Pushing the button: Why the US market is taking off

As US fundraising continues to soar post-covid, we take a look at what is driving its recovery, including which segments are the most popular.

After a choppy 2020, US private credit markets were incredibly active in the first half of 2021, as fundraising rebounded to beyond 2019 levels and M&A activity surged.

More than $40 billion was raised for North America-focused private debt funds in the first six months of the year, well up on the $27 billion raised in the first half of 2020, with an average fund size of nearly $800 million, which far exceeds anything seen in recent years.

As fund sizes continue to escalate, the opportunity to do ever-bigger deals is playing into the hands of larger credit managers. Kipp deVeer, head of credit at Ares Management Corp, says: “We’re continuing to see the expansion of the addressable market as larger companies are increasingly seeking the speed, flexibility and certainty of closing that large direct lenders can provide compared to what a bank or syndicate-led solution can deliver.”

With so much sponsor-led M&A activity, there is also a growing willingness on the part of private equity firms to embrace private debt, deVeer says: “We continue to find attractive relative value among larger companies given our market position, and the increasing acceptance of private financing solutions in the upper end of the middle market.

“We believe these larger companies have scaled platforms, diversified business models, sophisticated management teams and generally created less competition, which makes them highly resilient.”

Two industry sectors that have stood out ahead of others are technology and healthcare. Craig Farr, senior partner at Apollo, says: “Within this M&A-driven opportunity set, we have seen attractive opportunities to invest in companies that thrive in today’s market, including many technology and tech-enabled healthcare businesses.

“While rates and terms are tight, many of these deals have significant equity as percentage of the capitalisation, are backed by leading sponsors, offer forward-looking views on contracted revenues, and exhibit top-line growth at rates that should enable faster deleveraging.

“Technology and healthcare M&A and LBOs remain very active. Both sectors are thematically strong and typically have high recurring revenue, high growth and good macro trends, which support higher valuations, large equity cheques and manageable leverage. Investor demand is strong for these sectors both in the private and liquid markets.”

On the fundraising side, there has been increasing specialisation in strategies, with placement agents reporting a flurry of activity around tech lending, healthcare lending and specialty finance unrelated to corporate credits.

Data shows senior debt strategies and those focused on subordinated or mezzanine debt accounted for more than three-quarters of the dollars raised for US private debt in the first half, at a combined $32.3 billion. Senior debt strategies continue to dominate, accounting for 42 percent of the market.

‘Significant rebound’

At the law firm Ropes & Gray, partner Melissa Bender says: “This has been a really busy year and an active time for all our clients, both in terms of transactions and fundraising. On the fundraising side, we are seeing activity across all parts of the credit spectrum, within all different strategies. One area of particular note is the increasing interest from high-net-worth individuals in the asset class.

“The activity we saw about a year ago was largely associated with taking advantage of market opportunity in terms of dislocation strategies. Over the course of the past 12 months that has altered, and we have seen more traditional fundraising.

“Managers have been very active and able to fill capacity in their funds and deploy capital pretty quickly, meaning they are returning to the market with further funds on shorter
timetables.”

That’s a view shared by Jeffrey Griffiths, co-head of global private credit at Campbell Lutyens. He says: “Last year the fundraising numbers were down about 25 percent in private debt, in line with other alternatives markets like private equity. We are seeing quite a significant rebound right now, which is not surprising given the performance proved so resilient through the pandemic and dealflow has come back strongly.

“Managers don’t have enough money; they are burning through their funds and coming back quickly to raise new funds, which is a symptom of a lack of capital in the market, with fund sizes arguably not big enough.

“Most of the scale in the market is driven by private equity dry powder, which is very high, and a large proportion of private equity deals must be financed by private credit, so private credit fundraising needs to follow on from that.”

With sponsor-led deal activity on track to reach the highest level in a decade and the market flush with capital, the temptation is for some lenders to execute deals with aggressive terms and looser documentation standards.

At Ares, the firm’s largest US direct lending fund, Ares Capital Corporation, reported a record level of $4.9 billion of new commitments in the second quarter of 2021, with the growing breadth of its pipeline enabling it to look at a larger and more diverse set of investment opportunities. Still, the fund only finances approximately 5 percent of the new deals looked at.

DeVeer says: “Our most important focus is to be highly selective and invest in what we believe to be the best companies. We also use our ability to commit larger hold amounts and our long-term relationships to negotiate the best deal terms for our protection.

“Overall, we continue to invest on terms that are favourable compared to the broader market and believe that we are able to do so because of our positions of incumbency, scale, flexibility and our partnership approach to relationships.”

Farr at Apollo agrees that there is a need to address the erosion of deal terms and the enhanced need for underwriting discipline.

He says: “We focus on good credits that we expect to perform in the near-term, we partner with our best sponsor relationships, and we look for deals where our domain experience can give us a competitive advantage.

“In evaluating more aggressive deals, we want to see good credit quality, significant equity cheques, and typically emphasise things like cashflow sweeps, restricted payments and limitations on debt.

“Basically, we look to draft credit agreements that bring borrowers back to the table based on performance, corporate activity and general M&A. And we’re examining any issues or historical gaps in credit agreements that could impair seniority in the future.”

ESG minded

He says the firm also continues to discuss ESG-type pricing and adding pricing step-downs to slow refinancings when credits exceed expectations.

The need for credit managers to up their game on ESG has been a significant theme in the first half of 2021, in part driven by the advent of the EU’s Sustainable Finance Disclosure Regulation pushing the asset class to take a more uniform approach.

Another theme has been a renewed spotlight on the private debt secondaries fund market, which has been growing slowly for some time. Bender at Ropes & Gray says: “We see growing interest in secondaries strategies, with funds being raised to acquire interests in other credit funds and potentially GP and manager stakes.

“Credit secondary funds really haven’t taken off in quite the same way as in private equity in part because the tax structuring around them tends to be quite complex, but people are very interested in getting into that space and figuring out how best to manage that and other challenges unique to credit.”

In April, Apollo Global Management announced the launch of a new credit secondaries unit, co-headed by former Goldman Sachs partner Earl Hunt. The firm’s $1 billion of initial capital comes from its insurance clients, with a third-party fund slated for some point in the future.

In the next 12 months it looks like scale will continue to be a dominant feature of a bullish private credit environment. DeVeer says: “We believe private credit managers will continue consolidating and scaling to serve as a one stop shop for investors.

“We believe scaled, multi-strategy alternative investment managers can drive outperformance and differentiated returns by sourcing unique opportunities across asset classes through a large, global origination footprint.

“With respect to the credit markets, we believe large-cap sponsors and upper middle market issuers will continue to favour a private financing solution over broadly syndicated facilities. We see this as a permanent trend in the market as issuers favour more flexible, partnership-oriented investors in their capital structures versus the syndicated bank market or the high yield market, where there is less certainty and less flexibility.”

The past 12 months may not have been plain sailing for alternative investors, but private debt funds have proved their worth as agile, supportive partners to both sponsors and management teams, and can expect to reap the rewards with heightened dealflow for some time to come.

Healthcare and tech are the post-pandemic favourites

With direct lenders always keen to focus on defensive, non-cyclical industries it is perhaps little surprise that two covid-resilient sectors came to the fore over the past 12 months in the shape of technology and healthcare credits.

As both demonstrated their ability to withstand an economic downturn, sponsors piled into deals in both industries, with a record $80 billion spent by private equity firms on companies in the global tech sector in the first quarter of 2021 alone, according to Bloomberg. The rapid acceleration in tech adoption across every industry has driven up valuations as businesses have far exceeded growth expectations.

“Consistent with our focus on high free cashflow, non-cyclical companies, the largest two industries for our commitments this year to date are in software services and healthcare equipment and services,” says Kipp deVeer, head of credit at Ares Management Corp.

“Within our diversified portfolios, we tend to be overweight in the software and services, healthcare services, commercial and professional services and consumer durables industries. We believe these sectors are currently the most attractively positioned industries and sectors of the economy.”

While the healthcare market benefited from its own technology transformation, private equity interest in the sector was also at an all-time high. Not all parts of the industry appeal to lenders, with some getting their fingers burned on physician practice management companies where state regulations can limit the protections available to creditors.

But with the sector accounting for 18 percent of US GDP, the need for continued innovation, efficiency and scale across healthcare is driving significant sponsor interest going into 2022.