As I prepared this article, I reflected on how credit approaches, products and strategies have evolved, but very little has changed in respect of the principles of providing credit. Money is lent, the borrower pays in some way for the use of that money and the lender expects to be repaid. The basic principles for institutional investors remain: match strategies with risk and return objectives; conduct detailed due diligence and select managers carefully; and be willing to say no and be contrarian.
Regardless of where we are in the economic cycle, the most important observation is that there appears to be no imminent bad news out there. However, risks are on the horizon, both economic and political, with the latter being difficult to forecast.
At the macro level, the uncertainties are more likely to lead to short-term volatility than to meltdown. Nonetheless, debt cycles are influenced heavily by micro considerations, for example the supply of and demand for debt, debt servicing metrics, specific industry cycles, debt pricing and downside protection.
The US recovery has been long and slow. At the time of writing, the consensus view is that the economic cycle is transitioning from a stage where the economic recovery has strengthened and policy makers have begun the process of policy normalisation to a later-cycle stage whereby the pace of recovery has slowed somewhat and interest rate increases are beginning to weigh on growth.
The US recovery is showing some peaky characteristics, such as high overall asset valuations, record corporate debt levels and record private market fundraising. Standards for corporate lending have declined, accompanied by a continuing huge appetite for risk. The US is at full employment and the Fed keeps on raising rates. However, corporations are well able to service their debt at current interest rate levels, and default rates remain low (for the time being, at least).
The Eurozone is earlier in its recovery and there is more to come, although growth seems to be stalling at present. The recovery was originally above expectations, but has been more problematic recently. Still, corporate profits are up in major countries, including Spain and Italy. Corporate valuations also seem to have further space to grow. The excess of bad loans is declining gradually in Spain where government action has been pronounced, and also more recently in Italy, in spite of recent political machinations.
There remains uncertainty about what the ECB will do in the current environment, but growth is stalling somewhat and there remains much more work to be done in both sovereign and corporate debt. The ECB has been in no rush to tighten monetary policy, but its bond purchase programme is likely to taper down in the third quarter and end by year end. However, the Eurozone will remain predominantly a low or negative interest rate zone, with extremely yield-hungry investors.
Private debt strategies must take these differing positions in the cycle into careful consideration, although carefully selected senior secured debt works throughout the cycle. In the US, where the cycle appears to be nearing a peak, strategies showing relative value would typically be emphasised, such as distressed debt and special situations. In contrast, in the Eurozone where more upward momentum is envisaged, more traditional strategies can be prioritised such as senior secured and mezzanine, and even unitranche if clearly defined.
Of course, things are rarely this simple. The micro environment in individual economies makes a big difference for private debt strategies. Interest rate risk does not influence asset prices in private debt for example, but spiking interest rates might influence companies with insufficient cash-flow coverage, and lead to more defaults. As a result, we strongly emphasise the following fundamentals regardless of which strategy fits into the cycle.
|Strategy:||Points to consider:|
|Senior Secured||– Can be industry selective.
– Pay attention to debt quality.
– Focus on managers with a specific advantage and proven ability to execute.
– Consider asset-backed and cash flow strategies but ensure underlying collateral holds value in liquidation, and companies have a “reason to exist”.
|Subordinated & Mezzanine||– Carry higher risk during downturns.
– Ensure managers have restructuring skills.
– Size and execution capability are significant: managers that arrange and control entire tranche have an advantage.
– Assess leverage at fund and underlying asset level, equity cushions of underlying companies, quality of earnings and equity risk taken.
– Consider entrenched managers that add teams to extend breadth of capital solutions.
|Unitranche||– Relatively new, so care needs to be taken on the entire debt capital structure.
– Watch out for bifurcated, synthetic structures that are effectively senior and subordinated tranches being disguised as senior secured.
– Lenders that can structure the unitranche loan and underwrite the entirety of the facility can often garner more advantageous terms and pricing.
– Understand the risk of the junior or mezzanine portions not directly agented by lenders who participate as part of club transaction.
– Ensure clear purpose and repayment of the facility.
|Special Situations/distressed||– Consider managers that can provide liquidity quickly in complex situations as well as structured finance.
– Traditional distressed-non control opportunity is limited; fund sizes must meet ongoing needs of “broken” balance sheets.
– Fund managers able to provide liquidity quickly in situations where pockets of dislocation occur – attractive over the medium-term.
– Fund managers may focus on rescue financing opportunities or other opportunistic debt investments where they can generate equity-like returns.
– Unique fund structures enable LPs to be more dynamic with capital deployment.
|Opportunistic||– There is strong potential for alpha generation and structures to enable dynamic capital deployment.
– Can be additive but have varying risk characteristics and tend to be smaller.
– Typically comprised of less competitive market with strong potential for alpha generation.
– Tend to include speciality strategies with strong cycle resistance and low correlation.
One final consideration that has been widely discussed in recent months is the recovery of the banks and their appetite for lending. This is a good thing and important for economic stability and growth. The banks, particularly the European ones, will continue to deleverage and also pick the best spots to increase their returns on equity.
Although many private debt managers see banks as competitors, we would contend that they can be good partners too. Today, around 50 percent of Eurozone corporate direct lending is done by the banks, down from over 80 percent since before the Global Financial Crisis. It is unlikely that the banks will stop lending, but they will continue to pick their targets carefully. Already, we have seen examples of banks forming alliances with private debt providers. In theory, this should be positive for both parties.
Although there are some danger signs on both sides of the Atlantic, private debt will continue to grow and gain importance in investors’ portfolios. The asset class covers such a wide range of strategies that fit well in different parts of any asset allocation. At the senior debt level, the illiquidity premium will remain important, but demand – notably from small- and medium-sized enterprises – will continue because bank restructuring is hardly over. Moreover, strategies in the opportunistic areas represent ways to add differentiation and are generally less correlated with traditional asset classes.
Regardless of the timing of the economic or debt cycles, there will be a place for private debt strategies. As in all private market investments, selection and objective due diligence are paramount. Consistency of approach, proven track record through several cycles, and the ability to source investments and structure debt packages prudently are factors that should lead to success, and perhaps more importantly, help avoid disappointments.
John Hess is head of global strategic initiatives at Pavilion Alternatives Group, the US-based alternatives advisory firm
The information contained herein is for information purposes only and does not constitute investment advice. © 2018 Pavilion Alternatives Group®. All rights reserved.