Let the good times roll. That seems to be the message for investors in private debt from the recent Market Outlook and Asset Allocation report from consultants Cliffwater. It revealed that the long-term expected return for private debt had received the largest quarter-on-quarter boost versus 11 other investment options, rising 50 basis points.
“While there is a give-up in liquidity, private debt looks pretty good in total return delivery,” says report author Stephen Nesbitt, Cliffwater’s chief executive.
But what then of reports from the deal and fundraising frontlines that competition is tougher than it has ever been? If those reports are accurate, it begs the question of how expected returns are being maintained or even nudged up a little.
According to sources, in their efforts to improve returns, many direct lending funds have been migrating from senior debt towards unitranche and subordinated debt. This claim is supported by the latest MidCap Monitor from investment bank GCA Altium, which found that the increasing market share being taken by debt funds in Germany is largely accounted for by a surge in unitranche deals (up 44 percent from Q1 to Q2 2018). Other parts of Europe, notably France, are also witnessing a unitranche boom.
While shifting position in the capital stack can be good for returns, investors need to appreciate that the risk profile is different – and may even vary from the investment story they were originally sold. For their part, it does appear that LPs are adopting a more cautious stance towards private debt – reflected in the fundraising numbers for the first half of 2018. While still healthy, fundraising for the year as a whole is unlikely to threaten last year’s record number.
A leading placement agent recently told PDI that some LPs are concerned by the increasing numbers of private equity firms launching private debt units. When the cycle turns, do these managers have what it takes? Are they as intimately familiar with the various clauses, protections and covenants that help to insulate GPs from trouble as the incumbent industry veterans?
The same source also says there is a reluctance to accept the argument that debt is inherently a safer bet than equity in times of stress. While equity sits in front of debt in the capital structure, debt portfolios can quickly get into trouble if too many companies are struggling to make interest payments. Equity funds, by dint of size and having more strategic tools are their disposal, may be able to act in a more flexible way to protect their positions.
At the very least, the portrayal of debt as a safe bet in troubled times is too simplistic and much hinges on the workout capabilities of the manager in question. Investors are increasingly attuned to this reality.
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