Real Deals’ roundtable explored private debt's emergent role in a post-pandemic market. Here are some of the key themes that were discussed.

Listen to the summary of the discussion here

SPEAKERS:

Jordan Rothberg, Blue River Partners [an IQ EQ company]

Martin Luehrs, Morgan Stanley

Andrea Fernandez, Ares Management

Thibault Veber, Astorg

As capital markets emerge from a disruptive period, private debt is pegged to play an increasingly influential role in meeting deal and corporate funding requirements. Private debt AuM is expected to see an annual growth rate of 11.4 per cent, reaching $1.46trn by 2025. As investors continue to pursue attractive risk-adjusted returns in a low interest rate environment, there is a number of different variables pushing the increase in private debt allocations.

Market growth  

Jordan Rothberg: In the US, the wind is blowing strongly in the private debt and credit markets right now. What we’re seeing is a sustained uptick. It is increasingly being seen as a way for investors to secure their money and receive better returns over a longer period of time; whereas in the private equity market there is more of a risk return ratio. Especially when you are factoring in whether or not the deal is going to hit or not. The sales are strong for the private debt market right now, I think that will continue to grow over the next couple of years.

Andrea Fernandez: We’ve seen growth come from different angles. You have bank retrenchments, and you have private capital filling that void. One of the reasons I think LPs like the asset class is because it delivers a pretty consistently high yield, it has a liquidity premium and it has a local relation to fixed income and global equity markets. It has less market-to-market volatility and protections tend to be stronger. Basically, there’s less interest rate sensitivity and returns are contractual in nature. Having said that, manager selection is still key; not every strategy yields the same results. For us at Ares, being the sole lender in top performing companies with strong governance, our controls have proven to be defensive. We’ve been able to really work with our sponsors to protect our investors’ capital.

Rothberg: It has probably been the most sales calls I’ve had, on a consistent day in, day out basis for some time. Private debt is just starting to rip in the market yet again. From a fund administration perspective, we tend to see the cycles of debt, real estate, venture capital, and private equity ebb and flow. People are making the best of an unfortunate time and market, amidst Covid-19. That’s the main drivers, and reasons the debt market is thriving in the way that it is.

Debt funds vs banks 

Martin Luehrs: In terms of banks retrenching, what we saw in 2008 and 2009 after the global financial crisis, is that European banks retrenched to their home markets. That theme continues, for instance, the German banks are very strong in the DACH region, but are much less visible in the UK, France, and elsewhere, though with certain exceptions. In terms of future retrenching, it comes back to banks having specific lending criteria and policies. It can be harder for them to adjust as quickly, so when there are macro shocks in the environment, as we’ve seen in the last 12 months, it can be easier for the private debt community to adjust more rapidly to the new operating environment. In the near term, credits that do not fit into the traditional lending criteria of a commercial bank should fall into the domain of the private debt market. Private debt lenders can more easily create instruments that are bespoke and catered to particular situations. The more impacted industries are by Covid-19, the more challenging it is to deliver highly levered vanilla debt solutions.  However, it is worth noting that the banking community has arguably been granted a mandate by society, regulators, and central banks to ensure that capital flows continue and that a credit crisis does not manifest itself. That bank-driven liquidity remains in the system, and is ever-present. It’s a nuanced retrenchment by banks, if at all, in response to the new post-pandemic environment.

Rothberg: I think very strategic fund managers are going head-to-head with banks. It just depends on the size of the fund and the size of the investment class that they’re looking for. If it’s a billion dollar plus fund, then I imagine they’re going against the big banks. If we are looking more at the lower middle-market side of the world, the direct lending market is probably quicker to get in than the big bank, just because of the red tape that there might be on the bank's side, as opposed to the direct lending side.

Fernandez: We partner with banks, and I think banks are here to stay. We’ve partnered with them in fund level leverage, through first out, last out positions, in the syndicated markets. We have provided second lien options behind a first lien term loan that has been syndicated in the capital markets. There are a lot of ways that we have worked together with banks, I think that partnership will continue in the future.

ESG

Thibault Veber: The LP community is pushing for private debt stakeholders to be more accountable and to push ESG with each backed company. Obviously, it is important to make the same push on the smaller side with smaller businesses whereby the ESG function is often not as established. We are getting more and more questions and focus from our LPs on that front. We are definitely pushing that with our debt partners as well.

Luehrs: ESG is clearly currently a big theme in the market. It’s obviously been a feature of the market for a long period of time, but it is evidently becoming more significant as a factor we discuss with investors in our recent transactions. On the equity side, it’s absolutely paramount for fundraising in the private equity community. It has become an all-encompassing aspect of the markets. Just how that translates into debt transactions, we will see over the next coming months. We’ve already seen certain ESG margins being introduced into transactions linked to certain key indicators being met and tracking tools being used. It’s a real-time, evolving theme. We usually see a lot of trends in the debt market permeating from the US to Europe. However, the ESG push has mainly come from Europe to the US. In any case, it is clearly an important theme across the global debt markets. 

Rothberg: This is a theme that is the hottest topic in the US currently. I completely agree that it’s definitely something that Europe is way ahead of the curve on. That is not to say that the US fund managers aren’t considering the issue whatsoever, but I think it is increasing from a fundraising perspective. It is something that needs to be checked in order for an investor to enter into a fund, depending on their ESG perspectives. It’s one of the biggest market trends I’ve seen recently. It’s spanning across the entire industry. Whether it’s agriculture or
real estate or just straight private equity investments. I think it’s an awesome wave that’s sweeping the world, and it’s important that our investors are thinking about this on a daily basis. It’s reshaping how companies are building and forming.

Fernandez: Investors have brought [ESG] to the forefront of their investment objectives. That is really pushing the industry to be more accountable for ESG. Historically there was an argument that because direct lenders at the end of the day don’t control the company, that the involvement needed to be at the screening stage, rather than during the life of the investment. LPs are challenging that convention, and that’s why we hear it talked about more in the market. From LPs perspective, if you are a scale lender, and you have long-term relationships with these companies and these sponsors, then you definitely are a counterparty with significant influence. In fact, sometimes debt lenders are the only groups in capital structures, besides the sponsors. So they should be able to push and make these companies uphold high ESG standards. The other topic that is being talked about is lending to middle-market companies that are small and probably don’t have the resources or the infrastructure to really be tracking policies and frameworks. Direct lenders can act as a resource in that situation.

Maturing Market

Veber: The private debt market will continue to grow. In the same way, the overall debt markets will grow, especially with strong opportunities for the syndicated debt market. As the two asset classes have been growing, the private debt markets have become a little bit more institutionalised, certainly in terms of their products. They have been made a little bit more user-friendly or easier to read and understand when compared to the syndicated market. The two debt market solutions can co-exist very well, as each of them has clear and different features, perspectives, and benefits depending on the kind of transaction in question. I think financing will go between the two asset classes, I don’t believe the two asset classes are really going head-to-head. I hope that they continue to be differentiated but with their own points of attraction.

Fernandez: There’s a lot of space to continue to grow, but I think we’ll also see signs of maturity in the market. We will also have a little bit more consolidation, with fewer new entrants and some managers exiting the market. In general, the trends for growth remain there. This crisis has also allowed investors to see the fundamental investment thesis of the asset class, that it is resilient and robust contractual protections worked. I think that will give investors the comfort to continue to commit to the asset class.