Prior to the 2008 global financial crisis, the private debt industry was dominated by subordinated debt and distressed debt, with banks able to easily provide the senior portion of debt that made up the bulk of non-equity financing for private equity deals. But after the crash, banks faced an onslaught of regulation and balance sheet constraints that affected their ability to lend to all but the safest and most vanilla types of transactions.
As the economy started to recover, the gap in the market for senior debt was identified and many new and existing private fund managers sought to meet growing demand for senior debt with institutional money. More than a decade on from the GFC, senior debt has become one of the three major pillars of private debt, alongside junior debt and distressed debt, with each typically accounting for between 30 percent and 40 percent of capital raised.
However, the most recent crisis has seen senior debt fundraising take more market share and Private Debt Investor’s Fundraising Report 2021 recorded that 45 percent of all capital raised was for senior debt strategies, the highest proportion ever recorded and up from just 31 percent in 2020. In comparison, distressed debt fundraising fell from 20 percent in 2020 to 18 percent last year, while subordinated debt dropped from 38 percent down to 29 percent over the same period.
“Distressed debt has been huge historically, and we’ve seen a number of very large funds in that space that have blown the numbers up,” explains Trevor Castledine, senior director in the private markets team at London-based investment consultancy bfinance.
“Last year, we did not see as much interest in distressed debt and clients increasingly looked at private credit that is more towards the performing credit end of the spectrum.”
Among its clients, bfinance is seeing outflows from traditional bond portfolios due to concern about low yields and the risk of capital value erosion, given the current high inflation environment, which is creating the prospect of LPs seeing negative returns on their bond portfolios.
Castledine says: “This money needs a new home and investors need to look at what they are willing to give up in order to secure that higher return, whether it is moving out of investment grade credit, having unrated investments or a reduction in their liquidity.”
For many LPs, risk will be a crucial issue when reallocating public bond market investments into private markets – senior credit is one of the areas that can offer similar levels of risk to corporate bonds but with significantly enhanced returns, though areas such as real estate debt and infrastructure debt may also fit the bill.
But senior debt offers another significant advantage to investors in the current environment, says Alastair Baird, principal at placement agent Rede Partners.
“Inflation is rising, and it is really hurting bond portfolios right now, prompting many investors to rotate into floating rate instruments as they offer some protection from capital erosion. This has been a trend in the market for some time, but we’ve seen that accelerate through 2021.”
Another factor pushing LPs into senior debt funds is that many will be dipping their toes into private credit for the first time.
“The nature of our business means we often work with investors making allocations to private credit for the first time,” says Castledine. “When they want to reallocate from their bond portfolio, they want the next safest thing. We see that in a preference for senior-secured credit, which is the safest form of private credit, but there’s less interest in stretched senior and unitranche.”
He adds that investors who were previously cautious about private debt are now more receptive to making commitments, given that the asset class generally has performed well during the economic downturn caused by the covid-19 pandemic.
But it is not just LPs driving this uptick in senior debt fundraising, as the actions of GPs are also crucial in dictating which parts of the market are receiving the most attention through the types of vehicles they look to raise.
Funds get bigger
Notably, PDI’s fundraising data found that the average size of senior debt funds exceeded $1 billion in 2021 as the largest fund managers raise increasingly large vehicles, many of which are focused on senior debt. Of the 10 largest funds raised last year, six were focused on senior debt, with a total size of $53.84 billion. This compares to two distressed funds in the top 10 worth a total of $21 billion and two subordinated credit vehicles with a combined value of $13.85 billion.
“In the past year, we have seen a number of very large fundraisings and that has been concentrated in senior debt, which may skew the figures,” says Baird. “The top 10 debt managers globally account for more than 80 percent of total AUM in the industry.”
The reason for so many large fund closes could also be linked to the fairly low fundraising figure seen in 2020, when many countries around the world implemented travel restrictions as part of their response to covid-19. Some funds may have seen their launch delayed while others took longer to reach their targets as meeting LPs and securing commitments became harder. As many of these restrictions were steadily relaxed through 2021, fundraising activity has been able to resume, with significant pent-up demand among investors.
The momentum behind senior debt fundraising also looks set to continue into next year according to LP research conducted by PDI. When asked whether they are looking to increase, maintain or decrease allocations in the next 12 months, 35 percent of LPs said they are looking to increase direct lending in their portfolio, which is overwhelmingly made up of senior debt funds, while just 13 percent want to reduce their exposure.
Only distressed debt investing was more likely to see increased allocation at 38 percent, while only 22 percent want to increase their exposure to subordinated debt.
Although rising inflation will eventually translate into higher interest rates, and some countries such as the US and UK have already begun slowly raising rates, it is likely to take some time before public bond markets catch up to these rising rates. This means institutional investors will continue to require alternatives to ensure they meet their long-term liabilities.
With senior debt demonstrating it can offer superior returns while emulating much of the security found in more traditional fixed income investments and its ability to weather economic turmoil, it is likely to prove the asset class of choice for LPs converting their public market debt investments into private markets.