1. What is driving growth in the private debt market?
A number of factors have combined to make private debt more attractive, starting with banks having been less willing to lend to middle-market companies, creating a need for new sources of financing. On the buy side, the historically low interest rates during most of the last decade have prompted a hunt for yields beyond traditional fixed income. Lastly, institutional investors, such as pension funds and insurance companies, are driving a lot of the growth – they are looking to match their long-term liabilities with long-term investments. Private debt, private equity, real estate, and infrastructure funds are usually structured as finite life funds with long tenures, anywhere from seven years to twenty years. That matches up very nicely with the longer-term views of institutional investors.
2. Why is private debt more attractive than other private capital strategies?
Private debt is the fastest growing private capital strategy. Current returns for more mature segments like private equity and real estate are very attractive, over 10% median net IRR over the past few years,1 but valuations are currently high. This is good for funds in exit mode, but a fund at the beginning of its investment cycle can find it hard to find investments with sufficient upside to earn its target return. As a result, many managers are taking longer to find the right investments or are waiting for the economic cycle to turn when investments are likely to be more affordable.
Meanwhile, private debt provides an attractive risk-adjusted return, unleveraged – around the 6-9% range, according to Brown Brothers Harriman estimates. Much has been said about the European corporate and project funding model, which is bank-centric, following in the footsteps of the US market, where funding sources are much more diverse. The prevailing belief is that the demand for private debt among borrowers is a systemic shift, not a passing fad. While private debt is more illiquid than corporate bonds, private debt is typically uncorrelated with other asset classes, offering the chance to diversify portfolios. Asset managers offer different credit strategies at different stages of the credit cycle when interest rates move up or down, allowing investors to tailor their risk.
3. What types of fund sponsors are raising the largest funds?
Although the amount of fundraising has increased, the number of funds is actually declining. Fundraising for private debt is on track to beat the $26.5 billion raised in 2016 with assets reaching $23 billion in August. However, the assets seem to be concentrated in fewer funds, with the number of funds declining from 60 in 2016 to 32 in 2017.2
In addition, funds are getting bigger— there is a growing gap between bigger players and the smaller end of the spectrum. The reason for this trend is that deals are sourced through personal and professional networks so private debt sourcing comes down to a manager’s relationships. A manager’s ability to fundraise is directly related to their ability to source deals to deploy investor capital. Managers have relationships with accounting firms and legal advisers that are on the lookout for new sources of funding for their clients. Managers also often have symbiotic relationships with banks, which may lend only a certain amount or type of credit facility—and then steer their customers to private debt fund managers for the remainder.
An increasing trend is for big investors wanting to deploy a large amount of capital in a short amount of time. That requires a manager with a large network to find a sufficient number of deals in an increasingly competitive environment.
4. What other ways are investors accessing the private debt market?
One way is to establish a segregated mandate, where the manager has authorization to invest funds in a strategy or combination of strategies agreed up front with a client, in accordance with a specific risk/return profile.
Another way is called a fund of one. Here’s how that happens: First, a manager will launch a private debt fund and open it to a wide array of investors. During that fundraising process, a very large investor, such as an insurance company, will sometimes ask to have their allocation segregated from other investors. The manager then creates a separate legal entity as a fund for that single client. The investor can also negotiate preferential discounts on things like fees or specialized terms that suit their exact relationships. The fund of one can also function as a co-invest vehicle, where the investor can directly top up certain investments by the main fund.
In the past, investors who were new to private investments went up the learning curve first by buying interests in fund of funds, and then as they gained experience in manager selection, they invested directly in funds. Bigger investors would then selectively invest directly in large private investments on a co-invest basis or participate up front – for example, the Ontario Teachers’ Pension Plan, owns a string of airports. The private debt market has grown most strongly since 2007, and in a highly cost-conscious environment, with investors now largely bypassing the fund of funds stage.
5. What types of new private capital funds are coming to market in the private debt space?
The big players are dominating the opportunities for $40-50 million loans and they are oversubscribed. With new entrants piling in to the private debt space, managers have to find a niche, such as $1-5 million loans. This largely ignored space appeals to high net worth family offices, endowment funds, and smaller pension funds. These niche funds may also have a specific area of focus, such as emerging market debt. If an investor wants to zero in on a specific sector, they can go to a niche fund rather than a bigger player with a much wider focus. In general, funds specialize in a type of debt – for example, real estate, mid-market sized companies, or infrastructure – because evaluating the credit for a manufacturing company is very different than evaluating the credit of an infrastructure deal. Again, the success of the manager depends on their access to deal flow, via their network of contacts.
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1 Preqin Private Equity Online, August 2017
2 Preqin Private Debt Online, August 2017