As the European private credit industry continues to gain momentum, the range of strategies on offer is broadening and competition is intensifying. We sat down with Leo Fletcher-Smith, Strategy Head, European Private Credit at Aksia Europe, to learn more about the current trends and dynamics in the space.
As a research specialist on European private credit, what is your view of the current landscape overall?
It is a pretty tough market for LPs to invest in right now. Market competition is as high as it has been at any point in the past 10 years and there are very few sectors that haven’t experienced some form of decline in risk / return dynamics. Corporate credit is one of the worst hit sectors – leverage is high, covenants are disappearing, EBITDA addbacks are rampant, poor documentation allows for hidden leverage and lower quality credits are finding their way into lenders’ portfolios.
Where do you see the greatest opportunities and/or risks at this stage of the credit cycle?
In our view, the greatest risk is the erosion and, just as importantly, the variability of underwriting standards that we are witnessing across the market. Credit strategies typically involve asymmetrical return profiles. Upsides are often capped or limited so instances of investment downsides are often the main determinant of overall performance.
Whilst things have been somewhat benign to date, this variability in underwriting standards across the market will, in our view, lead to a much wider dispersion of returns than many people except over the coming years. We expect this to hold true even with supposedly low-risk, senior-secured lending strategies. The signs are pretty clear right now, potentially not in headline default rates, but certainly if you are willing to spend time analysing the right data and reading the underlying loan documents.
On a more positive side, the breadth of the private credit market continues to grow. We are continuing to see an increasing range and quality of credit strategies that investors can access, often characterised by underlying collateral / assets with fundamentally different return drivers that can offer the potential to build truly diversified credit portfolios.
How is the current macroeconomic environment affecting appetite for risk in the market?
From an LP perspective, we see investors actively positioning themselves at both ends of the risk spectrum. In terms of performing credit strategies, we often see investors moving down the risk curve into more defensive strategies, but at the same time we see many LPs actively positioning themselves to try to capitalise on the next wave of stressed / distressed opportunities.
How do you see an economic downturn affecting private lenders?
In terms of individual credits, we believe that defaults will take longer to materialise and credit performance will be able to erode to a greater degree than in previous cycles. When defaults do occur, recoveries may be both lower in aggregate and more variable than we have seen historically.
The wider point to consider is how the nascent private credit market will weather the next downturn. We believe that there is some merit in the view that PC funds are structurally better vehicles to hold long-dated credit assets, typically benefiting from better asset-liability matching compared to prior holders of credit assets – in particular hedge funds and, to a lesser degree, banks. We largely subscribe to this view, but we are also expecting to see a range of distressed opportunities emerge as funds / platforms under-perform, resulting in a failure to raise follow-on capital and in effect becoming zombie entities or, in extremis, suffer blow-ups. We aren’t expecting the latter category to be a large component of the market and, in most instances, we expect fund-blow-ups to be largely the result of poorly structured fund leverage facilities. However, we do expect opportunities to be created when fund investors start selling assets into an illiquid market.
We believe that Aksia will be well-positioned to go on the offensive when this does happen, because our research will be supported by a large quantum of data. Our loan-level database includes detailed characteristics and performance information from almost 10,000 loans across hundreds of GPs, and we believe the depth and breadth of our data will be a valuable asset to our clients.
How do you think private credit dealmakers will evolve in their approach over the next three years?
In our view, competition does not seem to be going anywhere and fundamental supply / demand dynamics do not show any signs of rebalancing. We believe that the trends that we have witnessed over the past 5-7 years – increasing leverage, reduced pricing, weakening of loan structures etc. – are unlikely to reverse in the near term, absent of some form of macroeconomic shock or repricing of risk.
Against this backdrop, GPs continue to face a decision over how they go to market – what are the terms they want to compete on, or more importantly which factors do they want to protect? Is it pricing, pace of deployment or risk tolerance?
Typically, GPs are able to protect one, or at best two, of these criteria in their portfolios but not all three and the variability in behaviours between GPs will continue to be a defining characteristic of private credit markets.
Under the spotlight: Leo Fletcher-Smith
Leo focuses on providing research services to the firm’s institutional clients across the European private credit space encompassing corporate lending, distressed and opportunistic strategies. Leo works closely with the Portfolio Advisory team and is responsible for sourcing investment opportunities, maintaining GP relationships and fostering Aksia’s private credit presence in Europe.