Discipline to differentiate: Challenges and opportunities for private debt

Sector selection and portfolio construction are absolutely key to alpha returns and we’ll see it more visibly across managers in this new lending environment. Up to 2022, we saw some particularly hot sectors with businesses that, whilst strong credits, had secured overly high leverage which is now creating problems as base rates have increased and potential maturity refinance risks appear.

We expect this to create performance dispersion amongst managers, with some now spending significant time and resource dealing with portfolio amendments and restructurings. This is in contrast with those managers who remained disciplined and committed to sectors where they have developed significant knowledge and a level of expertise, and crucially, arranged finance at lower attachment points.

For those underwriting new deals in 2023, there are green shoots. For example, strong credit sectors such as SaaS businesses, professional services and healthcare (always a go-to owing to its acyclical nature), are now returning to more normalised valuations and lower leverage levels. Combined with higher base rates and more lender friendly terms you can see why the private debt sector is one of the most attractive assets classes in alternatives.

At Investec, we diversify within our sector selection whilst remaining committed to certain market thematics where we have built expertise through our experience. It means we are credit-pickers, and our investments are protected through a combination of diversification and a true understanding of the businesses we’re backing.

Valuations are creeping down1 so people will be more controlled and considered around equity cheques on transactions. The returns they get from those will be in a new economic environment, and as that normalises, lower equity cheques will mean lower debt packages and a renewed focus on the cost of capital.

We expect to see a move along the spectrum towards more accurate pricing for the risk and better terms. We won’t move back to the incredibly lender-friendly terms of the early 2010s, but we have absolutely seen the reinforcement of the value of covenants and cleaner earnings metrics (so less EBITDA adjustments). This “purer” debt financing helps to give early and accurate warning signs of distress that provides lenders with the chance to sit around the table earlier, where optionality is at its highest, and to make plans alongside the business to unlock better outcomes for all capital classes. This covenant-loose cycle has seen firms fall into distress too quickly as the warnings were too late and breach leverage too high. Looking ahead it’ll be a more rigorous and differentiated market where some of the softer values of lending are coveted.

It's also never been more important for a borrower to trust their lender than it is today. They should diligence providers as much as lenders are diligencing them. It should be about taking a longer-term lens on partnerships, and this will lead to a flight to quality rather than worrying about the last inch of negotiation. We believe in this approach and the benefits of building authentic and trusted partnerships and we have seen first-hand how borrowers and sponsors rate this. For example, we have provided repeat financing for over 65% of investments in our Private Debt Fund I and have worked with over 80 sponsors since 2010, backing over one third of these, two or more times as they look to grow their portfolio companies with a committed financing partner.

1Source: Pitchbook, Q3 2023 Global M&A Report.

Callum Bell, Head of Direct Lending

Looking ahead it’ll be a more rigorous and differentiated market where some of the softer values of lending are coveted.

Over leveraging is a cardinal sin in debt investing – even if businesses can service in good times, it can suffer twice as much when under duress. We like to refer to the sobering expression that debt investors “earn pennies and lose pounds” to ensure we remain focused at the point of underwriting and to maintain leverage level discipline even when markets are on the rise as they were up to 2022. Discipline is important and it is encouraging to see that leverage levels have dialled back over the last 12 months. This adjustment is much needed after a sustained period of leverage creep to levels averaging closer to 5.5x prior to the interest rate paradigm shift2 – so a nice nod for fundamentalists. In our experience at Investec, we have found that a fundamental-based approach with low leverage attachment points – our average leverage has consistently been around 3.5x since 2010 – has supported a very low default rate and negligible losses. It remains to be seen whether the market will stay true to these principles or be accepting of lower coverage ratios in the quest for deployment.

It’s about perfectly formed capital structures, uniquely crafted for that specific business, that can perform in the good times and protect on the downside across the cycle.

If you over-index into sectors, those risks coupled with high leverage can double down on you and it can become more asymmetrical when the tide goes out. So beyond sectors, it’s about perfectly formed capital structures, uniquely crafted for that specific business, that can perform in the good times and protect on the downside across the cycle.

Achieving this requires looking at the credit holistically rather than merely the numbers. It will mean a strong understanding of the individual businesses, the motivations of management and the drivers of that sector, coupled with a strong equity cushion and the right covenants with appropriate headroom to provide an early warning trigger.

Outside of the capital structure, diversification – in terms of both sector and investment exposure levels – remains a critical risk management tool for private credit managers. Investec has a dedicated focus on the lower mid-market where deal volumes are high. With this market backdrop we look to construct portfolios where there is wide investment diversification with a minimum of 30 to 40 borrowers.

The debt investment business is a craft rather than a capital markets business, though it can be easy to forget about the key fundamentals. The lower mid-market in particular has real people behind every opportunity, and focusing purely on the numbers makes you too structure- and metric-led, meaning decisions can be based on the wrong inputs.

2Source: Pitchbook Leveraged Commentary & Data (LCD), European private credit research - Q2 2023.