Private debt faces dilemma of more capital than opportunities

Trust managers too much and you could end up following them into uncharted territory, warns Trevor Castledine in conversation with John Bakie

A dearth of capital chasing very few opportunities means investors must be cautious of where they put their private debt allocations, according to former investment director at the Local Pensions Partnership, Trevor Castledine.

“Right now there is more capital than there are opportunities,” Castledine tells PDI. “This tips the balance in favour of fund managers, so you have to be very careful about which managers you select.”

Limited partners need to apply filtering systems so they can rule out some managers quickly in order to put the right amount of effort into underwriting any particular fund proposal.

Castledine says one of the biggest problems among the investor community is failing to properly scrutinise successor funds. “You should never auto-reinvest into a successor fund. You have to perform due diligence again to see if the manager is still up to scratch,” he says.

One of the biggest risks of automatically re-investing in a follow-up fund is that the scope of successor vehicles can evolve. Most fund managers try to raise a larger fund than its predecessor, but investing a €300 million vehicle is a different prospect to investing €1 billion.

While smaller funds tend to be backing businesses in the lower mid-market, which can be riskier prospects in general, they will also be able to keep greater control over the terms of a deal, Castledine says. “At the larger end of the spectrum, it’s much harder to set the terms and you tend to be in a much more competitive environment, which impacts both pricing and terms.”

Castledine’s experience is that, when asked, most managers are co-operative with due diligence processes and present their business in a transparent manner, which should make it easy for investors to find out exactly what they are being sold, though there remain areas where caution should be exercised.

“One issue we see is style drift, where the manager tells you they’re going to do one thing but they end up doing something else,” he warns.

Some managers can present investors with overly-broad fund documentation that allows the fund manager to invest outside their core brief, and investors need to be sure they understand why those clauses exist and whether they are happy with any additional risk they might entail.


So what should investors be looking for in their fund managers? Despite concerns about terms and conditions, Castledine believes origination capability is one of the key differentiating factors for fund managers.

“Quality of underwriting is under pressure,” he says. “You can operate a very diligent and sensible underwriting process, but if you don’t take market terms then you won’t do any deals.”

With so much capital chasing so few deals, accepting lower pricing and more relaxed terms has become an inevitability in many parts of the debt market, and so it is the ability to source deals and deploy capital to high-quality credits, even with less-than-ideal terms, that is likely to decide which credit funds successfully ride out the next cycle.

Despite this, Castledine believes investing in funds over investing via increasingly popular separately managed accounts is a better path for most investors.

“What strikes me about using SMAs is, if you believe you’re that sophisticated to make the calls for an SMA, why not simply start your own fund? Even if you’re using it because of ESG issues, would it not be better to try and put pressure on the manager to provide a high level of ESG to all the investors in the fund?”