The private debt market came into its own during the last financial crisis, as it stepped into the gap left by tradition­al lenders. But what will the economic fallout of COVID-19 mean for the asset class? Ainun Ayub, senior vice-pres­ident in the alternative fund services business at Brown Brothers Harriman, believes it is poised to step up and pro­vide support to a large number of small and medium-sized businesses. The in­dustry may be on Wall Street, but at times like this it is the financial equiv­alent of an IV lifeline, helping to stabi­lise Main Street and the real economy when businesses need it the most.

PDI: How do you think the crisis will shape the private debt market in the next year?

Ainun Ayub: Plenty of people who have been watch­ing the private debt industry flourish of late were expecting a shakeout at some point. There have been a lot of new entrants raising money and competing for deals, and there is a sense that we’ll find out just how savvy those managers were. Because of the amount of money in the space, there was a concern that some managers would compete for deals by watering down or removing constraints on borrowers or covenants – through the provision of ‘covenant lite’ arrangements.

Experienced managers have kept their discipline, knowing that this would be important in a downturn. In the face of this severe contraction, it will be interesting to see how that discipline holds up and how managers work with their borrowers to weather this storm.

Some of these deals may well be re­organised, but I would hesitate to make any sweeping generalisations. Private debt managers tend to be smaller or­ganisations so they can be more vul­nerable than big banks with huge di­versified loan books, and credit teams backed by substantial operational and compliance resources. But these small­er players can also use their size as an advantage.

This isn’t to say that the analysts at a large bank aren’t close to the ground as well. But private debt managers – which, by their very nature, manage fewer investments – are going to un­derstand their borrowers more inti­mately. That creates unique perspec­tives that might be missed by banks operating with a more ‘assembly line’

approach. Being so up close, managers can customise solutions that take into consideration where a borrower is and where it may be headed in the wake of COVID-19.

PDI: There are still significant funds closing, even in the midst of the crisis. Might the current climate spark a rebound in fundraising?

Ainun Ayub: There is a strong impulse by some to get on the private debt bandwagon, but the firms making headlines with big closings right now tend to be more experienced players that have survived multiple economic cycles. Like all of us, LPs are nervous and looking for the safest route forward, and that has driv­en them to deepen their relationships with trusted managers.

Going back 10 years or so, LPs were keen to add new managers for new niches. But starting five or six years ago, we observed that investors found themselves facing high costs and opera­tional strain in handling so many man­agers. So, they began to winnow their commitments down to a smaller, trust­ed group that could provide a range of products. In some cases, they shed up to two-thirds of their managers to bet­ter focus on a few, and in-sourced some advisory activity. COVID-19 is likely to foster this trend, as social distancing makes it harder for managers to forge new relationships with LPs.

More experienced firms have also been bulking up their teams with niche expertise to offer the kind of skills LPs might have got with a specialist man­ager. This approach has allowed these firms to deploy more capital while ex­panding their focus beyond just a single strategy. Now, those LPs can get new cutting-edge products from known managers.

PDI: What kind of new products are LPs looking for at the moment?

Ainun Ayub: They are looking for products that are flexible enough to match whatever the moment brings. Distressed debt vehi­cles have been popular of course, but we are seeing a new focus on ‘dislo­cation’ funds. The exact parameters may differ depending on the manager, but they tend to offer a broader man­date than the classic distressed vehicle. Their investment life cycles tend to be shorter – between three and five years – under the assumption that these com­panies are not distressed so much as momentarily dislocated and can recov­er quicker. My guess is the lifespan of these investments will be closer to five years instead of three, but we will see.

The other trend is towards ‘funds of one’ and separately managed accounts, where the manager offers an LP a ve­hicle with a similar strategy as a larger fund but with the ability to customise according to the preferences of a single investor. For instance, managers may raise a $2 billion fund, but then manage a few $200 million-$300 million vehi­cles of one or SMAs alongside it. These operate under the same umbrella as that larger fund, but can give the LP additional room to tailor its exposure.

PDI: That seems to favour larger managers with the ability to raise the kind of money to fund both a main fund and various tailored vehicles. Will this prompt a wave of consolidations?

Ainun Ayub: That trend has been underway for some time now, and we can expect further consolidation or collaboration. Those bigger, more experienced play­ers have been finding all sorts of ways to translate their fundraising prow­ess into a diverse group of products, whether across private asset classes or within the credit spectrum. Some will bring such expertise in-house, on a full-time basis, and offer niche vehicles that operate like divisions of a single opera­tion. Others operate as an affiliation of managers under one umbrella. Private debt existed for decades under the um­brella of private equity, so it is natural that various private debt niches can thrive under different umbrellas.

Collaborations between larger play­ers and niche managers can be struc­tured all kinds of ways. The large GP might offer access to a series of niche funds to its LPs, as if it is adding a layer of due diligence to promote the oppor­tunities it thinks are worth backing. In addition to funds of funds, multi-man­ager platforms allow LPs to invest di­rectly in those niche funds, but they do so with the initial vetting by that larger, experienced manager the LP trusts.

PDI: Consolidation means bigger firms and size often brings attention, from the press and regulators. Could private debt run the same reputational risk that private equity firms face today?

Ainun Ayub: Watching the debate over the CARES Act in the US, and whether public funds should be deployed to private equity firms and their portfolio com­panies, private debt managers should be vocal about their value. During the last crisis, they entered situations that traditional lenders could not or would not, and they will do so again in this crisis. Taking time to collaborate across the industry to send out a strong posi­tive message on how they are helping to re-start and support growth in the global and local economies will be es­sential to build confidence in private debt as a source of finance for many types of businesses.

This article first appeared in the July/August 2020 issue of Private Debt Investor.

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