The private debt landscape has changed significantly since PDI’s March 2014 profile of KKR’s alternative credit team, which included Erik Falk, the firm’s former global head of private credit. At the time, there was a supply-demand imbalance favouring fund managers, which is hardly the case today.
“Simply put: when it comes to private debt, there’s more farmland than there are farmers,” we wrote at the time, riffing on Falk’s comparison of the private credit world of yesteryear to Iowa before farmers arrived.
Private debt has since transformed from a landscape of expansive fields with idyllic rows of crops into the tight, crowded plots of an urban community garden. More asset management firms, particularly private equity firms, continue to launch private credit practices, while established firms are broadening their product offerings and continue to raise successor funds.
The numbers show it. At the end of the first half of the year, more than 500 private credit funds were in the market, the most ever, PDI data showed at the time. In addition, 2017 is already a record fundraising year – through the first three quarters of the year, private debt managers raised $130.69 billion, surpassing the record $130.1 billion raised in 2013 with a full quarter left in 2017.
In April this year, Falk left KKR, returning home to his native Illinois to work on “strategic initiatives” at Magnetar Capital, a hedge fund based in Evanston, Chicago’s northern suburb situated alongside Lake Michigan. A source familiar with Falk’s background says he has known people at Magnetar for some time.
The firm has not announced what Falk’s exact duties at Magnetar will be, and declined to arrange an interview with him for this story.
But bringing in one of private credit’s notable figures to talk strategy certainly signals the possibility of launching a closed-end credit fund, which would not be the firm’s first foray into asset class.
Magnetar entered mid-market lending a decade ago when it backed business development company Solar Capital in March 2007. Falk’s new firm invested $525 million in Solar’s $700 million debt private placement. Magnetar gradually reduced its stake in New York-based Solar over the next several years.
In addition, Magnetar lost two fixed-income portfolio managers, Joshua Eaton and Carlos Mendez, in 2015. The men helped launch Crayhill Capital Management, which also sub-advises Magnetar’s Solar Opportunities Fund, an investor in solar generation projects in the UK, according to SEC documents.
CREDIT WHERE CREDIT’S DUE
KKR, which also declined to comment for the story, launched its debt arm in 2004 and made its first mid-market direct lending investment in May 2005. But the launch of a vehicle dedicated to that strategy in any current form was years off.
In 2008, the firm’s credit business began accepting institutional mandates to take advantage of credit market dislocations caused by the global financial crisis, according to investor documents from the Minnesota State Board of Investment.
Falk joined KKR that same year from Deutsche Bank and helped guide the growth of the New York-based asset manager’s direct lending arm. He oversaw the firm’s private funds within KKR’s credit business, which included the senior debt-focused Lending Partners fund series.
Two years later, Corporate Capital Trust, a business development company advised by CNL Fund Advisors Company and sub-advised by KKR, filed the requisite paperwork to be regulated as a BDC, and eventually launched investments and fundraising operations in 2011. In April of this year, KKR began preparing to take the company public and become the vehicle’s sole investment advisor. In 2011, KKR also raised its initial direct lending and mezzanine funds.
“He helped build the direct lending business from scratch. Those businesses didn’t really exist in any of those forms pre-crisis” – market source
By the end of the first quarter, shortly before Falk’s departure in April, the firm’s alternative credit vehicles – a division comprising senior debt, mezzanine debt and special situations vehicles – had rounded up $15.07 billion of capital commitments.
The firm was also in market with another incarnation of its senior loan fund, Lending Partners III, which has raised $618.8 million, as of 30 June, according to KKR’s second-quarter earnings report. For that vehicle, KKR will make a commitment to the fund of at least $50 million or, if less, 6 percent of the fund’s capital commitments, the Minnesota documents showed. It will charge 1.5 percent on invested capital and a 15 percent incentive fee over a 6 percent hurdle rate.
The latest vehicle’s predecessors, the $460.2 million Fund I and $1.34 billion Fund II, posted net internal rates of return of 6.5 percent and 13 percent and multiples on invested capital of 1.3x and 1.2x, respectively, as of the end of the second quarter.
Falk said in a note he was leaving the firm for a “new opportunity” in an email notifying colleagues of his departure.
Market sources speak highly of Falk, with one person familiar with his work style describing him as a “hands on, active manager”. “He was extremely organised, followed up on every [deal-related] lead, every idea,” the source says.
HARD TIMES AT HEDGE FUNDS
The potential launch of a private credit arm comes as hedge funds overall are receiving a rougher reception from investors than private credit. Poll results from Coller Capital’s Summer 2017 Global Private Equity Barometer show that 32 percent of LPs plan to trim their hedge fund allocation, while only 19 percent plan to increase their commitment to the strategy. Conversely, those numbers for private debt, respectively, were 8 percent and 40 percent.
A September survey from Preqin painted an even grimmer picture for hedge funds, as 49 percent of investors planned to reduce their allocation to the strategy over the next 12 months. The industry has recovered slightly at least as hedge fund managers have seen net inflows for the first half of the year of $24.7 billion compared with 2016’s $34.2 billion of outflows over the same time period last year, according to Preqin data. 2016 ended with net outflows of $109.8 billion.
Hedge fund managers running closed-end credit funds are commonplace today in the distressed debt space, with many strategies starting in a hedge fund structure and eventually morphing to a private equity-style fund, says Fraser van Rensburg, a managing partner at placement agent Asante Capital Group. This is less common on the direct lending side, he explains.
Magnetar has seen more capital withdrawn from its funds than committed, according to a recent Wall Street Journal report from May that profiled the firm’s embrace of quantitative trading. But the firm’s assets under management have yet to decrease, as the net outflows have been offset by solid returns.
Van Rensburg says investor appetite for hedge funds has “muted significantly”. In terms of allocation dollars, hedge funds and private credit don’t always compete for investor capital, he says, as the hedge fund commitments come out of a liquid allocation, while private credit often comes from the illiquid side.
“There’s also so much fixed income capital that it’s hard to say they’re really competing,” he says. “In reality, they are competing with the allocators, who are inherently conservative, to justify moving walls of capital across from fixed income to alternatives.”
As has continually been talked about in the industry and as covered by PDI last month, private equity firms have been hopping on the private debt bandwagon for some time, often as a move to diversify their platforms.
“In today’s market, private credit is still a very desirable asset class,” Stuart Wood, a managing director at fund administrator Cortland, says in the coverage. “There are a lot of opportunities for private equity managers to leverage their existing relationships and start a credit fund.”
When looking at starting a private credit arm, hedge funds might have to contend with a fundamental shift from liquid to illiquid investments, but private equity firms must deal with a completely different investment strategy – ownership vs. being owned.
While Magnetar may be weathering the hedge fund industry’s tough times, at least according to the Journal, diversifying investment products can only increase fee-paying assets under management and allow the firm to cast a wider net for potential investors. Should that be at the top of Magnetar’s list, the firm may have found its man in Erik Falk.