Why investment in scale is paying off for private debt post-Covid-19 ?

Before the spread of Covid-19 shuttered economies and disrupted capital markets, private debt was on a roll. 

The number of managers running private debt programmes and private debt assets under management had grown steadily over the previous decade, buoyed by bank retrenchment following the 2008 global financial crisis, investor appetite for long-term strategies that could deliver yield in a low-interest rate environment, and benign macro-economic conditions. Private debt fundraising was up 17.3% to US$125.9 billion year-on-year by the end of 2019, according to PitchBook data, and dry powder levels had swelled to US$250 billion. 

The growth in new entrants and expanding capital war chests drove up competition for deals and pushed pricing and terms in favour of borrowers. Debt became commoditised, making it harder for investors to differentiate managers from each other.

Here for the long-term

Lockdowns and market dislocation, however, have drawn a line in the sand. Markets have done an about-face, with the focus falling onto portfolio management rather than accelerating deployment.

Fundraising has dipped and investors have become more selective. According to PitchBook only 53 private debt funds closed in H1 2020, raising US$47.8 billion between them, putting the market on track for its weakest year in the last half decade.  

Against this setting, attention to credit quality has intensified, as has the value of long-term investment by private debt players in their teams and geographical reach. Scale and infrastructure have proven crucial for shepherding portfolios through the lockdown period, while also maintaining new deal activity through these challenging times.

“There are now some unknowns for investors. How will private debt perform through a downswing in the cycle? The backdrop has been supportive until this year. Now investors will finally have a data point to judge private debt through a cycle, and to draw distinctions between managers,” says Mark Brenke, Head of Ardian Private Debt.

Local presence in key jurisdictions, coupled with investment in origination, are two factors that have come to the fore through the Covid-19 dislocation period, establishing a point of difference between managers who have this capability and those that don’t.

Prior to the pandemic’s spread, private debt managers were among the beneficiaries of an M&A bull-run that ensured a steady flow of opportunities and sustained activity levels for lenders. According to data compiled by law firm White & Case, Western European M&A volume increased by more than 80% in the decade from 2009 to 2019, up from US$413.95 billion to US$748.72 billion, providing tailwinds for the expanding number of private debt managers coming into the asset class. 

But, as deal flow has dropped off through the pandemic, with European M&A value falling 27% year-on-year in H1 2020 to US$281.88 billion, local presence and resources for origination have been key levers for sustaining activity under these difficult circumstances.

Brenke says Ardian’s network of offices and local teams across the core European markets in the UK, France, DACH and Benelux regions have been essential for maintaining the firm’s deal pipelines.

Many of the European mid-market companies targeted by private debt funds have historically used bank finance, and have turned to their familiar lenders through the upheaval caused by the pandemic. Even during stable times, it is a big step to switch to private debt capital. Local partners and relationships have been valuable for supporting the transition.

“It is not impossible to do these deals without local partners, but it is a lot more difficult. Europe is a vast jurisdiction that is difficult to cover from one office. In addition, the fly-in, fly-out model has been severely tested through the lockdown period,” Brenke says.

Perhaps even more crucial has been the fact that during a time of reduced M&A activity, investment in origination has allowed managers to remain selective about the credit they fund.

“Investment performance is dependent on the ability of a manager to maintain selectivity. We will do between 10 and 12 private debt financings a year from the 400 to 500 deals that cross the desk,” Brenke says. “The more deals you see the more selective you can be. The priority is to increase deal flow, and that requires investment in proactive sourcing rather than relying on advisers to ring you, which dilutes the number of opportunities you see.”

The value of proactive sourcing across the credit cycle is further amplified by the typical private debt fee model, where fees are paid on deployed rather than committed capital.

In a steady deal market, where there are high volumes of activity, this is manageable. But when activity levels off managers without large portfolios that are generating income come under much more pressure. This can lead to the pursuit of more marginal deals and less breathing space to be selective, with implications for overall fund performance.

“A manager that has to deploy capital to keep the lights on is more likely to deploy less selectively and buy the market. That is fine when the market is going up, but when it is going down risk-return metrics and credit quality come into focus and determine which managers will continue to perform well,” Brenke says.

Portfolio priority

The pressure on managers to keep deploying capital in order to bring in fee income can be further exacerbated through periods like the Covid-19 pandemic when portfolios are experiencing stress too.

The European Union (EU) has forecast an 8.3% contraction in European GDP this year and ratings agency Fitch sees European default levels for high yield bonds and leveraged loans rising to between 4% and 5% in 2020, and continuing to mushroom into 2021. Credit insurer Atradius, meanwhile, notes that insolvencies in Europe are climbing for the first time in a decade.

Portfolios have required support throughout this period, but resources absorbed by workouts and portfolio management have diluted the bandwidth available to look at new transactions.

“It depends on the health of your portfolio, but when the market does go through a period of dislocation, like the one we have experienced this year, it becomes much more difficult to sustain deal activity when resources are drawn away to portfolio management,” Brenke says.

The capacity to manage portfolios and keep deploying at the bottom of a cycle is easier for firms of scale to digest, and Brenke sees the possibility of consolidation across a market that has seen a sustained rise in new entrants over the course of the last decade.

“The larger managers will get larger and the smaller managers will find it more difficult to secure follow-on funds,” he says.

Opportunities ahead

For managers that successfully navigate the current crisis and come out on the other side, however, there will be opportunities to grow market share and do deals on better terms in a less competitive environment.

Indeed, private debt’s rise in Europe following the global financial crisis of 2008 was aided by the fact that the banks had to cede market share in order to recover and rebuild balance sheets. Brenke doesn’t see similar bank retrenchment this time around, but does believe that opportunities to take market share will emerge.

“This is a health crisis, not a financial crisis, so while there is an opportunity for private debt to take market share from banks focused on existing client bases, I don’t see it happening on the same scale as what we saw following the credit crunch,” Brenke says.

With respect to deal terms, there hasn’t been much movement on the favourable borrower terms that characterised the market pre-Covid-19 for high-quality credits, but Brenke has seen positive shifts from a lender perspective in some areas.

“Documentation hasn’t actually moved that much, but there is an element of natural selection. Only the very best companies have come forward, and they have been able to continue securing favourable terms because of their credit quality. That said, there have been some shifts back towards lenders, particularly around EBITDA add-backs and grower baskets,” he says.

Overall, although the private debt market is bifurcating, which will see a shake-up, and some winners and losers will emerge, Brenke is confident about the fundamentals underlying the asset class’s long-term prospects.

“So far private debt has proven resilient and there is every chance that institutional appetite will increase,” he says.