kirkland & Ellis’s Boston office. “The market for private debt strategies is generally 1.5 and 15. Where a fund is focused only on senior loans, this strategy doesn’t support higher fee loading and so 1 and 10 is more the norm.”
While in Europe most private debt funds still tend to focus on a single strategy, their US counterparts can offer greater variety to borrowers – and that can affect the overall fee level paid by investors, says Justin Mallis, principal at First Avenue.
“There is a big difference in the fees levied according to the position in the capital structure that funds are lending into,” he says. “Senior-only is largely at the 1 percent end of the fee spectrum, while further down the structure attracts higher fees. You also have a lot of funds in the US financing across the capital structure – blended packages that include senior, first and second lien and subordinated debt – and these tend to charge higher fees to account for the higher risk and return profile. There are few European funds that can do blended structures.”
The difference is illustrated by the variation in subordinated debt caps in senior private debt funds between the US and Europe. Where in Europe-only funds, 31 percent have no subordinated debt and 15 percent are permitted to invest more than 30 percent of the fund in subordinated debt, in the US just 5 percent of senior debt funds cannot invest in subordinated debt and 32 percent can invest over 30 percent in more junior structures.
And then there’s the question of leverage. US funds are more likely to feature leverage at the fund level than in Europe – and, given the purpose of this is to target higher returns, fees will naturally be higher than in unleveraged funds.
“Comparing US and European private debt fund fees is difficult because they are not apples to apples comparisons,” says First Avenue partner Tavneet Bakshi. “US funds tend to apply more leverage to generate higher returns and therefore can often charge higher fees. This is especially so at the senior end of the spectrum.”
This is leading to more leveraged funds in the US market, adds Bakshi, although they may not always get the reception they might wish for. “Managers want to charge as high a fee as the market will bear and if they can get that through a leveraged vehicle, they will,” she says. “The issue is that many LPs don’t want this and if they do, they only want it at the senior end of the market – investors are understandably nervous of leverage levels, particularly if they perceive the current cycle to be drawing to a close.”
Yet, despite these distinctions, there is a definite downward trend for credit fund economics in North America. “Just as in the European space, you’ve seen a lot of new entrants to the US market,” says Gregg Disdale, head of illiquid credit at Willis Towers Watson. “If they are seeking lower fees, that can be attractive for investors, which, overall, see further scope for fee compression.”
Mallis agrees. “Fees are under pressure in private markets in general, in particular for strategies that return between 5 and 6 percent,” he says. “That’s not only because of the level of return, but also the competitive pressure – there are a lot of funds that can do this. Where you have strategies that return in the higher single and lower double digits, there are far fewer managers that can do this without leverage and they are likely able to command higher fees.”
Yet it also comes down to fund size. Those with scale are now offering lower fees and carried interest than those at the smaller end of the spectrum. “There are more large funds in the US and these are offering lower fees,” says Mallis, pointing to an interesting trend in the US “for unleveraged senior-only funds to offer no carried interest or preferred return”.
Yet even where fee and carry levels themselves are not coming down, more investor-friendly terms are being seen. “There has been a definite move towards fees on invested capital rather than committed capital, as in Europe,” says Bakshi. “Newer managers are able to justify fees on committed capital – they need fee income to keep the lights on, but for more established managers, our recommendation is generally to go for fees on invested capital.”
There has also been a shift away from deal by deal carried interest, which used to be prevalent in the US.
“European-style carried interest waterfalls are becoming very hard to argue against,” says Siobhan Burke, partner in the corporate practice of Paul Hastings. “Many investors are seeking this.”
And finally, as with private equity funds, investors with larger allocations are increasingly seeking separate account arrangements in private credit in the US as a way of reducing fee drag. “We definitely see a trend towards SMAs, with private debt programmes blended across the liquidity spectrum, although this is really only for the bigger investors that have $100 million-$200 million-plus to deploy,” says Bakshi.
Yet what we are unlikely to see is a move towards co-investments as has been seen with private equity – for now, at least. This is partly because of the need for greater diversification in the private debt space than is the case in private equity, but also because of the speed needed to react. “Co-investments in debt require that investors execute in much shorter timescales than in equity investments,” Bakshi explains. “Many LPs are not established or mature enough to be able to do this.”
THE LEVERAGE QUESTION
Transatlantic appetite for US strategies has brought leverage under the spotlight
As demand for private debt strategies grows, investors are branching out to achieve greater diversification in their credit and alternative portfolios. The bfinance study of March 2017 says there is a “notable trend in investor appetite… evident from manager selection engagements” of European investors seeking access to US private debt strategies.
“As a group, US senior debt funds tend to produce higher returns than their European counterparts,” says bfinance private markets associate Dharmy Rai. “This is in large part due to the additional leverage they use at the fund level.” She adds that this is typically 1x-2.5x on senior debt, compared with zero or occasionally 1x in Europe. “Those levered funds tend to come with a heftier price tag and, for a European investor, the premium tends to be offset by currency hedging costs.”
Yet, historically, many European investors have remained concerned, the report notes, about certain features of the US market, with leverage at the fund level key among them. “The majority of European institutional clients are not prepared to tolerate [US levels] of leverage,” says Rai.
Demand for less risky, unlevered products is therefore now starting to feed through to fund manager offerings, as Berdik explains. “The issue of leverage is a big topic in direct lending – some want it, others don’t,” she says. “This tends to come down to which part of an investor’s portfolio the capital being deployed is allocated from. If it’s intended to enhance fixed income portfolios, where there are lower return expectations, investors don’t want leverage; if the commitment is part of an alternative allocation, leverage is more accepted. Some fund managers, given this divergence, are now offering levered and non-levered options with differing fee levels as they seek to try and please a variety of investors.”
BDCs: DIFFERENT ECONOMICS
The liquidity premium demanded by BDCs has made them more popular among managers
With many US private debt fund managers forming business development companies in recent years, the news that The Carlyle Group took its BDC public in June this year came as a welcome relief, given the two-year drought in BDC IPOs. As PDI reported, many others are now expected to follow suit as net asset values per share improve and funds seek to offer investors more liquid alternatives to the closed-ended private equity-style vehicles that have historically been more prevalent in the private debt space.
Yet the trend also raises the question of how economics vary from private equity limited partnership structures. Overall, they tend to be more expensive for investors, given the improved liquidity they can offer and the additional cost of public reporting. While fees clearly differ between BDCs, they are in the 1.75 percent-2.5 percent range of the fund portfolio’s gross assets, according to a note by lawyers Morrison Foerster. This includes leverage at the fund level – an important point, given moves by the US House of Representatives to overhaul financial regulation laws that include a provision that, if passed, would allow BDCs to increase their maximum leverage from a 1:1 debt-to-equity ratio to 2:1.
“The fees tend to be dramatically higher for BDCs than in private equity-style structures,” says a seasoned adviser to limited partners. “Many firms are therefore now trying to raise BDCs.”