Direct Lending: to Cycle or Not to Cycle?

Source - Private Debt Investor

Investors have been debating how to approach private debt ahead of an anticipated downturn for at least three years. According to received wisdom, we are long overdue a correction in the market. Yet investors should be cautious about any form of received wisdom, and this is no exception. Although there are clear risks to the economy which may lead to increased stress, key factors that have led to previous credit default cycles aren’t obviously in play today; there is no clear reason why the current protracted, policy-led period of weak GDP growth and elevated asset prices will not persist.

Nonetheless, avoiding hubris and accepting for a moment that a correction in credit markets may take place, how should private debt investors approach portfolio construction? Position to exploit a downturn through commitments to distressed credit strategies? Press pause on new commitments altogether? Stay the course, even in a climate of slow deployment and almost hysterical market debate?

Market timing and the lure of distressed debt

The general acceptance that we are “late cycle” has certainly presented a major marketing opportunity. Distressed debt funds raised massive commitments in 2017 on the promise of potential bargains; little of this capital has been deployed effectively as the anticipated “distress” failed to materialise.

The data from 2019 evidences plenty of appetite for Distressed strategies. Perhaps this is a reflection of commitments made in 2017 not having been drawn down, leading to excess capacity for further commitments. Distressed strategies tend to have significantly longer-term fund structures than straightforward direct lending funds, more akin to private equity, and - importantly for investors - do not provide running cash yields. 

Source - Private Debt Investor

Investors should consider whether distressed strategies actually represent the best way to exploit the private credit market and indeed a potential correction if one occurs. There are strong arguments to be made that, if a downturn does take place, direct lending could be a better performing segment than distressed credit, simply because the dry powder now in distressed credit may act to erode the returns (relative to the risks being taken), while mispricing of risk in more senior direct lending strategies will put lenders in a stronger position. High-quality borrowers will have to pay more for their loans and accede to stronger lender protections in order to refinance the debt they put on a few years ago.

It is important to remember that private debt investment does not typically involve buying existing positions; a commitment today will fund the creation of future positions during the lifespan of the fund. It is false logic, borne of confusion with public markets, that making a commitment to direct lending today will expose one to a market on the brink of collapse. If there is a collapse tomorrow, investments made in previous years may suffer but today’s commitments would be deployed into a market likely to be strongly favourable to investors. Rather than being a foolhardy investment into a frothy market, making a commitment to a direct lending fund in 2020 is consistent with positioning oneself for a downturn.

Steady investment also draws on the historic lessons of illiquid investment programmes in other asset classes and the well documented importance of not missing vintages. One cannot get into this market quickly, any more so than one can exit it rapidly. Limited historical data exists on the effects of missing years in private debt, due to the relative immaturity of the sector, but the academic evidence on private equity overwhelmingly speaks to the dangers of trying to select vintages and change allocations dynamically.

While attempting to time the market may be ill-advised, careful tactical positioning of new commitments is very important indeed.

Now is certainly not the time to reduce one’s capacity to invest through a down-turn – especially one’s capacity to invest in loans to performing borrowers on improved terms. While attempting to time the market may be ill-advised, careful tactical positioning of new commitments is very important indeed.

Direct lending strategies are by no means straightforward to invest in right now: there are legitimate concerns about hefty fundraising, slow deployment, weaker pricing and erosion of investor protections. Figures indicate that the biggest managers hold an increasingly large share of the market. Lazy re-ups to the same managers (or the same strategies) already on one’s books are not necessarily the right way to go.

Wanted: “best ideas” in private debt

It is unlikely that the “best idea” from one or two years ago will be the best idea this year – not least because that idea may have raised a lot of capital that has not yet been deployed. It is crucial to identify more attractive segments and managers.

1) BIG IS NOT NECESSARILY BEAUTIFUL

If there is an area where risk may be mispriced against the best interests of investors, upper mid-market sponsored lending may well be it. This sector has been disproportionately affected by the wall of capital targeting private debt and competition from capital markets and syndicated bank facilities. Large private equity houses seeking to use extra leverage in order to juice up their IRRs can find multiple willing suppliers for that leverage, easily setting up competition between private debt managers who are under pressure from their own investors to deploy assets and anecdotally willing to accept increasingly unfavourable terms (see Do Fewer Covenants Really Mean More Risk? and Waiting for the explosion: The dangerous game of covenant-lite). This has led some commentators to speculate on the “Fool’s Yield” of Private Credit.

These observations can also reveal an opportunity: at the smaller end of the scale, private equity managers are similarly keen to boost leverage and often have fewer willing lenders to work with, creating less competition. Direct lending funds targeting the lower end of the market are, of necessity, smaller. Small deals require the same amount of effort for a private debt manager, whilst sending less dry powder out of the door. Good managers in this area have appeared to exercise more discipline on their fundraising caps; and appear to be better able to resist the pressure to drop investor protections.

We should not tar everyone with the same brush – there are good managers in the larger space; and poor managers in the smaller space. Yet the dynamics of the space in which a manager chooses to play will necessarily impact on the universe of opportunity which they can access.

2) COUNTRY AND SECTOR SPECIALISTS

Some of the most attractive direct lending managers right now are those with a dedicated focus on a particular country (e.g. a specific area within Europe) or a particular industry, such as healthcare, pharmaceuticals or technology.  Industry specialists have been more common in the US, and there are more appearing in Europe currently.

These specialist managers can really understand their market, tailor the loans more explicitly to their base, develop stronger relationships for both unsponsored and sponsored deals. For an investor worried about cycles, this specialist expertise can also be beneficial to workout and recovery rates. Again, this is not to say that larger, generalist managers cannot be good, simply that investors should take a close look at teams with a narrower focus.

3) ESOTERIC STRATEGIES

We also observe a number of less conventional segments where supply/demand dynamics are more favourable. Examples include a number of opportunities that are driven by overly complex or conservative regulation: providing mortgage finance to prime borrowers who want to (affordably) borrow at a higher multiple than that permitted by banks (4x), senior lending secured on real assets which require specialist knowledge to understand, trade and receivables financing, fund-level financing of PE and other strategies. Bank regulatory relief (‘risk transfer’) strategies remain particularly interesting, with areas of substantial dislocation between the risk being taken and the capital which regulations require to be set aside.

These managers may not have marketing budgets or be highly visible outside of their home jurisdictions

Such managers are not necessarily easy to find. They may not have marketing budgets or be highly visible outside of their home jurisdictions. They will not often appear on the buy-lists of big investment consultancies. They may not have the full trappings of institutional client servicing, where the big players are increasingly adept. Investors must be prepared to do the legwork on manager selection. In a market where mega-funds are increasingly prominent, the smaller strategies which play in less competitive sectors may provide a more attractive destination for new commitments.

Conclusion

Trying to time the cycle in any market is particularly hard. In private markets, where commitments today are invested over the coming years, it is virtually impossible and definitely ill-advised. Investors should focus on what role their private debt allocations are playing for their portfolio – diversification, income generation, volatility reduction, return – and deploy accordingly, steadily and through the cycle.

That being said, it is important to tilt the balance of one’s commitments to reflect the commercial dynamics of the market at a given point in time. Today, this means seeking the managers and strategies which provide access to attractively mis-priced opportunities.