This article is sponsored by Dechert
In early October, PDI staged a roundtable in London with five leading women in private debt to hear their thoughts on areas such as competition, the stage of the cycle, regional comparisons and diversity issues. The fruits of the discussion are reproduced below.
What are the opportunities and challenges in private debt today?
Vanessa Brathwaite: The main opportunities are coming from the big flow of assets under management into the asset class that we’ve seen in recent years and the ability to raise funds and deploy capital. Earlier this year, we closed our fourth generation of direct lending funds with more than €2 billion. We also see commitments coming from a very diversified international investor base. So I think it still remains very attractive as an asset class for investors, but also for borrowers.
If you look on the loans side, you see a big trend from bond to loan issuance. The supply is good and should remain that way. I think one of the main challenges we’re facing in the segment of the market that I operate in, mid-market loans, is the re-emergence of competition from banks which, of course, had all but disappeared. Indeed, the retrenchment of banks from the market is what gave birth to direct lending and now we see them popping up again.
In club deals in Europe, especially in Spain and Italy where their banking regulation is at a different stage, we compete with banks – more so than in France and the UK where the private debt market has been around for a while and is a bit more mature in terms of everybody understanding where they get value.
Caroline Mortimer: I would highlight increased competition and the impact that is having on the legal documents because there is a lot of competition and a lot of pressure for lenders to accept precedents and agree to flexibility and, on day one, when everything is going well, people don’t necessarily focus on a portfolio company underperforming.
As a lawyer and as an investor, you really do have to expect the unexpected and make sure that the legal documents are robust. When there is this competition and pressure, we have to make sure we stay diligent and don’t just accept anything to win a deal. Precedents get continually rolled out and what appear to be little things chip away at the protections that lenders have. It is really important that we keep pushing back.
Zeina Bain: The big change is the sheer amount of equity content in these deals. Valuations have gone up ahead of leverage ratios, so the equity cushion, if you look at historical precedent, is much higher now – in terms of getting 35 percent or 40 percent equity – than a decade ago. So, while covenants are an early warning signal, the equity investment professional will look for the warning signs that the investment case is not panning out well before the business gets anywhere near a covenant problem.
Given the growth that’s often being signed up for to underpin the equity case, the equity investor is stressed way before the lender needs to be. Clearly one can dictate aggressive terms on big deals given the large fee pot that makes them attractive. However, when there is such a big equity cushion, lenders can take some comfort that the sponsor has significant conviction and focus.
CM: The amount of equity in a transaction is important from a commercial perspective but it’s key for the investment team that the documents work as we all expect them to – in the large-cap market there are high-profile examples of flexible documents being manipulated, for example, with cash leakage such as disposals and dividends coming from a source that wasn’t originally anticipated. You see that less in the mid-market, but these large-cap concepts are creeping into term sheets and we have to resist.
Vanessa Brathwaite, senior portfolio manager, Tikehau Capital
Brathwaite heads the senior loans business at Paris-based Tikehau. She reports to Tikehau private debt co-head Cecile Mayer-Levi across the three areas of private debt, direct lending and CLOs, where Brathwaite manages funds including unlevered loan funds and some managed accounts. She invests in high-yield bonds, broadly syndicated loans, club deals and unitranche.
“I think one of the main challenges we’re facing in the segment of the market that I operate in, mid-market loans, is the re-emergence of competition from banks”
What about the late-cycle talk? Are things already turning?
Marianna Tothova: We have been hearing for the last few years that things are going to slow down and clients are worried about the possibility of a downturn. We hear from our clients quite a lot wondering what they should do. ‘I’m raising a new fund with some liquidity features, what liquidity issues might I be facing? What should I be focusing on in the documentation?’
Over the last six months, we have prepared lists for our clients of what they should be aware of in the fund documents. For example, we have been working on quite detailed gating mechanisms so that our clients can carry out whatever they have promised their investors in the case of a downturn.
Mikhaelle Schiappacasse: One thing that might indicate the market thinks we are coming to the end of the cycle is that more managers are talking about establishing funds pursuing distressed strategies, including special opportunities funds. In other words, they want to be ready to take advantage if the market falls.
I’ve heard, although haven’t seen it myself, that there are a couple of managers who went into the market with that strategy and have run into the problem that the cycle hasn’t turned yet and now the fundraising period is closed and there are limited opportunities to deploy funds in accordance with the strategy. It’s a bit of a chicken and egg issue because you need lead time to get this type of fund up and running, but if you move too soon you won’t be able to invest effectively.
Marianna Tothova, partner, Dechert
Tothova focuses her practice on private funds investing in various asset classes with a focus on debt and private equity for both first-time and established managers. She also advises on UCITS and other retail funds and, generally, on fund and asset management-related regulatory compliance. She has over 12 years’ experience providing clients with advice on areas such as structuring, mergers and liquidations of investment funds.
“If the cycle changes, it’s going to be a real test for private debt managers to see what will need to be done in terms of restructuring”
As well as distressed, is it also time to shift from corporate towards consumer, or towards real assets or speciality finance?
VB: We do see a lot more interest in those strategies within Tikehau. Our real estate and private equity businesses have been growing. Although I have to say we still see a huge amount of interest in direct lending because we are very well established and were a pioneer in that segment of the market. But I also think it’s right to have some diversification if you think you’re going into a late cycle. It makes sense to have a broader allocation. I’m not sure that peer-to-peer lending is going to be as big a threat as we thought given the regulatory scrutiny there now and volume will remain limited.
ZB: In my mind there are two other drivers. One is you’ve probably seen bifurcation between listed private equity firms and non-listed ones but, in that search for larger AUM, a diversification strategy is one way of growing it rather than just making each fund bigger. And the second is that as LPs have more and more to deploy, they want more of a managed account type solution where an investment manager can be a one-stop-shop across different asset classes.
Zeina Bain, managing director, Intermediate Capital Group
Bain joined ICG’s European subordinated debt and equity team in April. She was with Carlyle Group for 18 years, where she was managing director in the European buyout team responsible for deal evaluation, origination, execution, document negotiation, portfolio monitoring and monetisation. At ICG she focuses on seeking opportunities for the European investment strategy.
“Europe has open and closed windows, whereas in the US you will typically find a clearing price and the market just stays open unless there’s an extraordinary event”
What similarities and differences are you seeing between the US and Europe?
ZB: There is more homogeneity in the US compared to Europe. If you look at how distinctive Italy and Spain are, you realise each European country is practically its own market, whereas in the US it is so transparent and there is equivalence across the whole market. There aren’t these pockets of differentiated structuring or where you have banks being as much of a genuine ‘take and hold’ alternative to debt funds.
Point number two is that in Europe you have variation according to fund currency, so sometimes sterling is popular, sometimes incredibly unpopular because if the European funds are looking at a sterling deal they’ve got FX risk to think about and Brexit has only exacerbated that. You do have points in the cycle where everyone would love to do a sterling deal but they’re becoming fewer and further between.
The third point is the US market has that sheer level of liquidity and, just as you’ve found with the IPO market in Europe versus the US, Europe has open and closed windows, whereas in the US you will typically find a clearing price and the market just stays open unless there’s an extraordinary event. So, if you’re a reasonably large issuer, the US market is your first go-to because you know it will be there.
MT: Currency is obviously an issue for many fund managers. LPs want to invest in a number of different currencies and across different markets and the manager must somehow manage that currency mismatch at the fund level. This is one of the difficulties of the European market, but also one of the opportunities: you need to know the local markets in which you are going to lend and it can give you a great advantage if you know, for example, the Spanish market.
CM: Any investor working in Europe has to be an expert in each individual jurisdiction – we need to have a thorough understanding of important issues such as withholding tax, financial assistance and local insolvency laws. The legal landscape is constantly evolving and we need to be confident as investors that we can exercise our contractual rights.
Mikhaelle Schiappacasse, partner, Dechert
Schiappacasse’s practice focuses on the structuring, establishment, management, marketing and restructuring of fund platforms and investment funds, including hedge, debt, real estate, private equity and funds of funds across a range of asset classes and fund domiciles. She also provides investor-side advice in connection with investments into a variety of fund structures.
“To some degree, it’s the infrastructure that exists in the industry that is naturally biased against change, not necessarily the people but the structure”
Is there sufficient diversity in private debt and, if not, how does that get addressed?
CM: Being an in-house lawyer, I have experience from being in private practice at a law firm where women are very well represented at the trainee, junior and associate level and actually quite well represented at partner level.
As a client, it’s very rare for us to be represented by an all-male legal team and it’s great that we don’t see that as an issue. In private debt for in-house lawyers and the investment team, again women are well represented at junior and mid-level, but at senior level I think it’s probably fair to say that more can be done. There has been a lot of progress that, so far, has been focused on flexible working for mothers, but only talking about childcare for mothers is massively outdated because flexible working should be for everyone.
The statutory right to shared parental leave has been helpful but I think the more forward-looking businesses will give equal pay and benefits to working fathers taking parental leave as they do to working mothers. In addition, now that businesses recognise how valuable women are in the workplace, it’s really important to acknowledge that women aren’t great at self-promotion and don’t always have the self-confidence to succeed. It’s those aspects that need to be addressed with coaching, mentoring and training.
MS: I think on the service provider side of the industry, such as legal and audit, there is more equality in terms of gender diversity, certainly than when I started. It’s still not complete. I could be wrong as I do not really have a window onto the portfolio management side of the industry, but I have observed a couple of things.
One is that when I go to conferences, unless you’re looking at service providers, it’s still 90 percent male. Part of this is probably that there are entrenched networks. Being successful in the industry is still very much about who you know and it’s still a bit of an old boys’ network.
Also, with closed-ended fund products, performance fees or carry pay out over an extended period and those there at the beginning of the life of the fund are more likely to benefit than those more junior team members joining later, who might be women or otherwise diverse. To some degree, it’s the infrastructure that exists in the industry that is naturally biased against change, not necessarily the people but the structure.
VB: I’m in an extremely fortunate position that all the senior portfolio managers or heads of business in private debt at Tikehau are women. So when I get asked this question, it’s a bit difficult. But we’ve all been in the market for 20-plus years.
ZB: I think for the past 17 years when I’ve been working in European leverage buyouts, the ratio of female private equity directors and above on the investment side has been less than 10 percent.
The industry is opening up. What can firms do? What they can do is look hard at how they promote people, how they mentor people and whether they are making sure people have a voice that gets heard. But it’s also a very personal choice: when juggling family and an intense job, one has to accept that you cannot apply the same perfectionism you bring to your work to your home life.
Another aspect is societal change. Previously if anyone on a conference call said, ‘I’ve just got to step out now because my kids are piping up’ or ‘I can’t do this anti-socially timed Sunday phone call because of family,’ you’d have tittered. Now both males and females accept that and that’s a massive change; you don’t have to pretend you have no life outside work.
VB: I think in the UK there’s been a lot of focus on getting more women into the industry and these things are evolving, but in terms of other issues of diversity, of race or even cognitive diversity … I’m not sure that cognitive diversity is changing very much. We are fishing in all the same pools for all the same people and that is something we need to think about as an industry.
Caroline Mortimer, director, Barings
Mortimer trained as a lawyer with Hogan Lovells and six years ago joined Babson Capital, which was merged with other entities within the Mass Mutual Group. She is responsible for private debt, including the structuring of Barings’ funds and working with colleagues on the execution of transactions. Mortimer focuses on private debt at Barings, which also has high-yield, liquid loans, real estate, alternatives and equities teams.
“When there is this competition and pressure, we have to make sure we stay diligent and don’t just accept anything to win a deal”
What key issues will we be talking about in private debt’s future?
VB: The private debt market has been around for a while but there is more of a regulatory focus on it. To date it’s been all about people doing what their investors asked them to do and structuring funds how they want to, but I think going forward it will be similar to other asset classes in being asked for more regulatory reporting. I think the upcoming changes to Solvency II will kickstart that whole process.
ZB: The blurring of lines between equity and debt is a key development because investors are looking across the whole risk/reward spectrum as opposed to one narrow deployment strategy. This encourages other strategies including core, core-plus, infrastructure or long-term rather than classic control leveraged buyouts – everything is just part of that spectrum.
Hitherto you’ve seen equity investors diversifying into debt. I think there’s space for it to go the other way around, as is the case for ICG, leading to the emergence of crossover capital as an increasingly important part of the investment strategy. Why? Some businesses are getting more mature and that sort of solution makes more sense than trying to make 3x on a fairly mature buyout. There are families, founders and CEOs who don’t want the classic buyout with a three-to-five-year timeline, they want a more long-term, partnership-type investor.
MS: We’re starting to see more multi-asset hybrid fund structures – structures that are trying to mix long-dated assets with short-dated assets and it is quite difficult to deal with the potential need to meet liquidity requirements of investors while at the same time dealing with the risk that a particular position will need to be held to maturity.
So there’s a lot of hard work around structuring, and managers are either moving from a more stereotypical hedge fund structure into a closed-ended product with various liquidity management tools built in, or from more of a closed-ended structure but building in a mechanism for early withdrawal such as withdrawal proceeds being paid out on a run-off basis or some kind of evergreen mechanism. I would guess that this is likely to increase in the future because the investor group interested in investing in more illiquid assets is broadening.
CM: 2020 will be all about ESG. The commitment to ESG is already there in many businesses – the employees drive it and the investment team drives it but now demand is coming from LPs. This means that we need to be more formal in how we document our commitment to ESG and we have to demonstrate to LPs how we are applying ESG in our everyday investing.
MT: I’m quite curious about how the regulation is going to evolve at the EU and national level given the importance of private debt funds in the real economy and direct lending and how that’s going to impact the deals that managers will be able to do in the future.
Obviously, there’s more firepower and the possibility to do bigger deals. I think it will be interesting to see the effect of much more money and much more competition in certain markets.
But I’m also wondering whether there will be a push to get into markets that are less developed and where there is less competition; maybe certain markets outside of Europe. If the cycle changes, it’s going to be a real test for private debt managers to see what will need to be done in terms of restructuring and whether certain managers will, for example, take equity positions. Those are all things I think that might be interesting in the coming years.