In a crisis investors flock to safety and, for private debt funds, such safety tends to be found among the senior debt vehicles placing themselves at the top of the capital structure. Although the pandemic has produced a somewhat different economic crisis than those we had seen previously, the way investors have reacted has not really changed.
Fundraising figures bear this out. In 2020 there was significant fall in overall fundraising for private debt. However, senior debt funds held up well, with only a slight fall in value raised, dropping from $61.1 billion in 2019 to $59 billion, according to Private Debt Investor data. The main losers of the pandemic from a fundraising perspective have been distressed and subordinated debt vehicles, both of which are seen as being much riskier propositions than senior debt funds.
Jeff Griffiths, co-head of global private credit at placement agent Campbell Lutyens, says a number of factors are driving investors away from other forms of credit investment and into senior private debt funds. These include both short-term issues linked to the pandemic and more long-term changes in investor behaviour.
“We see investors replacing their traditional liquid fixed-income investments with senior private credit,” he says. “They’re shifting away from high-yield bonds and leveraged loans because you can earn one to three percent more in a private credit vehicle with similar risk. Many of these investors have fixed liabilities and so they need to get more yield to meet their needs.”
There are varying estimates of how much additional yield investors can get from senior debt funds versus public markets. A recent report by the Saïd Business School and fund manager Pemberton estimated European direct lending funds – which are typically senior or unitranche debt – average a 3.5 percentage point higher return than syndicated loans. Nesbitt estimates they return 1.8 percentage points more and S&P LCD estimates the difference is just 0.35 percentage points.
Griffiths says that although superior returns might be achieved in riskier forms of debt, such as mezzanine or subordinated, these can be unappealing for investors. “If you’re subordinated it has been proven that you have a very high risk of losing money, and so you need to get paid a lot for that risk,” he says. “Also, if you’re relying on equity kickers and the equity market is overvalued, as it is today, then it’s not attractive.”
Although there is a lack of clarity over how much more investors are really getting from their senior debt, there seems to be a consensus that they will see better yields. With many pension funds struggling to meet their long-term funding objectives, an improvement in returns is likely to be welcomed, provided it adequately compensates for risk.
When thinking about risk in senior debt, it is also important to remember that this is a diverse form of lending. Although the term ‘senior debt’ may bring to mind direct lending to private equity-backed deals, it can be applied to any transaction where the lender is at the top of the capital structure as a means to protect itself if a borrower gets into trouble.
“We’re starting to see a recognition from investors that this asset class is not just a homogeneous mass,” says Baxter Wasson, co-head of O’Connor Capital Solutions. “There are lots of strategies out there and today we see a lot more awareness among investors of what we do, which is credit opportunities.”
Credit opportunities funds have been around for a while but have sometimes been associated with strategies such as distressed debt or special situations funds. However, O’Connor’s credit opportunities vehicles are focused on investing in senior debt at the top of the capital structure.
“If you’re subordinated it has been proven that you have a very high risk of losing money, and so you need to get paid a lot for that risk”
“In our first fund, 85 percent of the loans are senior secured,” he adds. “This kind of strategy is more about providing a solution for complex situations, but it’s not the same as special situations, which lean towards a capital appreciation strategy.”
He explains that O’Connor is getting paid high yields because it is providing high-value-add solutions to companies with non-standard credit requirements but with low loan-to-value ratios and good covenant protection.
“Predominantly we are also doing deals without a private equity sponsor, though sometimes we can work with financial sponsors when it fits the profile of the kind of deal we are looking for,” Wasson explains.
It is not just credit opportunities funds that can provide investors with the security of senior debt while offering outsized returns and investing beyond the private equity universe.
“There are lots of variants of senior debt in terms of the way the loans are structured,” says Griffiths. “You can have senior loans against much riskier companies and loans that are stretched unitranche and stretched senior. Senior debt can come with pricing of 10 or 11 percent but it’s a much riskier piece of paper.
“Asset-based lending has been one example of a very popular strategy among investors, and we see more senior strategies that are focusing on more than just sponsored lending as a way to diversify away from what private equity is investing in.”
Another area of senior debt which has been attractive to many investors in recent years is private real estate credit. Although some parts of the real estate market have been reeling from the fallout from the pandemic, which has led to deserted city centres and office spaces, senior debt has weathered the storm well and achieved superior returns.
Craig Wilson, partner in debt advisory at Knight Frank, recalls: “As supply in the debt markets fell, senior debt pricing spiked up by 25-150 basis points – depending on the lender’s source of capital and the resilience of the real estate sub-sectors they were lending into – and leverage dropped by 5 percent on average. Debt pricing began to soften in Q3 2020 and has remained largely stable, albeit at a rebased level, over the past six months, while leverage has remained conservative.”
Senior debt in the real estate sector can also benefit from the variety of risk profiles seen in direct lending funds, according to Wilson: “Debt funds may have stronger appetite for riskier transactions, whether higher leverage or more complex, and may offer a more streamlined, and consequently quicker, approach to underwriting and executing deals.”
These features of private debt and its ability to be flexible in its approach to each transaction mean it can generate superior returns while still being a senior-secured product – and, in the case of real estate, secured against a hard asset should the worst happen.
Although safety is crucial in a crisis, investors have never before had so much ability to tailor their exposure to fixed-income in order to take advantage of tough market conditions. Even low-risk private debt funds are able to beat benchmarks by looking at businesses that cannot raise finance elsewhere and making sure the transaction is structured to keep the lender safe.