As GPs and LPs gathered in London for the PDI Capital Structure Forum, discussions ranged from more theoretical topics, like the future of the asset class, to the more pressing issues of contemplating what a distressed cycle might look like in an era of non-existent covenants.
Below we’ve pulled out six takeaways from the annual conference: three points for GPs and three for LPs.
What GPs should know:
To tap DC money, credit managers will need to be flexible
Defined contribution plans, potentially huge sources of untapped LP money, are finally starting to look at private markets, most notably with the UK’s NEST pension scheme, which last month selected BNP Paribas Asset Management to manage a multi-strategy account that included infrastructure debt, real estate debt, US and European mid-market loans and UK SME loans.
The Law Commission investigated the need for daily pricing and liquidity for DC schemes, often cited as a barrier to private market investment, and found that there wasn’t a need for daily dealing, Maria Nazarova-Doyle, Mercer’s market engagement leader for DC and individual wealth, told the audience.
“There has to be product development to be able to have private markets do for DC what it does for DB,” she said, noting that the limitation has partly been cultural. She added that DC assets are set to surpass defined benefit plan assets.
There is also a fee cap of 75 basis points for the total plan, which makes existing private fund fee structures incompatible with the UK DC contributions. Trevor Castledine of Crescent Consulting noted though that a third way might exist: fixed-rate fees that are higher than a management fee.
“The entitlement to a performance fee has irritated me for years,” he said, suggesting the implementation of a negative performance fee as a possibility: GPs would start out getting the full fixed-rate fee but any losses would detract from that charge.
While GPs would likely prefer the upside of an incentive fee over a hurdle rate, access to DC retirement plans could be too large for the industry to ignore, and a fixed-rate fee would be a new form of investor alignment that DC plans might be able to get behind.
Mid-market lending returns aren’t exactly thrilling to LPs
Post-global financial crisis, direct lending provided a particularly attractive risk-adjusted return; there were few people doing it, allowing credit managers to charge higher prices with better documents. Nowadays, that story is much different.
Simon Davy, the head of private markets at Local Pensions Partnership, said his firm is reorienting its private debt portfolio from the mainly distressed debt and direct lending strategies to include more asset-backed and structured strategies. Mid-market lending returns have been less attractive lately, he added.
“Many are over-promising,” Connection Capital head of funds Lorna Robertson said. “[There are] a lack of people with enough experience to know what to do when it all goes wrong.” Robertson noted that the appeal of senior debt’s risk-adjusted return has faded recently.
Niels Bodenheim, a senior director at research firm bfinance, suspected LPs are becoming more astute as to what affects their ultimate net returns in private markets. Investors are starting to look at such factors as origination fee skimming and tax structuring costs as factors that could eat into their returns.
Developing an EM presence is a years-long slog
The Canada Pension Plan Investment Board is a household name among North American and European credit managers, but it is only just beginning to develop a presence in emerging markets. The credit team began working in offices in Sao Paolo, Mumbai and Hong Kong.
“Credit is a laggard to be moving into EM,” CPPIB senior managing director and principal credit investments head John Graham said. “Part of it is EM are not a typical credit market, they tend to be equity markets.”
Such an undertaking isn’t for the faint of heart though. CPPIB has relied on relationships it has built through partnering with local financial advisors and local counsel. While CPPIB mainly does direct investing on the credit side, committing capital to third-party commingled funds is central to credit’s EM push at the organisation.
What LPs should know:
Distressed should be a ‘grind-it-out’ strategy
Over the last decade, distressed debt managers may have had to get creative in where they find their deals, but that doesn’t mean the investment process should be right-brain activity.
Zachary Lewy, founder and chief investment officer at non-performing loan investment firm Arrow Global, noted that distressed investing should be a process focused on machinations and consistency.
“Distressed should be a grind-it-out style,” he said. “If an LP leaves a meeting with a GP feeling inspired, the wrong side of your brain has been stimulated.”
He pointed to NPLs as a matter that shouldn’t be particularly inspiring. For a loan portfolio to reach such a stage, there had to be a string of failures along to the way: the borrower would have to let it fail, the bank could not fix it and neither could a court, so the bank decided to sell it.
Instead, Lewy said, distressed investors should aim to generate alpha through one of three ways: financial engineering, an operational advantage or an informational advantage. The first way is the easiest to do but also the easiest to miscalculate from a timing perspective, he said.
GPs can also be more transparent with investors about the risks they are taking by discussing any operational and informational advantages, or lack thereof, he said.
Today’s covenants could result in tomorrow’s lower recoveries
The lack of teeth in covenants, or a complete absence of them, in deals structured this cycle may have helped lenders win deals, but if a situation goes sideways, it may not end well.
Romain Cattet, a partner at Marlborough Partners, said that in the private debt markets, when a lender can get involved in a distressed scenario has changed drastically. Previously, a covenant would be tripped and there would be six to 12 months to put a company back on the straight and narrow. Now, the company may be headed straight into an insolvency proceeding, he said.
Liquidity will end up being the issue for these borrowers rather than covenant trips, Sabrina Fox, an executive advisor at the European Leveraged Finance Alliance, said. There will be little value left when lenders can enforce their rights.
Make sure GPs are ‘cycle-proofing’ their documents
Private equity firms began preparing for a downturn a long time ago by pushing for flexibility in loan documents, Fox said. Pushing for the ability to add extra debt onto a portfolio company or other similar provisions gives private equity managers the ability to maneuver in a laissez-faire manner.
“Private firms are looking to cycle-proof their documents” by negotiating flexibility, she observed.
She said lenders should look to “cycle-proof” their documents as well, particularly by ensuring they have a consistent information flow and fully understand a loan document’s covenant: how might a specific provision come back to haunt you?
“One aspect that is a greater focus today is documentation,” Golding Capital Partners managing director and head of private debt Abhik Das said. “Beware of any GP that is not willing to share a credit agreement with you.”