Low interest rates and fierce competition are putting pressure on fund returns. We ask the experts whether taking on additional risk to boost return is a sensible strategy
Low interest rates and fierce competition are putting pressure on fund returns. We ask the experts whether taking on additional risk to boost return is a sensible strategy
In just 10 years, private debt has established itself as an important alternative asset class. Assets under management (AUM) worldwide has almost tripled from $341bn in 2011 to $975bn as of September 2020, the most recent date for which data is available, and has almost certainly now crossed the symbolic trillion-dollar threshold (Fig. 1).
While US companies have long raised debt capital from bond markets and funds, the globalization of private debt is a direct response to the Global Financial Crisis (GFC). At the investment level, the withdrawal of banks from corporate lending markets opened a gap that funds were able to fill, while at the investor level, ultra-low interest rates drove a search for yield. With COVID-19 prolonging the low interest rate environment, demand for debt fund returns in the high single digits is strong.
GPs have found opportunities to deploy capital. Dry powder has risen substantially, to $336bn, but the ratio of dry powder to AUM has been in a narrow range of 32-41% for the whole of the past decade, and in decline since 2013.
But it’s not all good news. Returns have also been on a downward path for most of the past decade. The three-year rolling IRR has slipped from 12.7% in 2014 to 3.7% as of September 2020 (Fig. 2). And 2020 was a particularly bad year for performance: the one-year rolling IRR to September was -2.4%.
Over the past couple of years debt funds have sought to add some juice to these lackluster returns, either by leveraging the fund itself or by taking on broader exposure through the capital structure. We asked three experts what these developments mean for funds, investors, and the relationship between debt and private equity funds.
Have the boundaries between private equity and private debt begun to blur?
Will Nicoll, M&G Investments: The past 13 years – since the GFC – have proven over and over again that rigid mandates that force fund managers to invest ‘only in equity’ or ‘only in debt’ can be value-destroying. When the economic cycle turns and the market landscape changes, fund managers might see new opportunities that are clearly within their investment capabilities, but in which they are unable to participate because mandates do not permit.
LPs have become increasingly comfortable with more flexible mandates, which have allowed the investment activities of private equity and private debt fund managers to overlap, on occasion. Offering greater flexibility to companies and sponsors also builds a fund’s reputation as a commercial, constructive partner. This increases the total number of deals in the fund’s pipeline, which, in turn, enables the fund to be more selective.
Increased private debt exposure in traditional private equity arenas is likely to lead to higher valuations, increased levels of debt, and less restrictive covenants overall, which in turn may facilitate greater M&A and industry consolidation. A firm’s ability to provide investors with access to a full range of solutions across both private equity and private debt strategies will lead to greater flexibility in funding and more tailored solutions for companies, delivered in a more efficient way.
What is driving GPs to take different or multiple positions in the capital structure?
Tavneet Bakshi, FIRSTavenue: We need to distinguish between two approaches here. On the one hand, we see credit investors (GPs) looking to add more convexity to the return profile. They will underwrite their deals with a credit mindset, but take equity and equity-like exposure to boost the upside potential. The equity is typically a part of the investment, but increasingly, especially where there is hard asset underpinning, we have seen the proportion of equity/equity-like components increase significantly, often almost replacing any yielding structures in the investment. Investments tend to be squarely mid-market or smaller, quite often financing growth companies, or companies with some ‘special situation’ that makes a standard direct financing more challenging.
On the other hand, we see GPs going after private lending opportunities with larger and well-established corporates in the mid-market, where the ability to provide non-dilutive or less dilutive investment structures allows them to compete with more traditional buyout capital. This approach usually involves a private equity mindset, varying degrees of control, a longer timeline, and a more hands-on approach to managing the investment.
With either approach you’re offering more than just contractual yield and, perhaps, a better MOIC (multiple on invested capital) to credit LPs. But you’re also introducing equity risk, and possibly more complexity in terms of the ongoing management of the investment and valuation considerations. I think there’s enough room to play with both approaches, and I see it as a healthy expansion of the tool kit that borrowers can access to solve often complex financing needs.
How do these developments change the relationship between private equity and private debt funds?
Fenton Burgin, Deloitte: Massive liquidity is pouring into private credit strategies, attracted to the 7-10% yields that can be achieved. But the market is fiercely competitive; lending rates are coming down and spreads in private credit have come in by maybe 100 basis points. At the same time, pension funds, sovereign wealth funds, and other long-term investors are telling the private credit funds they would love the opportunity to co-invest and boost yields.
So, in response to these dynamics, a number of the larger funds have started to offer minority equity in their transactions to boost the return. From a risk perspective, they still have the benefits of the documentary protections in the loan facilities to protect that minority equity investment, provided they are invested across the capital stack.
We're in a very interesting crossover phase. A lot of private equity houses use private credit funds extensively to finance transactions, so there will be difficult challenges to navigate if private equity starts to perceive credit funds as direct competitors. Very few credit funds are prepared to say they’re going head-to-head with the private equity market; but, in my view, it’s inevitable that some of the larger funds will go down that road.
Today, we’re seeing more leverage in debt funds. Of course, we’ve seen this film before following the GFC when the adoption of mezzanine finance similarly accelerated; investors holding these equity tranches may suffer the first and biggest losses in circumstances where defaults rise, as was the case post-Lehman. The fact that you're seeing increasing use of minority equity to finance deals is symptomatic of the late stages of any credit cycle. For those reasons, we’d see some investors pivoting out of minority equity at the first signs of rising interest rates; although, we don’t see that happening any time soon.
About the Experts:
Will Nicoll was appointed CIO, Private and Alternative Assets at M&G Investments in February 2020. He is responsible for private debt, real estate, private infrastructure equity, and teams investing in third-party funds. Prior to this he served as Head of Institutional Fixed Income and was previously co-head of Alternative Credit. William joined M&G in 2004, having worked at Henderson Global Investors and Cazenove & Co. He is a CFA charter-holder and a Chartered Fellow of the Chartered Institute for Securities and Investment.
Tavneet Bakshi is Partner and Head of EMEA at global placement agent FIRSTavenue. She joined First Avenue in 2007 and is Partner and Head of EMEA. Tavneet has led numerous fundraises across private market alternative investments, with a focus on private credit and infrastructure. She leads a team of 16 and is based in London. Prior to joining First Avenue, Tavneet worked with Pioneer Alternative Investments in Hong Kong as a Senior Investment Analyst in the fund of hedge funds business. Tavneet began her career in finance with Morgan Stanley in London and Hong Kong.
Fenton Burgin is a Partner and Head of UK Corporate Finance Advisory at Deloitte, responsible for a team of more than 450 professionals. He joined the firm in 2008 to establish a Debt & Capital Advisory Practice and has worked in investment banking, M&A, and corporate finance for more than 30 years, advising publicly listed and private companies, financial institutions, and governments. Fenton sits on the Corporate Finance Faculty Board of the ICAEW, representing over 7,000 M&A professionals and more than 80 member organizations.