The emergence of private debt as an investable asset class in the past 10 years has had invaluable benefits for capital markets. What was once the exclusive domain of banks has now been opened to a deeper and broader network of institutional investors, namely pension funds, insurance companies, endowments, foundations, sovereign wealth funds and wealth management firms. The systemic shift of private, corporate credit risk from banks, backed largely by short-term liabilities, to private funds, backed by investors with long-term liabilities, strengthens and stabilises the savings and investment nexus at the heart of developed economies.
The exciting growth of this market presents both risks and opportunities for investors. They should tread carefully, given expectations of future economic turbulence after a long period of sustained growth. Senior secured private direct lending provides a compelling solution for investors seeking to protect their total returns versus both traditional fixed income and alternatives, while sustaining a key financial role in the economy for capital provision to mid-market enterprises underserved by banks.
Origins and growth of the market
In many ways, corporate, private debt is one of the oldest and largest financial assets in the world. Lending directly to companies privately, without a public listing or syndicated instrument, has always been one of the main components of commercial banking activity, alongside lending to consumers, real assets and governments. This market has never really been open to non-bank investors other than through the purchase of bank securities. The tightening of bank regulatory capital ratios via implementation of the Basel accords has curtailed banks’ commercial lending activities in longer-dated loans to highly leveraged corporate enterprises. This particularly applies to the financing of leveraged buyouts, bolt-on acquisitions, dividend recapitalisations and major capital expenditure programmes.
Prior to the opening of private debt markets, institutional investors other than banks were forced to rely primarily on liquid credit instruments to gain exposure to corporate risk. Although sizeable and deep, both the investment-grade and high-yield credit markets limited investors to financing large-cap businesses at tighter spreads than what the private markets can offer.
“There is a growing recognition that lending to non-sponsored businesses should form a core part of a private debt manager’s portfolio construction”
Also, institutional investors, such as pension funds, insurance companies and endowments, have the advantage of long-term liabilities and the ability to invest for the long term, rather than needing to match short-term liabilities with short-term assets. It makes a lot of economic and financial sense for these long-term asset holders to be the principal capital providers for longer duration credit, such as bullet maturity term loans for buyouts or capital expenditure programmes. It does not make sense, from a macro prudential perspective, for deposit-taking institutions, such as banks, with very short-term liabilities, to provide these loans. The structural and regulatory framework, therefore, for banks to exit the corporate, leveraged credit markets, and for institutional investors to enter it, is sound and desirable.
Companies need private capital, especially in the lower mid-market
As the banks retreat from longer-term, leveraged credit exposure, companies that require leveraged finance and are not large enough to issue a broadly-syndicated loan or high-yield bond, have by necessity gravitated to the private debt fund market for capital. Banks remain the main contributors to corporate credit in short-dated, asset-backed and working-capital facilities because these instruments work better from a regulatory capital perspective. However, mid-market businesses that are looking to complete a leveraged buyout, add-on acquisition, major capital expenditure programme, shareholder recapitalisation or dividend re-cap need to approach the private debt fund world for their capital needs.
As institutional investors continue to allocate increasing amounts of capital to private markets versus public ones, the available capital for investment in private equity and debt has increased substantially over the last 10 years. Although initially growing out of a subset of private equity dealflow, growth in private debt is starting to outpace that of private equity. This is because most private, mid-market and lower mid-market businesses are not owned by private equity funds. Businesses owned by families, entrepreneurs or employees, or even publicly-listed ones, also have a need to finance growth with private debt capital. Often these businesses are unable or reluctant to issue new equity to finance this growth, and therefore private debt presents itself as a cost-effective solution.
The relevance of the illiquidity premium
In exchange for taking on illiquidity, private markets should offer investors a return premium over their public equivalents. In the case of private debt, various market estimates of this premium are between 2 and 4 percent per annum. For example, an investor can expect to earn an approximately 6 percent return by investing in the current broadly-syndicated leveraged loan market in the United States. The comparable return in senior secured, private direct lending is between 8 and 10 percent, on a gross, unlevered basis.
“It is important that senior lending is backed by real assets as much as possible. Otherwise, the value of a ‘senior’ facility could be rendered worthless”
The Cliffwater direct lending index has shown that senior private loans in the US have returned about 8 percent since 2010. This compares with an average yield to maturity on the S&P/LSTA leveraged loan index of just above 5 percent for a similar time period (suggesting a 3 percent premium).
Institutional investors with a long-term investment horizon, who do not require a large amount of liquidity in their fixed income allocations, have been shifting portions of their liquid leveraged credit exposures out of public markets and into the private debt markets. This is primarily the result of being able to earn a better return for comparable levels of risk – with the only cost being the assumption of additional illiquidity.
But it is important to recognise the risks in this market for investors. A lot of fund capital has been formed around addressing the financing of businesses in the upper mid-market, or deal sizes in excess of $200 million. Although there are fewer lenders who can commit to larger deals, the competition to complete these transactions is often higher versus what occurs at the lower end of the market. This is especially the case for private equity sponsored deals, where the debt arrangement processes are highly efficient and intermediated.
As a result, pricing is lowest and credit protections are weakest in larger-cap deals, where the financing packages need to resemble more the terms on offer in the publicly-traded credit markets. It is important that lenders at the upper end of the market remain as selective as possible and turn away deals that may be stretched from a leverage perspective and provide unattractive risk-return dynamics versus what is available in the public markets.
Likewise, managers will deliver “alpha” in senior secured lending by loss avoidance, and not necessarily through maximisation of gross returns. Investors should evaluate strategies based on their assessment of whether an appropriate return is being extracted based on the risks assumed. It is not enough to benchmark funds based on their gross or net returns, especially in an environment in which default rates have been so low in the last decade.
Fund managers who choose the right credits, minimise default rates and maximise recoveries will likely outperform those who may build the highest-yielding portfolio but sacrifice on diversity, creditor protections and quality of asset protection. A manager’s philosophy of investment in the current market, and their rigour in implementing it, is arguably a better predictor of future performance in an environment where credit losses have been very minimal.
Finally, it is important that senior lending is backed by real assets as much as possible. Otherwise, the value of a “senior” facility could be rendered worthless. Managers in leveraged credit must lend to businesses that have estimable and reliable recovery values in the case of insolvency or distress. Certain services businesses, such as in the technology sector, are currently commanding high levels of leverage, some with relatively light asset protection. Senior lending strategies depend on a robust recovery value in order to protect in a downside scenario and avoid capital losses, which can very adversely impact the net performance of a fund and wipe out interest income earned in the rest of the portfolio if not properly diversified.
Despite the likelihood of entering more difficult economic conditions in 2020, investors should view private debt exposure – especially well-managed, diversified portfolios of senior secured loans – as offering robust and resilient returns. The high levels of current income earned on portfolios can act as a strong buffer against elevated loss rates. The value of asset protection, covenant enforceability and portfolio diversification are greatest when going into an elevated credit risk environment. Relative to other markets in both liquid leveraged credit and equity alternatives, private debt has proven to provide robust and resilient returns. Investors are fortunate to have this new market as an allocation alternative to navigate increasingly complex markets and protect and preserve quality returns for their stakeholders.
The current market for private debt expansion is not only limited to traditional, private equity-backed deals
There is a growing recognition that lending to non-sponsored businesses should form a core part of a private debt manager’s portfolio construction. This leads to greater diversity in deal selection, and often superior pricing power and robust creditor documentation in non-sponsored businesses. Also, most businesses in the lower mid-market are not owned by private equity sponsors, but that does not make them unattractive debtors to providers of private debt capital. The challenge is opening the non-sponsored market up to capital formation – and encouraging signs of this growth have filtered through the markets recently.
Another growth area is providing not just term loans to companies, but also competing with banks on asset-based facilities, such as working capital loans and equipment leases. Banks often have rigid requirements for these loans, and private debt funds are increasingly seeing an opportunity to provide customised solutions to businesses that have non-standard financing requirements in this area.
Finally, private debt does not only need to be the realm of high-leveraged corporate balance sheets. There is a growing market for investment-grade-type risk financed privately. This would provide investors with an illiquidity premium over investment-grade bonds, rather than leveraged loans or high-yield bonds. The opportunity to provide leverage to most family-owned, mid-market businesses is naturally capped by their often more prudent desire to restrict leverage to a reasonably low level for financial stability.
However, these financings are often not possible due to bank restrictions. There is a very promising market in the making for providing low-levered loans to businesses for mid-single-digit returns in return for a lower risk exposure, rather than only focusing on higher risk, higher return sub-investment grade credits.
Jeffrey Griffiths is a principal at Campbell Lutyens