By Witold Witkiewicz
Private debt is an asset class in its infancy, but there is a significant structural shift currently taking place, with institutions increasing allocations to this area and diversifying their current positions, both geographically and across the various subclasses in private debt.
Many investors start by selecting managers locally, but with growing demand to top up existing allocations and greater specialisation among managers, there is now a need to better understand the investment opportunities across Europe and the US.
Spurred by the recent prominence of private debt, a range of new managers has entered the market over the last few years. With established managers also diversifying into this asset class, there are approximately 200 funds raising finance for the private debt sector. Institutional investors may require specialist advice to select the right managers for their needs with such a diverse array of options.
In corporate debt, other than the obvious dimension of capital structure, two main types of managers have emerged. The first focuses predominantly on CLO-type structures targeting chiefly the lower-risk senior end of the capital structure. These portfolios can comprise from 60 to 80 or more investments which are traded to a degree in order to generate additional alpha or outperformance.
At the other end, there are the traditional private equity focused fund managers entering the debt space, mostly targeting mezzanine opportunities and direct lending. These portfolios are much more concentrated with perhaps 20-25 investments and bilaterally negotiated terms, and held to maturity.
In addition to navigating the increasingly diverse manager environment, institutional investors face the challenge of selecting which areas of private debt offer the best fit for their portfolio requirements. Real estate debt in Europe, for instance, is a market dominated by relationships, where the most successful ventures involve in-depth local real estate market knowledge and well-established, extensive origination networks.
Among the subclasses within private debt, direct lending is one of the fastest-growing areas. A combination of lower appetite for risk and greater regulatory capital ratio requirements in the aftermath of the financial crisis has led banks to reduce their level of available debt financing and redirect funds to more established, larger companies. The European debt landscape is heavily weighted towards banks, which supply an overwhelming majority of capital, with only around 20% provided by alternative lenders. This structural shift away from banks has therefore deprived many middle market companies of the growth finance they require.
While it is unlikely that the European debt market will shift so far as to mirror the US, where only around 20% of capital originates from banks, it will inevitably experience a rebalancing in favour of institutional debt funding as institutional capital moves to fill this void.
With the market evolving so quickly and fresh inflows from institutional players on the rise, there are concerns that greater competition is driving down yields and leading to a re-evaluation of risk adjusted returns. In the short term, however, the large reserve of untapped demand for debt continues to sustain higher yields, and as the market matures we have seen lower middle market and even SME companies join the ranks of candidate borrowers.
The greater competition from managers also favours informed investors, opening up better deals. However, in such a young market, and in light of the often illiquid nature of the assets, asset owners must take particular care to weigh the prospect of higher returns against the attendant risks, making transparent manager due diligence imperative. One of the main aspects for investors to understand and evaluate is how managers have invested their strategies in the past and how they are expecting to invest going forward.
Private debt is here to stay as the European debt market continues to shift away from bank-led lending. Institutional investors are embracing private debt as a source of higher returns, while managers are entering this space and diversifying their offering to suit a wide variety of investor needs. We can expect the market to continue its ascendance driven by a buoyant M&A market and the demand from middle market firms for growth finance.
Structural opportunities will however remain sensitive to the cyclical nature of credit markets and asset owners seeking to capitalise on these opportunities will benefit from a cautious approach, taking into account the varied approaches and undertaking rigorous due diligence to understand sources and risks of value creation. With an informed approach, the opportunities in private debt can form an integral part of the solution in the search for yield.
Witold Witkiewicz is director of private markets at bfinance
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