The private debt market in particular has swollen in recent years as more and more investors are drawn to the expected higher returns and lower volatility compared to other asset classes. Another element of appeal are the floating-rate structures that allow yields to grow as interest rates rise. Private debt fundraising has exceeded $100 billion for the past four years and annual returns for the asset class have averaged around 10% since 2008, with higher yields than are available in public debt.
Against this backdrop the market has become increasingly competitive, with downward pressure on pricing leading managers to increasingly look to vary terms and fund structures. Tim Atkinson, Director at Meketa Investment Group, reveals what investors should be doing to manage risk and maximise potential returns in the current environment.
As an investment consultant, you must see a lot of the private debt market and the structures and terms employed by managers. Are you seeing much variation in how private debt deals are being structured?
With most private debt strategies and investments, it is a borrower’s market. Investors (lenders) have been eager to quickly ramp up private debt allocations and get capital invested, so borrowers have taken advantage of this increase in supply by pushing back on loan terms and structures. The posterchild for this has been covenant lite loans – issued with fewer restrictions on the borrower and fewer covenants to protect the lender – but there are many other ways a borrower can push back on deal structure. Documentation and structure in these deals tends to be more homogenous as well.
The one area where credit investors appear to have some influence on structure have been on “special situation” financing, often regarded as an alternative to traditional direct lending. Special situations tend to be more complex since they involve helping companies navigate through difficult operating and financial environments, leading to fewer interested lenders as investors may not want to spend the time to underwrite a borrower that their investment committee may not understand or ultimately approve. In many of these cases loan documents and structure may be more bespoke and can offer unique lender protections not found in more straightforward loans.
What trends are you seeing in this regard at this stage of the cycle?
It’s usually very difficult to categorise a particular point in the credit cycle in real time. Over the past several years easy credit has led to lower underwriting standards and pricing. It appears that public markets have started to be more discerning with respect to credit quality over the past few months, and I would expect, if the broad market backdrop continues, this will continue with an increase in dispersion in private markets.
In terms of specific trends, private debt dry powder keeps rising and larger loans in the crowded upper mid-market are becoming more borrower-friendly with looser documentation and covenants. Essentially, borrowers have many more options and time if they experience a period of difficulty. A recent report from law firm Proskauer found that for deals arranged in the private debt market, covenant-loose structures jumped to 59% in the first half of 2019 compared to 26% recorded in all of 2018. Furthermore, heightened competition for deals has pushed managers to sharpen their focus on origination, building their sourcing capabilities to help set them apart.
What should be the biggest priorities for investors in private debt funds at the moment and what should managers be doing to meet these?
We strongly believe that investors now should be focusing on strategies that exhibit two key attributes. First, GPs need to be able to successfully manage existing portfolios through a period of lower growth and reduced capital markets liquidity. Secondly, we believe strategies that have the ability to opportunistically make new investments that have higher expected returns in a dislocated market environment will outperform strategies that rely solely on origination in market segments that do not experience as much price volatility.
Under the spotlight: Tim Atkinson
Tim Atkinson has worked in the financial services industry for 12 years and joined Meketa Investment Group in 2008, relocating to Meketa’s London office in 2015. His responsibilities at Meketa include investment research and client servicing. Mr. Atkinson is responsible for sourcing and research for all Credit and European Private Markets strategies. He leads investment due diligence, and helps clients create custom public and private credit investment programs. He received his Bachelor’s degree in Finance from Northeastern University.