Reasons to be worried about mid-market funds

Despite booming popularity of funds in the segment, Pete Drewienkiewicz of investment consultancy Redington says they can carry hidden risks that investors need to be aware of. By John Bakie

Pete Drewienkiewicz is concerned that some people seem to think private debt is immune to broader global dynamics affecting capital markets.

The chief investment officer for global assets at the investment consultancy Redington has been examining the asset class, its recent popularity with investors and its long-term prospects. One of his key worries is a trend in valuations that has been developing over the past two years wherein EBITDA adjustments are frequently used to justify higher levels of leverage. This means loans are being made on much riskier terms than they appear to be.

“Right now, everyone is incentivised to play along with these adjustments because it looks better for everyone involved, including the debt fund, if the multiple appears lower,” Drewienkiewicz says. “But investors need to really think about the impact of lending much higher loan-to-value and what that means for risk.”

Non-sponsored deals potentially offer a route to avoid such overvaluations, which are commonly driven by private equity investors in sponsored deals. But they come with their own set of complexities in terms of deal sourcing and resources for origination teams, making it much more difficult to get these deals done than in the sponsored market.

Drewienkiewicz is particularly concerned about fundraising in Europe, which has seen a very large amount of capital raised in recent quarters – often eclipsing the well-established US market. Deploying capital in Europe is substantially more complicated due to its array of jurisdictions.

While Germany has often been cited as a significant untapped market for European private debt to grow into, Drewienkiewicz believes the market is still hugely overbanked and shows little sign of changing in the near future.

“As long as banks are still there, it is going to be hard to lend into Germany,” he explains. “And if you have to put money to work, relying on German Mittelstand companies could be challenging. This situation has persisted for years and it’s hard to see what catalyst will force a change in the way banking is done in Germany.”

Despite these difficulties, Drewienkiewicz believes private debt will continue to be a popular destination for institutional investor allocations, especially because so many face long-term liability matching challenges that credit funds can help them address.

Investors often ask Redington how they can avoid the sorts of pitfalls laid out above, and Drewienkiewicz’s advice is: “You need to be where the capital isn’t.”

Avoiding some of the biggest funds in crowded markets like mid-market direct lending is one way to do this, though for many investors the relative simplicity of these funds along with a good risk-return profile can make them difficult to avoid. He suggests looking at areas like non-sponsored finance, provided the investor can become comfortable with the fund manager’s strategy in this area.

The other way to avoid the pack is to seek out complexity to earn what Drewienkiewicz calls the “can I explain it to my granny premium”.

He says exotic strategies that are inherently complicated can put off institutional investors, who worry they won’t pass an investment committee. He believes investors willing to take the time to really understand complex financing methods like asset-backed lending could net a significant return premium while avoiding the risks of getting into a crowded market.