Private debt racing towards consolidation
By A Paris – Competition has been ramping up in the private debt arena as more managers chase fewer transactions globally. This is paving the way for consolidation in the space as some of the more aggressive players may stumble, having taken on too much risk, and the larger lenders look for solid acquisition targets among the more cautious groups.
Private debt is expected to be one of the fastest growing asset classes over the next five years. According to The Future of Alternatives 2025, a report by Preqin, assets under management (AuM) in private debt will increase at a compound annual growth rate of 11.4 per cent rising from USD848 billion to USD1.46 trillion. This outlook is driven by investors seeking alternative sources of yield and banks continuing to pull back from the lending market due to concerns of default and higher risk.
As the world was sent reeling by the Coronavirus pandemic in 2020, the private debt market, like all other investment sectors faced what some call its first big test. “The appetite for private debt versus bank financing is a long-term trend which has been amplified by the outbreak of the pandemic. It has been fantastic to be a really nimble, reactive investor in this environment,” outlines Cecile Mayer-Levi, head, private debt at Tikehau Capital.
She points out that the private debt sector has been very resilient and there have been a considerable number of transactions in the space. Tikehau’s third quarter results stand as testament to this success. The firm saw strong net new money flows of EUR1.5 billion. Added to the EUR1.1 billion generated during the first half of 2020, Tikehau generated EUR2.6 billion in net new money for the first nine months of a very challenging year. The firm attributed the positive results to momentum in private debt, particularly in relation to the initial closing of the group’s fifth generation of direct lending funds.
Jorge Hendrickson, Chief Revenue Officer, Opus Fund Services remarks: “The continued growth in private debt reflects global asset allocation trends. It is a resilient asset class due to its diverse make-up and ability to remain relevant and attractive to investors during all market cycles.”
Deborah Zurkow, global head of investments at Allianz Global Investors, believes private debt has a critical role to play in financing the recovery from the global slowdown caused by Covid-19. She notes: “One reason we believe that private lenders will play a major role in the recovery is their financial firepower. They are sitting on a record USD 1.5 trillion in cash, according to January 2020 data from Preqin – a figure that is the highest on record and more than double what it was five years ago.
“SMEs are set to be a beneficiary of this funding. Globally, these enterprises represent around 90 per cent of businesses and employ more than 1 in 2 people. Yet they increasingly struggle to access traditional lending – a situation that may be exacerbated as those lenders become even more risk-averse in the current environment.”
This view is supported by data. A third of all private fund managers surveyed by Preqin, believe banks will be less or significantly less important as debt lenders over the next five years. This compares to a quarter that expect them to be more important. “A substantial majority (62 per cent) of respondents expect private debt funds to play a bigger role, with just 4 per cent saying they will be less important,” the data provider says.
Alongside the growing fortunes of the asset class is increasing competition and the consequences this brings with it – both positive and negative.
David Wilmot, partner, Apera Asset Management, comments: “At the larger end of the market, our observation is that there is more competition. There is lower pricing in that part of the market, plus weaker financial covenants with wider headroom.”
Patrick Marshall, head of private debt and CLOs at Federated Hermes comments: “We have not been directly impacted by the competition, but there is no doubt that competition is rising. I know more managers are thinking of launching funds in the senior secured segment.”
Providing loans at the top of the capital structure is the specific focus of the private debt team at Hermes. Marshall and his colleagues manage two direct lending funds – one which lends to UK SMEs and the other to corporates in Scandinavia, Germany and Benelux. The strategies are focused on senior-secured loans in the mid-market space.
In Marshall’s view, new launches in this area are a positive development: “It’s proof of concept. It shows our approach is low risk as it worked successfully throughout the pandemic. We have had no defaults, impediments, or restructuring. In addition, none of the companies in our portfolio had to resort to government support schemes.”
Hermes’s co-lending partnerships with banks in the UK and Europe account for the good transaction flow. Marshall outlines: “As a result of the pandemic, banks have been gaining market share. They were supporting the real economy and have been considered to be the ‘good guys’ of the pandemic, providing companies with liquidity.
“One of the reasons we’ve been seeing good flows are the two lending agreements we have with four major European banks. Through these agreements, the banks are legally obliged to share some of the deal flow with us.”
One concern is that the rising competition could drive some lenders to taking greater risks. “We have been walking out on many situations where we felt that the leverage was going too high. In terms of risk from an industry perspective, people need to be aware that parts of the industry could become very fragile if everybody rushes ahead for the sake of winning a deal or making a transaction,” warns Mayer-Levi.
Marshall outlines what he expects: “In the next two quarters, I see defaults going up in the industry, particularly among unitranche lenders, who’ve been playing the strategy of kicking the can down the road. Some of these lenders are giving more flexibility on covenants and hoping the economy will allow certain underperforming companies to pick up.
“The harsh reality may be that the economy will not pick up at the pace they anticipated. This means the strategy of giving more flexibility will allow companies to continue operating with certain weaknesses. Recoveries would be higher if they had dealt with the problems up front.”
This increased flexibility in loan terms is partly driven by the growing competitive environment and unitranche lenders seeking to make themselves relevant in the new environment – it may end up spelling the downfall of some.
“Strong maintenance financial covenants are your first line of structural defence if you’re facing a decline in performance in the business. Without robust covenants in the financing documentation, you have limited protection against the business deteriorating to such an extent that it can be hard to rescue other than through some sort of restructuring process,” notes Wilmot.
Mayer-Levi gives her view: “There may be some disappointing performance for some managers and the coming year will be major test. This is what may eventually lead to some consolidation. Private debt has been a very fast-growing asset class with a lot of new managers coming into the market. Hopefully, we will end up fewer, more disciplined players, which is of benefit to the industry.”
Barbell effect as consolidation looms
“As private debt becomes more of an institutional product, institutional investors will demand more transparency and greater detail in terms of information. This means small direct lenders are likely to struggle to meet these demands,” says Marshall.
“Until now, in Europe, there has been significant room for all the private debt managers to fit in. However, we have learned there’s a move towards consolidation with managers trying to sell their private debt business. This is because with the increasing potential of competition some managers may not effectively be able to maintain their strategies under profitable conditions,” highlights Sebastian Dietzsch, director structured finance at Scope Ratings.
Some consolidation across the broader industry has already begun. Back in 2016, Canadian firm Fiera acquiring private debt manager Centria Commerce and Japanese bank Sumitomo Mitsui Banking Corporation (SMBC) bought a 5.4 percent stake in Northern Arc Capital Limited in 2019.
In March 2020, SMBC also went on to make a strategic agreement with Ares Management Corporation which included a USD384 million equity investment by the Japanese bank.
In fact, agreements such as this could be the way forward. In Wilmot’s opinion: “Rather than consolidation for consolidation’s sake, we might see more strategic alliances between managers and key investors. There’s a real appetite and relevance for private credit as a core allocation for investors. It has demonstrated strong investment features in terms of yield and downside protection; the case has been proven that it functions well as an asset class. We have already seen some instances of investors trying to get more closely involved with some managers.”
Evidence of this can be observed in the market. The Arizona State Retirement System stated it is looking to dedicate USD1 in every USD6 it manages to direct lending and Calpers is reportedly changing its investment policy which currently sees the fund not investing in the space.
Other US pension fund behemoths like the California State Teachers Retirement System (Calstrs) the New York State Common Retirement Fund, the Ohio Police & Fire Pension Fund and the Illinois Teachers’ Retirement System, have all declared their continued interest and allocation plans in relation to private debt.
According to Dietzsch the consolidation is going to have a barbell effect on the private debt industry with large players at one end and smaller niche managers at the other: “The players which are currently stuck in the middle will most likely drop out. There are niche managers who offer very bespoke solutions to companies and those will remain. The rest of the market will likely be made up of the larger managers who can absorb those middle-of-the-road groups. They are the ones that have, besides the market access, the necessary capacity and scale to maintain a deep insight into the different credits to ensure they don’t loosen their lending strategy.”
“I don’t see consolidation happening in the sense of private funds acquiring other private funds. It’s more likely that large, established funds will grow and funds that don’t have the necessary scale or track record will either slowly drift away or will have difficulty raising follow-on funds.
“If you fast forward six or seven years, I’d expect the number of European private debt managers to have reduced while the overall size of the European private debt market will have continued to increase. There will be larger funds with a reduced number of players, which shouldn’t be surprising given this is the natural consequence of a market maturing,” observes Mark Brenke, Head of Private Debt & Managing Director, Ardian.
Aani Nerlekar, Director, Solutions Consulting, SS&C Advent, gives his view: “There will always be room [in the market] for smaller niche players who purchase credit card debt [and the like], which can provide a good return but in lower volumes. I see the larger players moving towards issuance of loans and buying loans in the secondary market for higher potential returns.”