There is little evidence of investors falling out of love with senior secured private debt. However, competition for mid-market direct lending opportunities is such that some limited partners are starting to look outside what is becoming a crowded marketplace.

For sponsored deals, there is so much capital chasing deals that credit protections are being seriously weakened, even if returns have so far proved fairly resilient. According to Private Debt Investor’s latest fundraising report, senior debt fundraising dropped for the second year running in 2019, down to $51 billion from a high of $85 billion in 2017. Distressed strategies inched ahead to become the largest strategy in terms of fundraising for the first time.

Alexander Bode, founder of Cologne-based private debt advisory firm BB Alternative Partners, says investors are aware of the challenges but are not put off: “Margins are not decreasing any more, but what is deteriorating is the documentation, which is particularly difficult to follow for investors.

“Investors kind of don’t have a choice. A lot of them have substituted fixed-income returns from corporate bonds and are now looking more and more to the senior or direct lending market in the alternatives space to get 4-5 percent returns. So, are they worried by developments? Yes. But they don’t see many other options.”

Distressed and special situations strategies are the obvious beneficiaries as potential signs of market distress become more apparent, with documentation often seen as better from an investor perspective. However, Bode says: “That would be a real option for a lot of players, but most investors are shying away from that market. They don’t know it and they don’t have the resources to pursue that opportunity.”

For the large German insurance companies, Solvency II made senior secured private debt a more attractive option. Hans-Peter Dohr, founder and managing director of German advisory firm ICA Institutional Capital Associates, says: “German investors really like the very traditional direct lending approach because at the end of the day they like to match their liabilities. The insurance companies have managed to reduce their liabilities to close to
2 percent, so they are pretty happy with 4 percent net and they are relaxed regarding strategies and returns.

“We are seeing some diversification out of senior debt on the pension funds side, but on the insurance side, mid-market direct lending remains the favoured strategy. What I have seen is one of the big insurers looking at managed accounts with the big players to get a tailor-made product. Others are looking to diversify their portfolios between European strategies and leading managers in the US.”

For LPs looking for alternative options outside direct lending, speciality finance an emerging, complicated and currently niche part of private debt is proving attractive. In our recent LP Perspectives 2020 survey, 14 percent of investors said they intended to increase their allocation to speciality finance, whereas 29 percent said they planned to put more money into direct lending.

Shoving the banks aside

Speciality finance refers to asset-based lending tied to products such as residential mortgages, personal loans, auto loans, student loans, credit card receivables and aircraft or ship financing. Outside the US, institutional investors have typically been unable to access speciality lending as it has been dominated by banks, but the banks are now retreating. Private debt funds see an opportunity to provide bespoke solutions in a non-standard part of the market.

William Nicoll, chief investment officer of private and alternative assets at M&G Investments, says: “The direct lending piece has been competing head-on with the established syndicated loan market for the last couple of years and, as such, has started to become a little less popular with quite a large number of investors. The returns have come down exactly as we would expect in a mature market and people are looking to more niche strategies.

“We do quite a lot in asset-based lending on the basis it requires more work and more specialist knowledge on how to add value to the underlying assets. In strategies that require more work or are harder to do, you are still able to find value in comparison to the parts of the market that have become plain vanilla.”

The challenge for larger players is getting exposure to those markets, given the capacity constraints on many funds. The complexity of the strategies can also make it difficult, though the upside is that managers do not have to compete on price or terms as in direct lending.

Christian Allgeier, a director with a focus on private credit at placement agent FIRSTavenue Partners, says: “We often see investors making core allocations to private debt senior strategies and then venturing out into special situations, distressed, loan-to-own and other niche strategies, where the returns are sometimes as high as to compete with private equity. Asset-backed special situations is seeing quite a lot of activity at the moment.

“Generally, the LPs we are working with are quite satisfied with returns around direct lending. But what we have seen is, if you’re an LP invested in one of the large private debt funds, maybe investing £200 million, previously where you would have been one of the largest investors and so quite close to the manager, and receiving certain incentives and discounts, you are now dropping down the pecking order as the fund size continues to grow and commitments get larger.

“This can work as an incentive for those LPs to go to slightly smaller managers – from the number one or two in terms of AUM to perhaps number three or four, where they can still have that relationship and incentives without increasing their commitment size significantly and without seeing their returns necessarily impacted.”

Time for a downturn

The senior secured private debt market is expected to correct sooner rather than later, but credit losses could still be minimal

“LPs are almost waiting for a market downturn,” says FIRSTavenue Partners’ Christian Allgeier. “That is when we will really be able to separate the good managers from the bad. Perhaps the question we should be asking is, ‘If the market corrects, are a lot of those managers going to survive?’ Will we see a lot of consolidation that will transform the dynamics of the marketplace?”

Default rates remain relatively low and recoveries such that credit losses have been minimal. It can be argued there is no reason it should not continue even during a downturn, if managers can choose the right credits. William Nicoll at M&G says: “The returns in direct lending have come down as the market has matured. When there is a credit cycle, the direct lending market is now probably strong enough to survive that without too much fallout.”