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Given its incredible growth, it is easy to forget that the private debt market in its current form is a relatively recent phenomenon. Although it existed before the Great Financial Crisis, its growth has accelerated in the decade since, driven largely by the explosion of direct lending as investors flocked to higher-yielding, floating rate strategies against the backdrop of historically low interest rates. Having grown consistently each year since its inception, private debt assets under management (AUM) reached a record $697 billion1 as of September 2019. Now, after successfully enduring the initial stages of the COVID-19 crisis, the next phase of the private debt market appears to be taking form.
At the beginning of 2020, before COVID-19 engulfed the world, there were signs that the market was evolving. Following a wave of new entrants in the wake of the GFC – the number of private debt managers has doubled in the last five years2 – fundraising was increasingly consolidating towards larger vehicles managed by the most established general partners (GPs). Investors grew wary that the end of the credit cycle was approaching, driving increased allocations towards distressed debt strategies, and there was a perception of frothiness in the direct lending market that added scrutiny to those managers who did not have a track record through the last downturn. As a result, by the end of 2019 the median fund size had increased nearly 50%, to $444 million, up from an average of $298 million in 2016-20183, and was concentrated across the top quartile of GPs.
The COVID-19 crisis has further accelerated consolidation of fundraising to the benefit of larger GPs. The proportion of investors committing at least $50 million over the next 12 months increased from 36% in Q2 2019 to 63% in Q2 2020, while the proportion of investors planning to commit $300 million increased from 6% to 10% over the same period.3 Logic – and anecdotal evidence – suggests that in making fewer, larger commitments, investors are favoring large, trusted and established managers.
And while direct lending has proved resilient despite a modest pause in Q1 fundraising – it continued to be the dominant strategy in terms of funds closed – dislocation-oriented strategies such as distressed debt and special situations raised the most capital.
This trend is being driven by a number of factors. In practical terms, LPs have been unable to perform on-site due diligence as a result of social distancing measures, advantaging GPs with whom LPs have existing relationships. Given the opaque nature of the strategy, relationships are critical in the private debt space, and in an environment where risk has been elevated there has been an understandable preference by many LPs to allocate towards long-tenured GPs with whom they have a history. As the phrase goes, no one gets fired for buying IBM.
This dynamic is especially salient for direct lending strategies, where capital preservation is critical and upside more limited. Compared to return-maximizing strategies such as private equity or distressed debt, there is less incentive for LPs to take a risk on a manager who is perceived to be less proven. This has the potential to create somewhat of a circular affect – those lenders with the most capital tend to have the easiest time accessing the highest quality deals – which in turn makes them more attractive to LPs. More generally, consolidation is a normal feature of any maturing market: having enjoyed more than a decade of capital accumulation, it was inevitable that private debt would shake off some of the structures of its youth.
The consolidation of fundraising to larger players with larger vehicles means that direct lending and private deals are encroaching on the broadly syndicated loan market.
Historically, direct lenders have had a number of competitive advantages. They can offer certainty of close, a quicker turnaround, and certainty of terms given they either do not need to syndicate or have more limited syndication requirements than in a bank execution. Private equity sponsors need to manage only one or a small handful of lenders with whom they maintain long-term relationships, rather than the fragmented, more disengaged investor groups typical of the broadly syndicated market.
Moreover, as a result of these dynamics, direct lenders make it easier for borrowers and their sponsors to raise post-close financing for add-on M&A and can be more supportive partners during periods of distress. While bank financing is frequently cheaper than a direct lending execution, sponsors have shown that they are willing to accept less favorable economic terms for these benefits. With the onset of COVID-19, the ability of sponsors and lenders to support their impacted but otherwise strong portfolio companies through the pandemic have exemplified these advantages to their borrowers – namely a stable capital base and relationship approach.
In contrast, banks have had one crucial competitive advantage – size. Now, as direct lenders’ pool of capital grows, they are chipping away at banks’ biggest advantage of scale. Although the ability of private debt funds to compete with the bank market has been underway for the past decade, the pace of change is accelerating. Per Creditflux’s 2020 Private Credit Forum, some in the industry believe that in 2021, 10% of broadly syndicated loan opportunities brought to market will ultimately go private, a significant encroachment on the bank dominated BSL market.
LPs’ preference for familiarity and existing relationships, as well as increasing scale among a smaller number of players, is driving another secular trend across the broader alternative markets – consolidation around a growing number of supermarket-style alternative investment managers. In the credit world the majority of mature, scaled players now manage both direct lending and CLO strategies. Many are also active in distressed debt, mezzanine debt, and other parts of the private debt markets. Some of these GPs began as marquee private equity investors and have since expanded into credit, enabling them to offer a one-stop shop for a variety of alternative strategies.
This diversification (alongside consolidation) is coming about because of the advantages of leveraging LP relationships across multiple market segments. A well-known brand name with a long track record and pedigree typically has the resources to hire talent, and the fundraising machine to capitalize on emerging opportunities as the macro environment shifts. Having a perceived ‘stamp-of-approval’ can allow such asset managers to enter new segments with LP support.
Of course, there remain niches in the private debt market that – largely for reasons of small size and lack of LP interest – are unattractive to larger players, such as non-sponsor lower middle market lending (including management buyouts and refinancing), where private lenders are effectively acting as a substitute for traditional commercial banks. However, that remains a small percentage of the private debt market today and is not expected to grow at the same rate as sponsor-backed direct lending strategies.
There have long been questions about how the private debt market, especially direct lending, would hold up in a recession. While the COVID-19 crisis has prompted a modest change in LPs’ behavior, it has largely proved the doomsayers wrong.
Early in the crisis, Moody’s expected defaults to pick up on the lower end of the high-yield rating scale, with default rates between 11% and 16% predicted for lower-rated companies.4
Such figures proved to be overly pessimistic: a recent survey of US leveraged loan portfolio managers indicates that the default rate will peak at 6.6%5 while JPMorgan forecasts a 3.5% leveraged loan default rate for 2021.6
Certainly, COVID-19 has had an impact on activity in the private debt market. The number of private debt funds closing fell to 20 funds (raising a total of $8.4 billion in the third quarter) from 60 and $38 billion in the second quarter as the market adjusted to the impact of the pandemic, according to Preqin. However, the number of funds in market across private debt strategies is at record levels, targeting an aggregate $295 billion.7
Thus, the overall trajectory of the private debt market remains intact. A total of 95% of the investors and managers surveyed for a report by investor services group IQEQ – spanning Europe, North America and Asia-Pacific with a combined AUM of $388 billion – believe that the private debt market will continue to grow over the next three years.8 Preqin estimates that the private debt market will double in size from 2017 to 2023, reaching $1.4 trillion.9 With interest rates expected to remain near-zero through at least 2023, the durability of direct lending now proven, and LP’s flocking to exploit other opportunities created by the pandemic, the bullish run of private debt fundraising appears poised to continue. It is also important to recognize that despite its rapid ascent, private debt is still underrepresented in many institutional portfolios – according to Mercer Advisors 2019 European Asset Allocation Survey of European pension funds, only 11% currently allocate any capital towards private debt.10
More generally, the private debt markets’ ability to withstand a full cycle – and a particularly severe and rapid economic downturn at that – will increase its credibility and boost confidence in its sustainability. It is possible that some smaller GPs that have managed effectively during COVID-19 will now be able to point to their experience and – once business networking opportunities return to something more like normal post-COVID-19 – be able to leverage their track record. However, for the time being the trend is likely to continue to be one of consolidation, as the increased fundraising capabilities of large players bring benefits in relation to the opportunities they can access, and the value proposition they make available to borrowers and clients. Across the board, it appears the relatively young and fragmented world of Private Debt is moving in line with the alternatives market broadly – that is, sustained AUM growth and consolidation at the top. Whether this indicates the market is beginning to reach maturity or simply getting its second wind remains to be seen, but for now the message is clear: private debt has not only survived but thrived through its first true cycle, and LPs are taking notice.
3 Preqin Quarterly Update: Private Debt Q2 2020
8 IQEQ, Private Debt: Expect the Unexpected, September 2020
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