Last week’s PDI New York Forum opened in lively fashion, with participants on an LP panel being asked about the types of statements from GPs that put them in a sceptical frame of mind. Here are some of the statements, along with the reasons for the LPs’ scepticism:
“We always have at least one covenant in our deals”: OK, but how material are those covenants in terms of the protection they offer? Do they really make any difference?
“All we do is senior secured”: This is no guarantee that you are writing good loans, especially with confusion over the definition of senior secured these days. Will the increasing use of unitranche produce lower recoveries than people are expecting?
“We never do loans at more than a 5x multiple”: Yes, but that’s what everyone says.
“We do private equity-style due diligence”: See above.
So what else was under discussion? One of the messages to emerge from the panel is that LPs are aware of the compression between risky and less risky strategies – in other words, in today’s market, investors do not feel they are being fairly compensated for risk. This is causing them to have a bias for the safest, first-lien positions in the capital stack.
However, they are also aware of the possibility of “decompression” and the need to be nimble when market conditions change. There is an openness, therefore, to opportunistic strategies, and it is clear that a range of speciality financing – from real assets to capital relief, and from healthcare to royalties – is attracting more interest now than ever before.
This is partly driven by the perceived importance of diversification. The point was made at the event that more GPs than ever have gravitated to the larger end of the market. Attendees were asked how many managers they thought could write cheques of more than $100 million, and their estimates were mostly in the range of 15 to 20. Yet the answer is almost 40. “As managers go larger, diversification is under threat,” noted one LP.
Also on the minds of LPs – unsurprisingly – were fee arrangements. In particular, there was disquiet over origination fees being skimmed off by managers that are unable to take the whole position in a deal themselves and selling some of it on to others. Aside from exceptions where managers may need to retain all fees to keep the lights on, LPs were adamant that they should be sharing in these arrangements.
Thoughts also turned to the relatively short track record of most private debt managers and how they have yet to be seriously tested in an environment that has been benign for so long. Do they really have the ability to handle workouts and manage portfolios effectively in more volatile times? LPs are on high alert, and they are not in the mood for bland assurances.
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