The sense of a market feeling its way through a new set of economic realities is apparent in Private Debt Investor’s fundraising figures for the first half of the year.
Just 41 North American private debt funds closed in the first half of 2022. Despite this, the amount of capital raised by the asset class in the first six months of the year was still up on 2019 levels. The average private debt fund size stood at $1.1 billion, far above the $730 million recorded in 2021, and half of all the funds that closed exceeded their fundraising target.
While the number of funds closed in the first half is equivalent to a quarter of the number closed in 2021, PDI data shows investors are still willing to back sizeable credit funds, with a total of $48.2 billion raised, versus $51.4 billion in 2021.
Advisers say many LPs have pressed pause on their allocations and processes are taking longer, but the private credit asset class remains attractive to US investors.
Lorna Bowen, partner and chair of the US investment management group at Debevoise & Plimpton in New York, says: “It’s fair to say we are involved in quite a few fundraisings right now that are just limping along.
“Over the last 12 months, a lot of the products we have launched with clients have got to the finish line, but it has been a grind. But then there are plenty of others that have been very quick to launch, very quick to raise, and then bringing out the next vintage at a brisk clip. Across the market as a whole there is certainly more hesitancy.”
Many expect the pause to be temporary as LPs deal with challenges across their portfolios.
“Investor sentiment has shifted over the past few months as the macro environment has changed,” says Jess Larsen, founder and CEO of Briarcliffe Credit Partners. “The sell-off in public equities has caused the denominator effect in private markets allocations to look relatively overweight and liquidity to be a bit constrained. Many LPs are prudently pressing pause to evaluate how they’ll approach this new market environment.
“Some investors are considering the secondary market if they are overallocated in the primary market, or putting a hold on investing until the denominator effect reverses. Others think the private markets are the best place to be, given public market volatility, and are rotating into safer harbours like private credit.”
One interesting dynamic is a growing appetite for European funds among US LPs, who are keen to take advantage of currency differences.
“We are definitely seeing increased interest from US investors in European strategies, primarily because of the currency situation where the euro and the pound are low against the dollar,” says Campbell Lutyens’ Griffiths. “If you invest in a European fund denominated in euros and swap back to US dollars, you get a significant pick-up in yield because the dollar interest rate curve is higher than the euro interest rate curve. That is pushing US investors into European funds, because they see this as an attractive entry point.”
Larsen says there is increased interest from LPs in secondary trading of illiquid holdings, mainly in private equity, and a private market rotation into private credit where there is strong downside protection and LPs can still meet their internal hurdle rates.
“Many LPs are facing write-downs on venture investments already, so they are looking at private credit,” says Larsen. “While they may not be able to get 13 or 14 percent like in venture, they can get 8 percent with a good level of security and a lot of downside protection.
“LPs are on a pause so we will see a slowdown for the next few months, but after that we will see a real acceleration. The macro environment changed very fast and all the issues coming out of venture capital funds gave LPs a lot to deal with in their portfolios.”
Jeffrey Griffiths, co-head of global private debt at Campbell Lutyens, argues that investors in private credit are not unduly worried. “On the investor side, we are not seeing significant concern about the economic environment, which is good. Some investors are saying that moves in the valuations in their publicly traded portfolios are leaving them overallocated to private markets, but that is more of a problem in private equity right now. It could become more of an issue for private credit.
“The trendline is for pension funds and insurers to be increasing allocations to private credit over time. As a result, the fact that the denominator effect is kicking in is less of an issue because the tailwinds are in favour of increased allocations. But that is not a fast-moving shift, it is moving in small increments.”
Griffiths adds that with many of the pressures and excesses now coming out of the market and interest rates rising and credit spreads widening, the credit market is becoming “a bit more normal”.
“Comparing private equity and private credit, the value attribution is moving from the equity side to the credit side, so credit is going to be a relative beneficiary of the current market,” he says. “Fundraising will slow as deal pace slows, but the pace of fundraising has been such that LPs were struggling to keep up, so a little slowdown is no bad thing.”
Griffiths argues that the reality is that there has not yet been a significant pullback in dealflow on the manager side, because there is actually an increased opportunity set at the upper end of the market as the liquid credit markets become more difficult and, in the mid-market, a steady stream of deals continues. Still, dealflow and fundraising may yet slow further.
On strategies, the data shows that senior debt strategies remained the most attractive in the first half of the year, accounting for 44 percent of fundraising. A further 41 percent went into subordinated and mezzanine debt, while 11 percent targeted distressed.
“There is definitely a demand for managers that can capitalise on a choppy and uncertain market, so opportunistic credit and special situations are strategies that are getting a lot of interest,” says Larsen, adding: “Institutional investors are asking for strategies that are uncorrelated from public equity markets, which can come in many forms. Speciality finance is still popular, as are inflation-proof goods, like basic food.”
At Debevoise, Bowen says: “We have seen a shift away from traditional mezzanine strategies, where returns seem to be more challenging, as opposed to mezzanine being part of a broader opportunistic credit platform. And we have seen a growth in more asset-backed strategies because there has been a better return profile for those products.
“One big theme in the credit space has been an ongoing pressure to address traditional closed-end illiquid strategies. There has been a clear uptick in demand from high-net-worth and more retail-type investors for private credit, so an issue has been how to deliver these less liquid credit strategies with some enhanced liquidity for the retail market. It is pretty tough to sell something that is locked up for five to six years to that audience.
“Whether it is originated lending, special situations or opportunistic private credit, the question of how you can deliver those strategies in a platform that facilitates on-demand liquidity for a retail or retail-adjacent market is a big one. There is definitely demand there.”
Griffiths at Campbell Lutyens says there is less interest from investors in core direct lending, as a lot of US investors have reached their allocation limits. Instead, they are looking for higher octane credit strategies that can help boost returns in an inflationary environment.
“Where we currently see investor demand is for higher returning credit strategies, so special situations funds, capital solutions funds and growth capital funds,” says Griffiths. “There is a lot of demand for funds that can offer 15 percent plus returns, where you can get paid for taking additional risk and where there is an opportunistic angle that can be exploited to take advantage of dislocation.
“We are seeing a lot of interest in technology and growth right now, which have been impacted by drops in equity market valuations and turned from equity to debt opportunities. Investors are attracted by taking exposure through debt, with downside protection, rather than more potential of losing capital in equity.”
Bowen says: “Opportunistic credit saw a massive rush at the beginning of covid because there were a lot of opportunities in the market for people that could get into that quickly. Now, there is a lot of capital waiting in the wings, and a lot of lessons have been learned about getting those products up and running rapidly. Lots of people are now looking at the economy and trying to time that dip in the market.”
Griffiths sees little demand in the US fundraising market for ESG and sustainability products, compared with Europe. “That will change over time and ESG will become more of a factor for US public pensions, but for now it is not really factoring into investment decisions. US investors tend to feel their primary responsibility is to invest to get the best returns for their stakeholders,” he says.
Overall, despite a current slowdown in new funds closing, US investors remain bullish on the private credit asset class. Larsen says: “Short term, we will see a slowdown in allocations but, once LPs have gone through investment committee reviews, we can expect an acceleration.
“This environment really shows how important it is to have a good proportion of your capital in an asset class with downside protection that can still deliver the returns you require. We are continuously seeing LPs shift a proportion of their fixed income allocations into private credit because it delivers the returns without the mark to market volatility.”