Taking extra credit

As the private debt space becomes more competitive, funds are increasingly taking on leverage. A problem? Not necessarily, but it’s a situation fraught with irony.

Fire up your time machine and take a trip back to 2012. A senior debt fund has just finished its first round of fundraising, telling investors to expect returns between 7 and 8 percent. 

Fast forward to today. New entrants to the senior loan space have made competition fierce. Pricing is coming down, and that expected return looks less likely. How do you ensure the expectations of investors are met? 

One option is “stretching the senior” – adding a slice of unitranche or even mezzanine debt to an otherwise senior debt portfolio. It’s something some funds are already pursuing. According to a recent report from bFinance, the majority of European senior debt funds include a unitranche instrument, and in some cases, have up to 80 percent of the portfolio invested in unitranche. 

The other option is seeking out leverage as a way of boosting returns. With senior debt investments providing predictable cashflows, fund managers should be able to find willing creditors in banks. 

Institutional investors should by now be used to investment managers making use of leverage to aid returns. In fact, one of the signs of a successful financial market, arguably, is the appropriate and sensible use of leverage. Equity managers regularly buy stocks on margin, and many alternative fund products borrow money with a view to bolstering performance. 

An issue may arise, however, when these two scenarios intertwine with one another. When the leverage in an investment product causes issues, it’s usually a symptom of investors not understanding or appreciating the underlying risk-profile of an investment product. 

Additionally, the more subordinated debt there is in a portfolio, the more the risk exists of the cashflow of the fund becoming altered. This obviously has implications if it affects a fund’s ability to pay back money it’s borrowed. With lending banks ranking most senior in a non-performing situation, the knock-on effect to a fund’s investors could be problematic.

Turning attention to the providers of this leverage, the banks, there’s also a peculiar irony involved. If funds can enhance their performance by borrowing from banks, they can bring their prices down for senior debt.
Unwittingly or not, by providing credit to credit funds, banks are making alternative lenders more competitive in an area they have traditionally occupied – the extension of senior loans. 

Also worth a smirk is the fact that, by lending to debt funds, banks are exposing themselves to deals and borrowers they have been retrenching from. It may be fair to say while banks are unwilling to take on exposure to individual deals, there isn’t an aversion to having exposure to a cluster of borrowers.