Q3 2020
Investors still flocking to private debt
Michelle D’Souza
Diversification and forward-planning key attributes for direct lending funds
European private debt investors have generally been satisfied with fund performance, with the asset class proving itself to be resilient, paying coupons and providing stable valuations amid its first major challenge.
Although investors report that around 20% of companies have experienced covenant breaches, incidents of suspended or disrupted interest payments seem concentrated in the obviously distressed sectors. There has not been a general haircutting of valuations or interruption of cash flows.
Direct lenders, however, are not yet out of the woods. While sponsors have been supportive so far, the longer the COVID-19 crisis endures the less optionality sponsors will have – and the more likely that lenders will have to come in and provide capital to help save their investments.
Still, investors have confidence in the asset class and continued to flock to it in Q3.
Abhik Das, managing director and head of private debt at Golding Capital Partners, says the firm has continued to stay active with new commitments throughout the pandemic, pledging almost the same amount as in 2019 across global private debt funds. “Ultimately, investing in private debt funds means investing across a five-to-seven-year basis … You need to take a longer-term perspective,” he says.
Several investors also introduced or increased private debt allocations in Q3. The Iowa Public Employee Retirement System, for example, enlarged its private credit allocation by around US$1.7 billion from 3% to 8% of its plan, funding the commitments partly from a reduction in its core fixed income allocation (28% to 20%).
“The issue facing investors is the reduction in interest rates on traditional fixed securities globally,” says Greg Samorajski, CEO of the US$34 billion fund. “With a reduction in expected return, our board looked towards options in alternatives. We have a long-term horizon as a defined benefit plan, so we can allocate to illiquid assets.”
Christine Farquhar, global head of the credit investment group at Cambridge Associates, says many European pension funds are shifting assets from public credit into private. “Investors are focusing on senior direct lending when reallocating out of liquid investment-grade or high-yield credit,” she says. “Even though it’s not the cheapest time to put money to work in senior loans, there is still appetite.”
Other investors have begun to find direct lending appealing after previously shying away from it. “There are attractive new valuations for vanilla mid-market direct lending deals for the first time in a while,” says Chris Redmond, head of manager research at Willis Towers Watson. “There’s a good return potential in alternative credit and default rates have started to edge down … However, it’s more sector specific rather than across the board, suggesting active management will be key.”
Some LPs who previously allocated to direct lending funds when the market was more niche, however, are passing on opportunities. “For sponsored direct lending funds, there is too much capital in the market and terms have gone down significantly,” says Claire Madden, managing partner at Connection Capital. “While banks are tied up and there will be good opportunities for those private lending funds in the future, it’s probably not exciting enough return-wise for us.”
Dependence on diversification
Private debt investors say they are witnessing wide dispersion between fund outcomes, with diversification and a well-resourced team some of the key differentiators.
Jeffrey Griffiths, co-head of private credit at placement agent Campbell Luytens, says the funds that have done less well than expected are typically those with managers who are taking oversized positions in their fund. Funds with 15-20 loans will be affected more substantially by the bad performance of one of two companies than those with 50 positions.
“There are managers trying to stretch to do that really large transaction and putting it into their fund. These larger deals will continue to occur, and managers will need to get a hold on fund diversification,” he says. “It’s tempting to do a billion-dollar deal, as you’ve deployed your capital in one go and that means you don’t have to do a lot of other deals to deploy the fund. The flip side, of course, is if the outsized deal turns sour in two or three years, then fund investors could have a problem.”
Jason Proctor, co-founder of Truffle Invest, agrees and says investors are not looking for lenders to maximise their returns from conviction in single names, but rather to pursue downside protection through diversification. “There are no prizes in private debt for having a concentrated portfolio because you can’t outperform, you can only hit your target yields,” he says. “What we will probably see is that minimising company-specific risk in private debt portfolios will likely prove the correct way to go.”
Investors’ attention also turned to resource and portfolio management functions – assessing whether firms can dedicate resources to companies that start to underperform, while at the same time closing new deals in an environment that might be lender-friendly.
In the US, most managers are bigger and have the institutional structure to deal with multiple issues. “The biggest test for many European lenders in this pandemic is that COVID-19 has had an impact on virtually every single business in the portfolio,” says Das. “Larger and smaller businesses, stable and not so stable underlying markets, businesses with elevated and more moderate leverage levels. It is likely that we will only be able to properly assess the portfolio performance of the various private debt fund managers by the end of 2021/early 2022.”
Direct lending funds that will do well are the ones that are ready to deal with multiple issues at a time. Funds have taken varying approaches to their restructuring set-up, though investors agree it is too early to tell which model is right or wrong.
Investors also acknowledge that communication from private debt managers has improved throughout the crisis, though there has been some differentiation. “All the managers we are invested with, with one or two exceptions, have been extremely proactive in terms of communication, very forthcoming in terms of providing as much detail as possible, very transparent around issues they’ve had in their portfolios,” one investor tells Creditflux.
Dry powder
Flush with cash, managers are keen to deploy dry powder. And investors say managers certainly had more opportunities to lend creatively in Q3, with varying structures and larger equity contributions from sponsors. “We saw the same dynamic in the aftermath of 2008: slightly more lender-friendly covenants, though headline figures won’t move too much,” says one investor.
Managers, however, will be cautious about the existing portfolio, as well as about underwriting new transactions given the uncertainty. “The biggest challenge is to make sure that managers remain disciplined with deploying capital – even if many managers will claim that they are not under ‘pressure’ to deploy, their LPs will not want the capital to sit on the sidelines either,” says Das.
Sectors such as software, with a high degree of recurring revenues and long-term contracts, will see stiff competition. Finding those deals with the right risk-adjusted reward will be challenging for managers.
“Leverage levels have come down somewhat and the documentation has improved to the benefit of lenders, which means that overall risk-adjusted returns are definitely better than before the pandemic,” he says. “The overall environment should therefore present more opportunities to investors that stay disciplined.”
First-time funds split opinions
A recent survey conducted by placement agent Eaton Partners showed that 66% of investors are willing to invest in managers without physical meetings.

“When coronavirus first hit, physical meetings became impossible and commitments paused. Investors thought it was going to be short lived, but I think now people realise it’s going to be here for a while,” explained Peter Martenson from Eaton. “[LPs] still need to invest, so they are starting to bend the rules a little bit and get more comfortable leveraging technology, and I think we will see this trend continue. That being said, a good number of LPs are still unwilling to do it and write a big cheque.”
One investor tells Creditflux: “It’s preferrable to meet in person, but it’s possible and realistic to do remote due diligence. No institution or private markets investor should be making an investment decision based purely on a jovial conversation with a manager over a coffee, especially in private debt.”
Sources say the situation is unfolding in a similar manner to the last financial crisis – capital, and especially institutional capital, tends to flow to what it knows. “No one ever got shot for sticking up for a well-known fund with a good track record – you probably might get shot for a first-time manager that messes it up,” says Madden. “As investors get more comfortable, then they’ll invest in new managers.”
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European Direct Lending Perspectives
Q3 2020
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