Vive la difference

In areas such as size, structure and geographic reach, private debt funds have undergone enormous change over the last five years. Gus Black and Philip Butler of Dechert discuss some of the key changes.

6As private debt funds have grown larger, what impact has that had on the market – not just at the larger end, but the middle and smaller ends as well?

PB: When private debt funds were first launched, they were very much focused at smaller and mid-sized deals and could underwrite tickets of €20 million-
€30 million. Since then, there has been a significant change whereby larger funds can raise multiple billions and have the ability to write much larger cheques.

That takes them into a different part of the market where they compete with different products. Borrowers can go to a one-stop-shop solution provider for €200 million or more and obtain flexible financing and not have to suffer the vagaries of the syndicated loan or bond market. This trend has accelerated in the last five years and will continue to shape the market.

For relationship reasons, these larger funds however have not entirely moved away from the smaller and mid-markets. There are still plenty of deals to be done there as the retreat of the banks continues. But the newer funds that have been launched over the last five years have targeted the lower end of the market and now also compete in this space.

GB: The size of some flagship funds has increased but, as investors become increasingly sophisticated about the way they approach the asset class, we are seeing more niche strategies in demand – for example, focus on a particular country, sector or strategy.  That has actually militated against sheer size on an individual fund basis, but results in managers being able to offer a wider range of funds at any one time rather than being reliant on the classic private equity model of raising one fund every few years.

What is the competitive environment like and what pressure are we seeing on terms?

PB: Post-GFC, we have seen the retrenchment of the banks and the increase of private debt capital. For some deals, there are a lot of lenders competing and it’s become a perfect storm for borrowers in terms of access to capital. There are a lot of different products and a broad ability to look at a particular deal in different ways.

As some funds have gone up-market, deals in the mid-market have taken on board deal terms from the larger end. Larger deals are used to US-style bond and capital market provisions and these have been brought into the mid-market in what used to be an old banking-style market.

The mid-market has showed increasing acceptance of the pressure on terms. The obvious one is pricing but there are others which were previously confined to the bond and larger deal markets. With covenant-loose and lite deals there is more flexibility, especially where you have facilities designed to grow and develop a business further. When it comes to the need for more debt, for example, to make acquisitions, there is much more flexibility provided across covenant packaging than there used to be. Funds can be more accommodating to what might happen in the future rather than forcing borrowers to come back to the table and get consent all over again.

How has the asset class taken on the challenge of growing into new jurisdictions?

PB: It clearly makes sense for global asset managers to grow the private debt market globally, tapping into their investor base and ensuring they have diverse, well balanced portfolios.

Historically, certain jurisdictions have been more difficult than others due to legal or regulatory restrictions or cultural reticence to embrace private equity and leverage in particular. However, over the last five years many fund managers have developed a more open approach and they are now trying to find ways to do deals in these jurisdictions. As a result, France and Germany have become popular and have seen significant private debt investment as has Scandinavia and certain other Western European countries including the Netherlands. Over the last few years there has also been an increasing appetite for Southern Europe.

The trend is driven by investors’ need for diversity. When they talk to us, they tell us they want a well-balanced portfolio. More recently this may be influenced by Brexit, but they also think that if funds are marketing themselves as pan-European, then they should be doing a certain percentage of their deals in Continental Europe. Having said that, while favourable regulatory changes have occurred, Europe still has some way to go before it has the same ease of access and deployment as funds enjoy in the US and UK.

GB: We’ve seen a maturing US market expand into Europe and, while the European markets are very different, we’ve certainly found it invaluable to draw on our experience of raising funds in the US. In turn, as private debt fundraising grows in Asia-Pacific, we are applying our combined US and European knowledge appropriately adapted for those markets. Some people assume that private debt and private equity funds are much the same but in fact there are notable differences and traps for the unwary. There can also be significant tax issues for investors seeking cross-border debt exposure (for example, US loan origination strategies). The legal solutions available here have advanced considerably in recent years.

How have private debt firms and their products evolved in recent years? 

GB: Private debt is now quite a diverse universe, from the credit arms of private equity firms and multi-asset managers, opportunistic hedge funds, through to dedicated debt managers. We have seen more blurring of traditional silos, more innovation in fund products (both in terms of the structures available to use and manager appetite to use them), considerable evolution in terms and more crossover between liquid and illiquid strategies.

PB: If you go back 10 years, private debt in Europe was largely focused on unitranche as the mainstay product. Over the last five years in particular, there has been a major change in how private debt products have evolved. Funds now have access to more pools of capital and this enables them to provide many more options for borrowers.  Strategies are now built around what a borrower wants to do whereas it used to be the case that unitranche was the only senior debt offering. Today, there is much more variety and flexibility.

What have been some of the major fundraising developments?

GB: As LPs have become more experienced in the asset class, their appetite for direct investment and co-investment has increased and they look at how they will deploy with a manager in a more holistic way. Increasingly, LPs are thinking ‘What is the best way to structure my exposure to this manager over the next five years?’ rather than just ‘How large a ticket shall I invest in the next fund?’

There has been a big structural shift towards Europe-domiciled fund structures by both European and US sponsors. This has been partly driven by investors, partly by regulation (an EU structure can ease both fundraising and deployment) and partly by tax changes. However, there is always the prospect of further regulation which could alter the dynamics once again.

Gus Black is a partner and global co-chair of Dechert’s financial services and investment management group; Philip Butler is a partner in the global finance team.

This article is sponsored by Dechert.