Why big funds face big challenges

Large private debt houses with established brand names have continued to experience fundraising success, but that doesn’t mean there aren’t difficulties ahead, writes John Bakie

After several years of strong growth in benign market conditions, the private debt industry could face one of its first big tests in 2019, and John Bohill, partner at StepStone Global, says that taking the right approach to underwriting, data and investor relationships will be key issues firms need to grapple with.

When Bohill spoke at PDI’s Capital Structure Forum in London last October, he noted that LPs were increasingly looking to commit capital to very large fund managers, which is driving consolidation across the industry.

But he warned: “The big risk for those large funds is over-reach; if they raise more money than they can invest well, or make some bad calls, it could damage their brand names.”

However, he says StepStone, which has over $250 billion of total capital allocations and $46 billion of assets under management, recognises that there are some major advantages to investing in large managers.

“Large, well-resourced managers help to solve the absence of bank activity in the lending market,” he explains. “The banks have huge resources to back up their lending operations and the larger fund managers are now starting to match that with big teams.”

Large origination networks, good workout groups and strong in-house underwriting are also features of larger debt fund managers that make them attractive. However, Bohill says firms should avoid trying to grow their AUM by shifting into riskier parts of the market.

“Investors don’t want dislocation,” he says. “We have a core of investors who are looking for a fixed-income investing style. Four or five years ago they were looking for private equity-type investment, but you can’t deploy the amounts investors are allocating today in niche strategies.”

Sophisticated investors

Bohill says StepStone mitigates the risks it faces through the use of separately managed accounts, arguing this is a much more interactive and selective way of investing compared with committing core allocations to funds.

The size of the SMA market in private debt is unknown and difficult to track, as details of these arrangements are rarely made public. But it is thought to be a substantial and growing part of the industry.

“We have a highly interactive dialogue with managers and we speak to them monthly,” Bohill says of the SMAs which StepStone is responsible for.

However, for this style of investing to work, fund managers need to be prepared to deal with highly sophisticated and demanding investors. One of the biggest challenges they are likely to face is the demand for data.

“We’re quite pushy on our data requirements,” Bohill explains. “Managers need to provide monitoring and transparency.”

The firm has 24 manager relationships through SMAs, all of which are regularly monitored with a due diligence process based on full transparency. Bohill says data requirements are “absolute” and “very detailed”.

Private fund managers may not be accustomed to such demanding investors, but Bohill believes SMAs will become more common and that managers have to be able to keep up. While the industry has long evolved alongside private equity, it will start becoming more like other fixed-income assets where investors are used to a high level of transparency around underwriting and the performance of underlying credits.

This attention to detail also means Bohill is relatively relaxed about the potential for a market downturn in the near future, saying “it may be healthy for the industry to see through a downturn”.

He believes there is a degree of “institutionality” to private debt today, which means allocations to the asset class are here to stay and a downturn could weed out weaker managers. He also expects a resurgence in new teams and ideas to enter the market as more opportunities arise in the next credit cycle.