US special: Private debt's five key talking points

Fundraising: North America leads the charge
Global fundraising for private debt continues to gather momentum. In the first half of 2017, 67 funds held a final close, raising $61.6 billion – the second-highest amount of capital closed in a first-half period since 2010.

Of this global total, more than 40 percent was raised by funds with a sole focus on North American investments. Of the 67 funds holding a final close, more than half (36) were focused on North America.

Among the North America-focused funds closed in H1 were Macquarie Infrastructure Partners IV ($4 billion), Brookfield Real Estate Finance Fund V ($3 billion), and Energy Investment Opportunities Fund ($3 billion).

“Interest from institutional investors is strong,” says Neil Rudd, chief financial and administrative officer at fund manager NXT Capital. “There is an appetite that exists and has been growing for the last few years.”

However, can North American managers afford to rest on their laurels – or is there a sense that the market has reached its peak and the only way is down?

“There has been a narrative over the last three to six months that maybe there has been too much of a good thing,” notes Rudd. “If I get into the market now, am I too late to the game?”

Rudd answers his own question: “We say the fundamentals that have attracted people to the asset class still exist. Performance has come down a bit, but in a world without yield you can still get quite a nice premium for the illiquidity associated with the asset class. There is still a lot to like.”

Earnings: Watch out for window dressing
With deal terms loosening amid greater competition, private debt fund managers need to take a close look at the earnings being reported by private equity sponsors and borrowers.

Chris Wright, a managing director in Crescent Capital Group’s mezzanine team, said there is now commonly a disconnect between the reported earnings and the reality of the company’s financial position.

Speaking at the Pension Bridge conference, he said his firm had come across a deal where a company had reported $300 million in EBITDA, but $50 million of that was add-backs (expenses added back to profits) and another $50 million was derived from “synergies” that involved expected revenue increases or cost savings through combining aspects of the company’s team or platforms.

“You’re seeing a lot of window dressing, if you will,” Wright said. When it comes to add backs, he added, “some are real, some are fictitious”.

FT Chong, head of structured capital at PineBridge Investments, said it would be “very dangerous” for a lender to rely only on reported earnings from accounting firms. He said lenders need to dig deep and do real forensic work by looking into the borrower’s run rate, equity cushions and cashflows, as opposed to projected earnings that are impossible to prove or disprove. “There’s a 0 percent accuracy rate in financial projections,” Chong said. “I look at what a company generates currently … which is not necessarily the price paid by the sponsor.”

Distressed debt: Don’t be shy
As capital flows into distressed debt and special situations funds during what is perceived by many to be a late stage of the credit cycle, the question is how long those raising the capital should wait to deploy it.

With default rates staying persistently low and corporate earnings remaining high over the past seven years, funds are tending to sit idle, waiting for the next distressed cycle to arrive.

But panellists at the recent Pension Bridge Private Equity Exclusive conference in Chicago expressed the view that you don’t need a general recession to invest distressed or special situations capital. There are still opportunities to be found in certain sectors such as energy, manufacturing and retail – with retail undergoing a dramatic dislocation as Amazon grabs market share that once belonged to the bricks and mortar brigade.

“It doesn’t take a recession to do what we do,” said Ethan Vogelhut, executive director at investment firm Adveq Management, at the Chicago gathering. He said the firm sees plenty of opportunities for distressed-for-control or corporate carve-out deals. Managers can theoretically make good returns by taking control of troubled companies and addressing their problems.

Alan Kosan, senior vice-president and head of investment manager research at Segal Marco Advisors, said investors can still get a 15 percent net internal rate of return on distressed debt investments, despite the strong macroeconomic fundamentals.

He added that the key to distressed investing today is to invest in a company that has a good market position but poor management and is in an increasingly difficult financial position. Investors can buy into the debt or equity and add the value the company is missing. As he succinctly put it: “There’s always companies doing dumb things.”

At least 79 percent of LPs believe that special situations investing will be attractive over the next two years, while 75 percent think the same about distressed debt, according to a survey by Coller Capital of 110 institutional investors around the globe. 

This positive sentiment is no doubt shared by the nine distressed debt and special situations managers that closed on $11 billion of capital in H1 2017 – as well as by the 88 funds of this type still in the market, seeking almost $94 billion according to PDI data.

The message is don’t wait for economic Armageddon before putting the capital to work – a) you don’t need to, and b) it may not happen for a good while yet.

Fund facilities: Nice to have, but not forever
TPG Capital has set a nine-month cap on a fund facility for one of its private equity funds, chief investment officer Jonathan Coslet told the Pension Bridge conference.

This was revealed amid an ongoing industry debate about the merits of fund facilities – which are used to allow swifter deployment of capital than LP capital calls allow – and also over what is an appropriate time frame for such facilities to be in place.

Many express a liking for fund facilities, with LPs applauding the way in which they allow them to manage cashflow more efficiently and GPs naturally appreciative of the IRR boost they can deliver.

Aoifinn Devitt, chief investment officer at the Policemen’s Annuity and Benefit Fund of Chicago, told PDI she has no problem with a fund manager using credit facilities and that the pension plan doesn’t set time limits.

“We have cashflow needs,” she said. “If a manager is making us money by borrowing against our commitment and juicing their IRR in the process, then we don’t have a problem with that.”

However, some LPs worry that the longer a facility is in place, the less likely it is that all of their committed capital will be drawn down by the fund manager.

“The issue is one which has gained additional attention from our council in recent meetings, but we have not yet implemented any specific policy in this regard,” said Charles Wollman, director of communications at the New Mexico State Investment Council, in an email.

“That said, more aggressive practices in this area are of concern to us as limited partners. We will continue our ongoing assessment of the practice, which certainly could result in the council taking a formal position on the practice relative to its future commitments.”

In June, the Institutional Limited Partnership Association published a nine-point guideline on fund facility practices, in part a response to their increasing popularity.

The body, which represents LPs, recommended that managers and investors should agree to limits on the use of fund facilities, such as maximum percentages of all uncalled capital, the number of days it should remain outstanding and the longest period of time for which such facilities can be used.

Cybersecurity: Beware the hackers
Amid global cyberattacks and ransomware plagues, cybersecurity continues to be a hot topic in the financial world.

But while much of the focus has been on the way in which such attacks impact ongoing business operations, attendees at the Alliance of Mergers & Acquisition Advisors event in Chicago heard about a possible threat they had possibly not considered – to sales processes.

Jesus Gonzalez, a security director at AON, cited the example of Yahoo, which revealed it had suffered a massive hack and which resulted in Verizon knocking $350 million off the transaction value earlier this year when it agreed to acquire Yahoo’s core internet business for almost $4.5 billion. Theoretically, there is no reason why a private debt deal could not be similarly affected.

Steve Shapiro, an attorney at law firm Culhane, stressed the importance of protecting data in the due diligence process, noting that this was equally vital on both the buy and sell sides.

When an attack does occur, an effective response plan should initially take stock of information technology assets and the policies and procedures already in place. Areas to bolster could include the vulnerability of smartphones and tablets. Above all, expert outside advice should be sought.

Increasingly, cyberattack defence is a must-have rather than a nice-to-have – especially as the regulators are now on the case. For example, the pending European General Data Protection Regulation is a robust set of protections for EU citizens and threatens businesses with severe penalties for violating its statutes.

The discussion came in the wake of the WannaCry ransomware attack, which crippled companies in over 150 countries and showed how vulnerable many institutions are to cyber incidents.