Given the weight of capital that has flowed into private debt in recent years – especially into primary direct loans – it’s easy to forget that the asset class is still the youngest member of the alternatives family. Although there is some talk of it heading towards maturity, all the muttering about late cycles, intense competition and questionable underwriting suggest private debt may well be at the grumpy teenager stage of its development.
It is no great surprise, therefore, that the secondaries market in private credit is nascent. According to research from Canadian investment bank Setter Capital, the trading of stakes in private debt funds was worth only $1.5 billion last year – a drop in the ocean compared with the $70.2 billion of activity in the far more mature private equity fund stakes market.
A major factor is the long-prevailing benign environment in which private debt capital has been deployed. Funds have been able to ride the wave, having been spared the tougher times that may have forced more activity in the secondaries market. But predictions of trouble ahead have rarely been more widespread, and that’s why some observers are tipping private credit secondaries to be a trend to watch out for.
In our Future of Private Debt report, part of PDI’s soon-to-be-published November issue, Ken Kencel of Churchill Asset Management identifies what he believes is the most exciting development in the asset class: “We are seeing a secondary market emerge for private credit fund interests. Given the income dynamic of these investments, the market could develop significantly.”
In a Friday Letter two weeks ago, we reflected on the demand from LPs for direct lenders to focus on operational resources in readiness for possible challenges ahead. If loans do begin to struggle, throwing internal resources at the problem to preserve value would certainly be one way of responding, and many GPs are in hiring mode for just such an eventuality. There is, however, another possible response, which would be to simply sell the loans on to others – even if this meant accepting a discount.
Market protagonists in Europe say an uptick in loan sales is already taking place; that opportunities are arising in UK retail, with Brexit, higher material costs, increased minimum salaries and a hike in business rates combining to produce a perfect storm. Some managers are seeking to sell out now while the financial hit is still reasonably tolerable. And it’s not just the UK – Germany is another market where secondaries players detect signs of promise.
Many of the sales are emanating from banks’ loan books rather than debt funds’ portfolios. Give the market another year or two, some say, and that will change. With debt funds already having claimed a large slice of the primary market, it seems reasonable to expect the same in the secondaries market. Moreover, sources say there’s no reason why the market for trading LP fund interests shouldn’t also begin to pick up.
It’s possible that 2020 could be just another year in the safe and steady evolution of private debt. But add a bit more volatility into the mix and it could also be the year when private debt secondaries come of age.
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