There is no question that the senior debt market is a fashionable space at the moment. It is a simple matter of market dynamics that LPs are increasingly turning to the strategy as they crave yield in a low-interest environment.
But those working in the industry are increasingly concerned that a number of “unqualified participants” are entering the marketplace.
One fund of funds manager, with almost two decades in the alternative investment space, is particularly concerned that the “overcrowded market is attracting providers not considerate of the risks involved”.
“There is a lot of capital that has been raised quickly in the senior market, but it is an extremely difficult strategy to manage well. It is a market of excesses and is being pushed forward by a lot of very unqualified participants.”
He declined to identify any firms he would describe as not fully understanding the risks of lending in this area of the market, but said he saw a lot of overly borrower-friendly structured deals when he worked with sponsors sourcing debt.
“I hope it doesn’t crash, but it has all the characteristics of a market that is expected to fail,” he added.
Lending in the European mid-market is still heavily bank dominated, but the trend is shifting in favour of alternative lenders. Private equity sponsors are increasingly turning to institutional capital to refinance an existing portfolio company’s debt or the acquisitions of others, despite the increased cost compared with bank debt.
The competition among lenders, however, especially between funds with huge amounts of capital to deploy, has meant a reported rise in cov-lite structures increasingly becoming the norm.
“It is difficult to make generalisations about private debt funds since there are so many strategies, but one of the key drivers in firms pursuing riskier deals is that the amount of supply is outstripping demand,” said Matthew Cox, a finance partner at law firm Ropes & Gray.
For debt fund managers not to be drawn into underwriting riskier deals, firms need an edge in their origination capabilities. Hermes Investment Management launched its own senior debt investment product in September and has partnered up with the Royal Bank of Scotland, whereby the bank’s sizeable deal team supplies the firm with opportunities.
Patrick Marshall, head of private debt and CLOs at Hermes, said that “funds without a clear origination strategy and limited transaction flow are potentially forced to deploy into the few transactions that are visible to them” and that working with RBS allows it to “see the majority of UK market transactions”.
The groundswell of investors shifting allocations to private debt has meant the market has matured at a rapid pace. Where a network of managers, advisors and lawyers were required a couple of years ago to advise investors on the benefits of the asset class, that is no longer necessary as even some of the more conservative pension funds increase their exposure to private debt.
“Like in the aftermath of an earthquake, there are some tectonic plate movements in the market with large investors convinced that the current market conditions offer an attractive entry point to allocate part of their fixed income and alternative pockets to corporate debt,” said Cecile Mayer-Levi, head of private debt at Tikehau Investment Management.
She continued: “Many new managers are rushing to this space and seem ready to consider discounted terms for senior loan funds or managed accounts. This is leading to a vicious circle whereby investors are looking for inexpensive managers incentivised only on invested capital and managers ready to marginally agree in degraded credit conditions.”
There is no watertight investment strategy in private debt. Restrictive covenants and experienced teams may help guard against riskier deals, but the inherent risks involved mean there is always the possibility of never getting your money back.
But if LPs want some guidance, Cox said that “track record and past performance is really important in distinguishing alternative lenders in the market,” said Cox.