JC: Over the past few years, private debt has seen a huge amount of inflow, new market entrants, investors, and managers. How have you managed the expansion of the markets?
SN: Private debt as an alternative asset class is something that we’re excited about given investors’ demand for higher returns and company’s demand for financing. Private credit is very attractive for companies who historically haven’t had the luxury of diversification of financing sources and have been dependent on the banks. This capital is complementary to that which they have from the banks, for example. At Capital Four, we have managed the expansion by applying our 20 years of corporate credit expertise from similar situations in high yield and leveraged loans to the private debt market.
JC: You run credit strategies across the liquidity spectrum from CLOs to direct lending. Can you provide us some insights on where clients want to commit their capital and the options for companies exploring the private credit market?
SN: We’re a credit company at heart. In today’s market, investors place high demands on asset managers to deliver a lot of information on their activities, exposure insights, ESG requirements, and risk management. Focusing on one asset class gives you a chance to do that well. For the biggest companies we focus on the more liquid high yield market, leverage loans for the medium sized companies, and direct lending for the small caps. So, if you look at the liquidity spectrum it’s a question of where do clients want to commit their capital? They may want secondary market liquidity on an almost daily basis and therefore focus on the high yield market or they may want to take a little bit of liquidity risk and they’re fine with a fund that has monthly liquidity or is investing in CLO liabilities that has interest exposure to leverage loans.
What investors should focus on when they do their due diligence on a private debt manager is the experience of the manager and their investment process because we have to respect that private debt is a relatively young market. In Europe it is 5-10 years old whereas in the U.S. it’s a much older asset class compared to the high yield market, which has 20-25 years’ experience, and leverage loans with 10-15 years of experience.
As a company we’ve done more than 1000 transactions in leverage finance and private debt. This gives us a good insight on how to commit capital but also how to structure an appropriate package for a company that gives them enough flexibility so that they’re not constrained in the way they operate.
JC: Clearly the space is getting more and more crowded with more asset managers coming in. How do you keep differentiating yourself in an evolving market?
SN: It’s good for an economy to have adequate capital and companies that are engaging and providing that capital. Sometimes there’s a supply imbalance and it falls too much in favor of the lender and risk premiums start to shrink. We’re not there now and we have a strong and increasing universe to lend into.
We shouldn’t forget that in the type of private debt opportunity that we’re pursuing, much of private debt is driven by sponsor activity. That’s why it’s easy for us to call it small cap, mid cap, and big cap because it’s the same type of new deal activity and sponsors. It’s just that the ticket sizes may be different. So, the process is very similar with supply and demand in each market living its own dynamics.
Also, if you look at the overall market in all this particularly the market in private debt, we expect it to be very robust. Preqin expects private equity to double over the next five years and grow from a $4.4 trillion to a $9.1 trillion market.4 That’s a 15% compounded annual growth. If we assume that private debt will substitute some other types of lending because of its attractiveness, then it’s a tremendous growth opportunity and an opportunity to deploy in that fast-growing universe.
JC: With cash availability at record high levels, are assets becoming too expensive and is it becoming more and more difficult to deploy cash? Could a lack of availably of transactions or assets affect that growth?
SN: I’m always worried about the next year, but I’m not worried about the next 10 years because in my 20-25 years in leveraged finance that’s just how it’s been. It’s cyclical from one year to the next and the debt we provide is an important part of a company’s capital structure. I also think that lending through a syndication processes will beat lending from the balance sheet. Banks are important for society but they’re not always the right lender because they have a regulatory process that is dependent on solvency, which forces creditors to be extra cautious at the worst time. Private debt is a totally different mechanism. You raise the money and then deploy it. The money is then returned, and you start a new fund. It’s a good self-regulated mechanism where the ones who are doing well are the ones who are raising more money.
JC: What are the key challenges from a distribution perspective and what do you see as key to the distribution success in the alternative space?
SN: Its’ clear that when we talk to investors, here’s what they want: they want good investment processes, transparency and responsibility of the manager that works with them. You would be surprised at the level of detail some of our Limited Partners (LPs) are interested in and how much they’re engaging with us, for example on ESG. We’ve started including ESG KPIs in our direct lending transactions and many more clients are interested in getting more insight into these types of activities.
JC: What trends are you seeing in the democratization of alternatives and what new investors and products do you see to enable you to broaden the distribution mechanism?
SN: We’re working with banks who are guiding some of their high-net-worth investors into fund of funds and into direct fund investments. Of course, the threshold will go down over time so that the direct investments will become reasonable also for retail investors directly in the private debt market. There is a window where we’re working with a few parties on evergreen funds which includes a mixture of alternative or more private debt assets with less liquid assets.
JC: With the so-called democratization of alternatives, do you see scale as very important to success in the alternative space or is a boutique attitude critical to success?
SN: I think institutionalization is an even better term. We think over the next 5-10 years liquidity premiums will compress. There will always be more liquidity premium on a five-year locked up credit that is funded from an appropriate locked up capital structure. But the increasing institutionalization will lead to risk premiums being priced more accurately. From an economy perspective, we need less margin for error to price the risk appropriately. Within the the big caps, mid-caps, and small caps context, you will always have the highest liquidity premium in small caps, but the degree of premium will become more accurate so if you want to continue to play in that market you need the scale to support and have less leakage in that process. That means our fees will have to go down because in every basis point of fee we take out a company must pay more and can support less of their activities and has less cash available to drive the growth of their business. So, we want to do this more efficiently and ‘institutionalize’ and that’s good for everyone.
JC: How does the regulatory environment impact on ESG?
SN: I think often regulators have a difficult task to get it right for every issue in the market and every participant. This is a complex area and so many pension funds, assets managers, and regulators could be overwhelmed. So, one shouldn’t be surprised that what comes out is not always what companies would have done in terms of a proposed solution. When it comes to ESG, in my 25 years in this industry I must say maybe they’ve got it right. Capital Four spun out of Nordea and we have a heritage where ESG has been part of that, but we’ve been forced to develop a lot more by the regulators. Do they know exactly in which direction to push? No but we’re in this together and everyone recognizes that. They must help us, and we must help them.
