As we reflect on the impact of covid-19 in the private debt market, the dominant narrative has been the trend towards consolidation of capital in large vehicles managed by established GPs. Despite a broader slowdown in fundraising, larger managers fared relatively well in a remote-only environment, with the median fund size increasing 40 percent year over year and the league tables dominated by record-breaking vehicles raised by the likes of Apollo, Antares, Ardian, and GSO.[i]
This trend has been driven by several factors. In practical terms, LPs have been unable to perform on-site due diligence because of social distancing measures, placing the advantage on GPs with whom LPs have existing relationships. While investors have adapted to the challenges of remote work, there remains hesitation to forge new relationships in the heat of the pandemic.
This dynamic is especially salient for direct-lending strategies, where capital preservation is critical and the upside more limited than special situations or distressed debt. There is limited incentive for LPs to take a risk on a manager who is perceived to be less proven, and the flurry of dislocation opportunities created in March and April drew LP attention away from senior debt strategies. This creates a circular effect – those lenders with the most capital tend to have the easiest time accessing the highest quality deals, making them more attractive to LPs – thus attracting further allocations. As a result, it seems logical to expect the trend towards consolidation to continue into 2021.
Implications for the broader market
For small and mid-sized direct lenders, the picture is less clear. But anecdotal evidence and feedback from LPs suggest that there is more to the story than the fundraising data implies. First, the most common fundraising obstacle faced by firms launched in the wake of the Great Financial Crisis was that they had not proven themselves through a credit cycle. A GP’s track record remains the most significant factor evaluated in due diligence, and newer entrants have long faced an uphill battle when competing for capital against more tenured managers.
Second, the pandemic has highlighted to LPs the importance of transparency and access to their GPs in times of duress. Given the opaque nature of direct lending, LPs are heavily reliant on their GPs for portfolio information, advantaging managers who seek a partnership approach with their investors.
And third, fees and expenses continue to be a grating item for LPs with 47 percent of investors responding to Private Debt Investor’s LP Perspectives 2021 Study indicating these elements are a source of friction.[ii] For more established managers, fees and expenses have remained relatively stable, and while this can partially be attributed to the increased overhead required to support a more scaled platform, it is also a by-product of established managers with long-track records leveraging their reputations to maintain pricing power.
The fundraising outlook
We believe the most exciting trend for private debt managers is the significant white space that remains on the fundraising front. Thirty percent of LPs surveyed by PDI have no allocation to private debt. Furthermore, 45 percent of respondents who are currently invested feel they are under allocated, compared with only 9 percent who feel they are overallocated.[iii] Among LPs looking to increase their private debt exposure, 40 percent noted that they expect to increase the number of GP relationships they maintain.
In aggregate, this trend suggests that the bifurcation between the “have” and “have-nots” will not be determined by size alone. Rather, there appears to be an opportunity for mid-sized GPs with strong track records but less scaled capital bases to add LP relationships and capture new allocations as investors enter the space or seek to diversify their GP relationships.
Many GPs who entered the market in the wake of the GFC followed a similar approach to early-stage fundraising – that is offering competitive fee structures, embracing SMAs over commingled vehicles, and maintaining close partnerships with their LPs. Despite the flight to safety and slowdown in new GP relationships caused by covid-19, this appears to remain a viable growth strategy in 2021 and beyond.
While new entrants and the smallest managers will likely be disadvantaged in the near-term – and consolidation in the form of M&A is expected – many mid-sized GPs have emerged from 2020 with a demonstrated track record and stronger ties with their investors. Ultimately, as these GPs seek to compete with their larger peers, their success will be primarily determined by their ability to convince LPs that factors such as more favourable economic terms and personalised attention outweigh the benefits of investing with the most mature managers.
A bright future
With interest rates expected to remain near-zero through at least 2023, the durability of direct lending now proven, and LPs flocking to capitalise on other opportunities created by the market volatility, the bullish run of private debt fundraising appears poised to continue. Overall, the private debt markets’ ability to withstand a full cycle – and a particularly severe and rapid economic downturn at that – will increase its credibility and boost confidence in its sustainability.
In the immediate term, expect the trend of consolidation to continue. However, the extent to which this growth comes at the expense of smaller and mid-sized GPs will ultimately depend on the degree to which new LPs enter the market and existing LPs willingness to diversify their relationships. Whether this indicates the market is beginning to reach maturity or simply getting its second wind remains to be seen, but for now, the message is clear: private debt has not only survived but thrived through its first true cycle, and LPs are taking notice.
Ryan Crowell is product manager for private credit strategies at Allvue Systems, an alternative investment technology solutions provider
[i] Pitchbook 2020 Annual Global Private Debt Report
[ii] Private Debt Investor LP Perspectives 2021 Study
[iii] Private Debt Investor LP Perspectives 2021 Study