Regulatory pressure on banks, increased sophistication within the LP base, and a growing appetite for non-bank finance are all among the reasons why private debt has experienced phenomenal growth in the past decade. Global assets under management reached a record $560 billion according to alternative investment research firm Preqin. The success of the risk versus return balance and how this asset class is valuable to institutional investors trying to match long-term liabilities is well-known. So, what does the future hold for private debt?
Brown Brothers Harriman and Private Debt Investor hosted a roundtable of senior executives to answer this question. While the participants agreed that private debt presents great opportunity for borrowers and lenders alike, it also has its challenges.
Here are five considerations for managers seeking long-term success in this segment.
1. Expand Your Network with Non-Sponsored Borrowers
Most mid-market corporates are comfortable working with their banks for funding, but these loans are now less attractive to banks due to regulatory pressure from initiatives like Basel III in Europe and the Volcker Rule in the US. The challenge is that non-sponsored companies (i.e. those not owned by the private equity community) do not have much knowledge about the advantages of private lending or who is offering these loans. Moreover, access to these borrowers can be difficult for managers because of the sheer volume of mid-market companies across Europe. For those managers who can overcome this challenge, there is a huge opportunity. The blueprint for success is straightforward: Develop the network and build relationships with banks and debt capital consultants.
2. Keep Looking for Opportunities on Bank Balance Sheets
Deleveraging bank balance sheets is not finished, and we can only expect more regulatory change in the financial sector. There are still opportunities to purchase bank debt assets, either by full assumption or tranche. These opportunities will not be easy to find, but if they can be found, there is a great opportunity to build a solid deal pipeline.
3. Partner with Banks to Develop Robust Deal Pipelines
Managers who can develop complementary relationships with banks can develop great joint pipelines. Funds might not find revolving credit facilities very profitable and prefer senior or subordinated term loans. On the contrary, term loans may not be attractive to banks but they might still find revolving credit facilitates and related FX interesting. Because banks and funds can be complementary in their offerings, partnering with each other can be mutually beneficial - and it can provide a better service and benefits to the borrowing community as well.
4. Avoid Platform or Peer-To-Peer Lending for Now
While returns can look attractive, the level of due diligence and comfort a manager can get from a small company is still very low. For example, it is difficult to see how the depository oversight requirements under AIFMD would be met. There may be opportunities in the future, but the industry is not yet developed or regulated enough for institutional investment.
5. Build Investor Loyalty Through Transparency
Overseeing a private debt fund is more complex than overseeing a traditional fixed income fund. Private debt is illiquid and given the relative infancy of the sector, there are no industry benchmarks since many managers are new to the sector and do not have track records. Managers can build investor loyalty by providing the level of transparency investors need to do their oversight.
It Won’t All be Clear Sailing
There are great opportunities in the private debt market but it won’t all be clear sailing. We are in the last third of the credit cycle, and while most private lending funds have not yet seen defaults, some will. Managers with the experience and expertise to work constructively with borrowers will find a solution. This will help borrowers protect fund returns and maintain a positive reputation and in return help managers gain trust from borrowers and investors in the long term.
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