Campbell Lutyens: ‘Private debt is being used as a fixed income replacement’

An extended period of low growth, low inflation and low interest rates has been a boon to private debt. Investors have taken note. According to our PDI Global Investor 30 debut ranking, the top 30 of them combined have allocated over $200 billion to the asset class. It is a significant chunk of capital and marks its emergence from a niche alternative strategy to an increasingly mainstream part of any private investor’s portfolio.

With expectations of rising allocations to private debt over the next five years, we asked Campbell Lutyens’ head of private debt advisory group Richard von Gusovius and private debt specialist Jeffrey Griffiths about where investors are eyeing opportunities and where they should be careful.

Given the level of fundraising and deployment, is the private debt market overheated?

Jeffrey Griffiths: The question is: Is private debt more overheated than other pockets of the alternative market? I would argue no because although returns have compressed, as all asset classes have, it has not been substantial. Fundraising has been quite stable and we don’t see it falling back significantly in the future. We also see a healthy level of deployment. There is even a slight imbalance where managers’ desire to deploy capital is not completely met by the provision of capital by the investor community.

Richard von Gusovius: We are more optimistic today regarding capital raising than at the beginning of the year. As expectations of rising interest rates vanished over the course of the first half of 2019, more investors actively expressed an interest to start or increase allocations to private debt. This is slightly offset by some direct lending fatigue among investors that deployed two or three years ago that are waiting to see how their commitments perform before they take it to the next level. That’s natural.

There are pockets of exuberance but if you look at the capital overhang numbers over the past five years, GPs have always been able to deploy that capital. Compared to the broader syndicated loan market, private debt continues to see higher equity cushions and lower leverage levels particularly at the smaller end of the direct lending market, which we find particularly attractive. And we see increased use of direct lending, particularly among financial sponsors transacting smaller deals. Previously they depended largely on banks.

Would you say then that investors are under-allocated to private debt?

JG: Definitely. The traditional investor, a pension fund or insurance company, typically have long-term liabilities that require returns of 5, 6 or 7 percent. That lends itself very nicely to a private debt investment strategy. However, the average allocation to private debt is still in the low single digits, 2-5 percent max. Investors will typically have a large allocation to low returning fixed income – government and investment grade bonds – and maybe some high yield debt, and also a sizeable allocation to public and private equity. They are weighted on each end of the risk spectrum. We would argue that investing in private debt is more efficient and less volatile. But we understand it’s a relatively new asset class where investors would like to monitor performance over the longer term before they build out their allocation.

Is there room for growth in both capital raising and deployment?

JG: Definitely in the senior secured direct lending market that is starting to diversify into transactions with non-private equity owned businesses, including family and employee-owned companies. That’s a much bigger opportunity than any other in alternatives.

RvG: Also, increasingly investors are looking to deploy outside of corporate lending into more asset-based structures, consumer lending and real estate. There’s continued interest in infrastructure but also in aviation, equipment financing and working capital financing. That’s a trend we’ve seen over the last 18 months and where there is probably not enough of an institutional grade offering yet.

During fundraising, what concerns do investors voice?

RvG: A few years ago investors would only be worried about deployment. Those that have been in this asset class for four or five years have certainly learned a lot and now know the questions they need to ask: Is the team big enough to deploy capital well; are managers well diversified geographically and in underlying sectors; how would a manager respond when things go wrong? They look at the team and ask who is your workout expert? They are more realistic than they were about the prospects and more informed.

Are they carving out more private debt-specific allocations?

RvG: Increasingly yes, but still at a low base. Institutions are still in the discovery phase. They are subject to stringent approval processes, so once they have gone through all the pain of establishing the asset class, they will run it separately rather than invest from their public or alternative pockets. Certainly private debt is being used as a fixed income replacement rather than an alternative asset class. That’s where most of the growth will come from.

What types of new investors are eying private debt?

JG: We see more insurance companies investing in the market. Asia has a large, expanding pension market where institutions have to invest outside their home markets typically. This type of exposure can be attractive. And we also see some family offices increasing allocations as a stable source of income in their portfolios.

“Private debt is being used as a fixed income replacement rather than an alternative asset class. That’s where most of the growth will come from”

Richard von Gusovius
Campbell Lutyens

RvG: One segment that is yet to be fully tapped, at least outside of the US where private investors have access to BDCs, is private wealth. The retail market certainly would benefit from more affordable offerings. If someone were to create a product that independent financial advisors could put into individual pension funds that would unleash quite a big volume of capital.

Where do they first dip their toes?

JG: New allocations generally go into lower risk, lower return, large fund strategies with brand name managers with longer track records. That’s why you’ve seen, particularly in Europe, an explosion of fund sizes where brand name managers are able to aggregate increasingly large sums of capital.

RvG: Private debt has reached a place where managers at the large end have pulled away. Those teams need to deploy capital into huge transactions and are increasingly competing with the public markets. We’ve seen unitranches of over $1 billion being offered and executed. That wouldn’t have been possible three or four years ago. Sponsors at the large end can keep transactions out of the public realm for which they pay a premium. In terms of number of transactions, there’s much more happening at the smaller end of the market, where relatively speaking there is an undersupply of capital.

Is that where you see the most opportunity?

JG: Financing lower mid-market companies with EBITDA of between $5 million and $30 million, including non-sponsored transactions, is where we see the biggest opportunity and the best risk return, the strongest deal structures, reduced competition and the best pricing.

And where should investors exercise caution?

JG: There is more risk at the larger end of the market where the pricing is thinner and the erosion of creditor protection has been a theme that has filtered down from the leveraged loan market.

Through another default cycle, we don’t expect to see a change in default rate behaviour, but loss rates might be higher because creditor protections are weaker. And private equity sponsored activity may witness higher loss rates.

The interests of equity and debt holders can be very different and antagonistic. The most aggressive business owners are typically private equity funds that are motivated by financial gain, as opposed to a family or employees who hold a much more constructive, longer-term value preservation mindset.

RvG: At the larger end of direct lending, typically sponsored lending, we have seen cases where private equity owners were able to use weaker creditor protection to their advantage, ahead of a credit event, for example by being able to sell off profitable parts of the business, IP, etc, and extract value for themselves when traditionally the lender would have had a say over capex or disposals.

Sponsored lending is an important part of any given portfolio, but investors need to ensure there are no conflicts of interest and their GPs are underwriting companies, and not sponsors. Investors can simply check during due diligence whether the GP in question has a material concentration of sponsors in their loan portfolio.

Also, at the larger end of the market, some very large funds are competing for a limited number of transactions, and as they start competing with capital markets and therefore need to lend more for less for longer, LPs should be very cautious.

When you talk to LPs, are they wary of a possible downturn?

RvG: A lot of them have strong views that there will be one. Views range from a corporate credit-led Armageddon, which we don’t believe in, to a sideways movement of sector-led volatility, for instance by the German automotive industry. Investors need to make sure they are diversified over a broad set of strategies, sectors and geographies and that their underlying GPs don’t take unnecessary risks. We often see GPs that want to participate in the larger end of the market are tempted to underwrite larger loans to raise a larger fund going forward. That’s a very dangerous spot.

JG: Investors in this market tend to be risk averse. They are not necessarily looking for upside but for downside protection. They worry about whether this is the right time to invest. With downside protected senior secured lending strategies you shouldn’t try to time the market. It’s about adjusting the size of your allocation. If we do experience a rough patch, we could see more aggressive participants perform badly and some angry investors. That will flush out the market and help investors discern between riskier and more conservative practices.

As more LPs look to this market, do you see any changes in fund structures, fees or terms?

RvG: As investors learn the asset class, build relationships and seek to deepen them, we will see more permanent capital vehicles and the rise of large bespoke mandates that absorb the sizeable allocations entering this market. Rather than LPs recommitting every two to three years, for which they don’t have the bandwidth, in this model investors will have core direct lending relationships with say two US and two European GPs that manage open-ended structures they can call. The GP will take the principle flows and reinvest the capital and give the investor the share of income they need to meet their liabilities, and the investor will have the capacity to pursue more accretive strategies around it.