Stick or twist

At a late stage in the credit cycle, LPs have a choice of playing it safe or taking on board extra risk in the hope of higher returns. David Turner explores the different approaches

One way of understanding recent trends in the European senior debt market is to imagine an old-fashioned British telephone kiosk – an appropriate location for the metaphor, since so many of Europe’s deals are agreed in London.

Let us imagine, too, that yield is a tangible object, like the yield on crops. Investors hear of good yield in the kiosk, so many of them clamber inside, squeezing the yield thinner and thinner. In reaction, some investors look for fatter yield in the kiosk’s corners, nooks and crannies. Others leave the phone box in search of more substantial yield elsewhere.

Marc Wursdorfer, EMEA head of the private funds group at UBS in London, sums up the senior debt situation. “When this asset class emerged in Europe, a number of senior debt managers were selling funds with 10 percent-plus gross returns,” he says. “However, because of the increasing competition, the target return for senior debt managers has been coming down to 7 or 6 percent.”

Some limited partners remain content with this level of return, since it is still better than for high-yield bonds, even after allowing for the fees charged by private debt funds – typically around 75 basis points on invested capital. The ICE Bank of America-Merrill Lynch Euro High Yield Index effective yield was only 2.8 percent in mid-March.

However, others have put money into senior debt funds run by managers with boots on the ground outside the UK, perhaps in the hope of spicing up returns a little.

It’s complicated

One such manager is Hayfin Capital Management, which attracted total commitments of more than €3.5 billion for the latest fundraise for its European direct lending strategy, completed in February 2017. The strategy is based on senior secured loans to European mid-market companies.

“Our stage number one was to put offices in places where there were fewer funds,” says Andrew McCullagh, head of origination in London. “The great thing about Europe is that it is a reasonably complicated place to be: it is different country by country, with local laws for restructuring, different banking sectors and other complexities.” Because of these barriers to entry for debt fund managers that lack national expertise, as well as the origination advantage that comes from a local office, “we can hopefully find some situations that provide a somewhat better risk-adjusted return”.

Hayfin staff originate deals from Frankfurt, Madrid, Paris and New York, as well as London.

A further option is to develop expertise in particular fields. As McCullagh puts it: “Stage number two is looking at various different niches within those geographies, such as asset-backed lending, shipping or healthcare.”

Rewards for establishing market leadership within a niche can be high. “If you dominate a particular sector because you have specific skills, you can generate double-digit returns on senior debt,” says Jeremy Golding, head of Golding Capital Partners, a pan-European debt fund of funds manager headquartered in Munich.

“A lot of investors have built substantial exposure to this part of the market, so they are now looking for diversification as they consider new manager relationships: strategies that are complementary to their current exposure,” says Wursdorfer of UBS. Because of this, they often seek funds that receive “a premium on complexity”, if they remain within senior debt – deals that require a specialist’s understanding of a particular industry, for example.

Many limited partners have responded to the declining yields on senior debt by accepting debt that is slightly riskier in structural terms.

Wursdorfer of UBS says that limited partners are focused primarily on senior debt, but he also suggests that notions of acceptable levels of risk within some senior debt strategies are “a bit blurred”. “Leverage levels are increasing and vary among managers – as does their willingness to offer unitranche loans, which makes the risk position very different.” These are hybrid loans combining senior and junior financing within a single structure.

Managers are also prepared to travel down the debt structure into junior or even distressed debt, he says. Having said this, Wursdorfer thinks that most investors are still putting “a substantial proportion of their private debt programmes” into senior debt strategies.

Golding goes further, saying: “Senior debt/unitranche funds are considerably more attractive at this point in the cycle due to their more conservative position in the capital structure, and their generally greater discipline in terms of pricing, covenants, and resistance to dividends.”

There are, certainly, barriers and risks to expanding abroad and to taking on more junior debt. Market observers warn that when the credit cycle turns and defaults increase, investors may regret taking on debt that was not at the very top of the capital structure.

Do the maths

It also costs senior debt fund managers a lot to set up an office in another country. Private debt executives say that it takes a number of years for staff in the new office to start to earn their keep by building origination capability; moreover, it may not be commercially viable even after this point for many debt funds, because of the mathematics of fund management. If the average fee on invested capital is 75 basis points, and the bulk of fund managers have under €2 billion, 0.75 percent of €2 billion is only €15 million, which hardly pays for a suite of offices around Europe staffed with highly paid industry veterans.

Moreover, because it is harder to scale up niche strategies into large funds, it is harder for the largest private debt fund managers to offer them. Although Hayfin has a number of specialisms, it looks at a wide variety of deals.

Golding thinks this tension between the pros and cons of being large or small is being resolved largely through a “bifurcation in terms of investment trends”. He sees, on the one hand, “a preference among many investors for larger managers with €3 billion and upwards in fund size”. They provide the benefit, he says, of “stronger underwriting capacity and extensive origination networks across Europe. They are also able to support and manage buy-and-build strategies as companies grow and need additional financing”. They will also often have dedicated workout teams, that can handle complex restructurings should debts go bad when the credit cycle turns, he adds.

However, Golding also sees continued interest in smaller niche managers that can generate higher returns – in many cases by lending to riskier but faster-growing businesses. “Smaller managers can start a financing relationship with growing companies at an earlier stage of their development, and support their expansion plans by meeting their ever-increasing financing needs,” says Golding.

If we are at a late stage in the credit cycle, is it the right time to invest in private debt at all, at any point in the debt hierarchy? For Ari Jauho, chairman and partner at Certior Capital, a Helsinki-based private markets manager that advises clients on investments as well as managing its own funds, there is a danger for limited partners in believing that it is always “the wrong time to invest”.

After all, if they recoil from investing before a downturn, when the downturn comes “we know for sure they’ll say it’s too risky a time”. Jauho concludes philosophically: “One never knows where we are in the cycle, but regardless of the cycle, senior lending is always the safest bet.” This approach is followed, he says, by the Finnish institutional investors that make up his firm’s client base.