Discipline to differentiate: Challenges and opportunities for private debt
29 November 2023
Part 2 of our Challenges and Opportunities series looks at the importance of discipline and manager differentiation.
3 min read
The extraordinary rate changes in the last year mean today’s private debt market is very different to that seen over the last 12 years. Most deal terms agreed in the old paradigm didn’t anticipate such pressure on businesses and consequently some interest coverage levels now look tight on pro-forma interest rates, vs new transactions which are better calibrated to a new debt capacity.
Undoubtedly legacy portfolios pose challenges around credit performance and looming maturity events will test original underwriting quality. This will create the biggest test yet for private debt since it came into the mainstream. The skillset for managing existing problem investments is different than for deployment and it will mean diverting resources to existing or old funds. Managers will want to do this because their track record and carry is closest to those funds, but they’ll also want to deploy as rising interest rates will create a buffer for any losses whilst noting the current vintage is likely to be the strongest we have seen for years.
The challenge is trying to simultaneously deploy dry powder with more lender-friendly terms whilst navigating challenging legacy borrowers which have a disproportionate impact on returns (and resources). The market is dealing well with these dynamics thus far as rate rises have only partially filtered through and so the real challenge still lies in front of us. Juggling these concurrent trends presents a new challenge for credit managers as existing portfolios are effectively decoupled from the opportunity that lies ahead.
Despite the present challenges, the asset class should do well and prove out the benefits of sitting at the top of the capital structure, showing its true worth as an essential and increasing part of the asset allocation of LPs.
The next few years will be the best vintage for many years for private credit with double-digit returns, tighter documentation, and lower leverage all working to make it a more lender-friendly environment. We have seen this evolve over the last year, so it’s a great time for investors to increase their allocation to private debt. The market is already large – with shadow banking now very much in the light – but capturing these sorts of returns for senior-secured lending in an asset class significantly less volatile than public markets is very attractive, more so when equity valuations remain challenged.
The tests faced now by private credit managers will create much-needed differentiation among managers as capabilities are revealed. It is good news for differentiated managers with robust portfolios and those who can navigate the challenges (i.e. the opportunity to stand out for future fundraising). It is also good news for investors as they can see how strategies differ as the cycle progresses and to support allocation decision making. Generic strategies may prove less interesting, while moving up and down the yield curve may see certain asset classes coming back into vogue, such as asset-based lending to lower rampant costs of capital and subordinated facilities to slot into any overleveraged structures.
This will provide choice for LPs. For example, at Investec we remain focused on direct lending to the lower mid-market as the overall credit market has grown and seen many financiers drift to larger deals where efficiencies are greater. Staying put is our differentiator, where lower competition combined with ongoing high deal volumes support our focus of underwriting the highest quality borrowers at the optimal risk-return profile. For example, since our inception in 2010, Investec has consistently generated IRRs per turn of leverage (a risk-adjusted return metric) over 2.0 percent, compared with the broadly syndicated loan market that is typically less than 1.0 percent. We have achieved this because of the positive attributes of the lower mid-market and our disciplined focus on capital preservation.
Today’s market reset is a great time to build allocation in core direct lending, with ABL and lower leveraged financing solutions set to become more interesting strategies for investors. It is also likely that the private equity trend of secondaries increases in private credit as LPs seek differentiated strategies and exit some commitments to enter new ones.
This is part 1 of a 2-part series. Part 2 will be published over the coming weeks where Callum will share his views on the importance of discipline and manager differentiation.