The great balancing act

Investor allocations are shifting towards senior debt as a strategic risk management tool. But LPs could be getting more risk than they bargained for, finds John Bakie

As revealed in last month’s PDI (March 2018, p.14), senior debt fundraising has now overtaken junior debt, and its rapid rise in recent years indicates a change in the mindset of investors. Between 2009 and 2017 the number of senior debt funds increased from nine to 57, with the total value of these funds hitting $62.4 billion last year.

While junior debt’s higher returns have often been a tempting route into private debt for institutional investors trying out the asset class for the first time, it seems many may now be moving towards senior debt to provide diversification and risk management for their portfolios.

But is this trend the sign of an increasingly sophisticated approach to private debt, or simply a sign that investors are preparing their portfolios for a turn in the credit cycle?

Max Mitchell, head of direct lending at ICG, says: “For a lot of institutions, private debt has now become a separate asset class. In the past they might not have a specific bucket to invest in debt but today they are much more sophisticated with dedicated allocations and benchmarks.”

While in the past LPs might have turned to capital-market debt as the way to gain lower-risk exposure, the increased familiarity with private debt funds and the way they operate means many are shifting towards investing in senior funds to further diversify their allocation to debt, looking at it as a way to manage risk, rather than simply a method of getting an illiquidity premium.

“It’s no longer an opportunistic investment, now private debt is much more part of the traditional landscape and has a permanent strategic allocation,” Mitchell adds.

According to Idinvest’s Francois Lacoste, the approach towards the asset class and whether they lean more towards senior or junior debt often depends on the type of investor.

“Lots of LPs are diversifying, but they do it differently depending on strategy. Insurance companies want steadier returns and lower risks and use senior debt to diversify their portfolio. Others are more interested in mezzanine and other junior debt to chase returns. Some fund managers also offer a broad mix of investments across the risk curve from senior right up to private equity,” he explains.

In a recent Hermes Investment note, the firm’s head of fixed income, Andrew Jackson, said investors are beginning to adapt their positioning in response to macroeconomic indicators, and suggested that private debt has its own particular role to play in portfolio construction.

“By applying a selective approach, private debt can exhibit more defensive characteristics than public debt and is relatively conservatively underwritten. Leverage and operational gearing is also lower. Long-term investors don’t only have to view illiquidity through the prism of risk, but as an additional dimension to the risk-reward dynamic,” he remarks.

General partners with wider investment remits across the risk spectrum are also adjusting their portfolio composition in response to expected economic events, and favouring senior debt. Arron Taggart, loan originator in Cheyne Capital’s real estate debt business, says the lateness of the credit cycle has affected his firm’s investment approach.

“In the UK we’re getting pretty late in the cycle with local economic headwinds and political issues as well. As a result, we’ve been positioning the book to come down the risk curve over the past two to three years and moving further into senior debt.”

While it appears the trend towards senior debt is a sign of a sophisticated investor base and knowledgeable fund managers conservatively managing their risk, things may not be as simple as they appear. Private debt does differ in one key way from the public markets because it demands an illiquidity premium and GPs investing in senior debt must tread a careful line between adequately compensating investors for their illiquidity and ensuring they are meeting expectations on risk.

But there are growing fears that the current glut of dry powder and its consequent pressure on pricing, terms and covenants, could be tempting many GPs to take on more risk than investors expect to meet return expectations.

According to Taggart, within the real estate segment: “The £5 million to £30 million space is really crowded now. What may happen in the future is funds will push each other up the risk curve to justify their returns.”

However, ICG’s Mitchell says in the area of the market in which his firm operates, there has been less concern: “In the upper end of the market where we operate, while it is competitive, we see no overall increase in risk-taking. We’ve been able to maintain our pricing and terms for the past three years.”

Thierry Vallière, global head of private debt at Amundi, warns: “We’re seeing a juniorisation of parts of the senior debt portion in some deals due to pressure from unitranche providers.”

“There are a lot of transactions where, legally speaking, it’s senior debt, but economically it’s much more like junior debt,” he adds.

Unitranche is an area of the market often viewed as being quite fuzzy in terms of definition. An Ashurst research note from 2014 stated that unitranche as a term lacks the precision of mezzanine, where return and risk expectations are far more established. Differences in the way unitranche is viewed can also vary between the US and Europe and, while there is a general expectation that unitranche carries slightly more risk and return than pure senior debt, the extent to which this might vary is unclear.

And it is not just in unitranche where investors could face higher risks, Idinvest’s Lacoste says: “Some senior secured is not being marketed properly. Pricing is not reflecting the risk.”

It is perhaps understandable that, when faced with pressure to put money to work in an environment of plentiful capital supply, GPs may seek more exotic deal opportunities.

But investors in a senior debt fund will have certain expectations of the kind of risk they are being exposed to.

“You can’t tell your investors that they are investing in senior debt when you are going out and chasing much riskier positions, there is a huge reputation risk. Many investors are in the dark about this,” exclaims Vallière. “Unitranche is sometimes being sold as real senior debt. It is legally true but economically this just isn’t true. You cannot be paid 6 percent to 8 percent for a traditional senior risk. There is no free meal.”

But it seems investors are beginning to wake up to the threat and, as their level of sophistication grows, are beginning to ask more questions of their GPs, both during fundraising and as deals are made to stay on top of their risk exposure.

“We do see more questions from LPs about risk issues,” says Lacoste, “they are much more aware of the potential to be taking on more risk than expected.”

Keeping a close eye on each deal, the way it is structured and the risks that are involved is likely to be particularly important to keeping GPs on the right path. As LPs’ sophistication in their approach to private debt grows, it is likely their oversight of positions will also increase, enabling everyone to make better-informed decisions and to utilise senior debt as part of genuine long-term, risk-adjusted portfolio construction.6