Q1
Recent research reveals that assets under management (AUM) globally are expected to grow by 11% CAGR between now and 2025, to $1.46tn, and that nearly half of investors confirmed that they would be increasing their private debt allocation this year, compared to 2020. Several strategies within private debt have been popular with Limited Partners (LPs).
Direct lending is one of them: it is driven by a real need from the economy, in particular from the systemically important mid-market sector and mid-caps, generally comprised of “in-between” companies, spanning the upper end of the SME universe, and larger private companies that do not receive the wider coverage of large, usually listed, companies.
Regulatory and capital constraints on banks post 2008 have caused them to largely retreat from that market, with the funding gap being filled by alternative lenders, funded by institutional capital rather than deposits. Direct lending will continue to have a growing role to play in helping mid-market companies navigate the crisis but also, importantly, in supporting strategic growth plans.
Another area is subordinated debt, for example in the infrastructure space. The internal risk-weighted asset models of banks tend to penalise subordinated debt. We see an increasing number of private equity fund managers diversifying across the capital stack and subordinated debt allows them to leverage their knowledge of the infrastructure asset class, while offering their clients returns that are still very decent compared to public markets.
Last but not least, the peer to peer and FinTech funding space is another one to be watched. Again, here we’re talking about provision of financing, where it’s most needed, and meeting a very real economic need despite the much smaller tickets compared to other private debt strategies. This strategy is very volume intensive and requires a solid risk and systems architecture.
Q2
Private debt has become mainstream, and specifically a mainstream part of the alternative investment space.
The pandemic has caused a flight to quality among LPs, meaning that LPs have directed allocations towards managers who can demonstrate a solid track record and provide evidence of strong past performance. Many less mature fund managers have struggled to attract LPs except where they were able to offer a key differentiator in their product offering while backing up their statements with a track record of market knowledge and market access.
Private debt as an asset class has been in focus for many years, meaning the quest for the next innovative strategy is a well-trodden path, and not many niches remain to be uncovered. We believe that offering access to new geographies could be part of the answer. For example, Asia is seen as a promising market for direct lending: in early 2021 there were 44 private debt funds in the market focused on Asia, up from 38 at the beginning of 2020 (Preqin), and this trend is likely to continue accelerating.
Another angle could be ESG, as demonstrated by the abundant use of “green”, “responsible investments”,” impact financing” terminologies in the headline pitch of most funds currently in the market. We’ve seen some infrastructure debt funds being launched with claims at a very high bar in terms of ESG-compliant investment sourcing. It remains to be seen if this space will become over-crowded before even reaching maturity.
Q3
Traditionally, where LPs would look for GPs to add value is on market access, origination acumen and wise selection of investment opportunities. The GPs’ position on the growth curve is a key factor, as it informs the choice of priorities in terms of resource allocation and focus. If you are a very mature manager who has been in the market for many years, with several vintages of multiple strategies, chances are that you will have developed some internal systems to cater for middle and back office (to manage capital calls, provide financial reporting to LPs, etc.). The key question is whether internalisation is the most efficient way to deliver strong operational performance and allow you to grow further. In any case, it is very important to find the right balance between having these functions serviced in house vs outsourced. Your performance also lies in your ability to scale-up and, for this, teaming up with partners whose core business it is to provide you the newest technologies wherever you next choose to focus your investment strategy, from a product and geography perspective, is a key factor of success.
Q4
The pandemic has had an impact on the performance of the investments as well as on the way the investment management business and fund raising were carried out.
Asset management is a business where trust and relationships are of paramount importance. And to survive, trust requires predictability, to a large extent.
The pandemic brought with it the parameters for a real-life stress testing exercise for asset performance, and LPs were anxious to know, preferably right now, how their investments would fare, short and medium term. They asked for more data and interaction with their managers than before. It was crucial for the credibility of managers in maintaining that relationship of trust, to be able to deliver on that need for information and updates. Being able to deliver this was key. The personal relationship hasn’t changed, but it’s been enabled and reshaped by technology.
During the pandemic, the well-established practice of LPs conducting onsite due diligence as a prerequisite to a new allocation could not be maintained, and many managers venturing into new strategies were at a significant disadvantage. Meanwhile, those LPs who embraced virtual sessions were able to get exposure to a much wider set of stakeholders than a physical meeting at the manager’s premises would have allowed, giving them a better feel for the capabilities of the manager overall.
Technology has found a new place in enabling that relationship of trust. It hasn’t made the relationship between GP and LP less personal; it’s allowed that relationship to survive and helped to avoid breakages in communication.
Q5
Asset origination experience, combined with an in-depth understanding of LP allocation drivers, is what matters in the current, very competitive fundraising environment. It is no longer sufficient to bring origination firepower to the table to convince LPs. The investor universe is increasingly diverse: public and private sector pension funds, foundations and endowment plans, family offices, insurance companies, sovereign wealth funds.
Understanding what role they are assigning to private debt in their portfolio mix is the key to a successful offering. This requires having very specialised and knowledgeable sales and product specialist teams, the Achille’s heel of many managers, or for want of that expertise in-house, being willing to team up with placement agents and taking a long-term view. This is what differentiates asset managers, especially in the illiquid space, from bankers, in particular those from the so-called originate to distribute houses, where performance is measured on the ability to maximise first year’s fee income on a given investment. Asset management is very seldom about quick wins.
Q6
To answer this question, we need to remind ourselves of two of the fundamental differences between debt and equity positions in a company or a borrower: the benefit of upsides/increase in value and the type of controls that can be imposed. An equity shareholder will benefit from an increase in the company’s value, the lender will not. An equity shareholder has the ability to give the company a direction, the lender can only incentivise through various levers. This key difference needs to be borne in mind when putting ESG objectives into practice. Private debt lenders have been looking at investments through an ESG lens for a long time, by refraining from lending to some types of industry (nuclear for example) or being mindful of the reputational risk attached to others.
The increased emphasis on ESG means that more demands are being placed on managers to assess and track how the investments fare from an ESG perspective. This means availability of data, which in turn means ability for the lenders to receive that information from the borrowers. This has to be embedded in the financial documentation through covenants. If equity and debt share the same understanding that ESG is a key factor and feel their interests are aligned in this, then the shareholders of the borrower will be minded to agree with a set of covenants that allows ESG monitoring.
One of the incentives that has been implemented in the past year is to link margins to ESG performance: we have seen many large corporates issuing bonds with sustainability-linked pricing ratchets – where issuers pay a lower coupon on their debt if pre-agreed ESG Key performance indicators (KPIs) are met (or a higher coupon if they are missed). In the first half of 2021, the issuance of such bonds increased fourfold year on year to US$ 160bn (according to the Institute of International Finance). This is a much more radical approach, but it has the merit of clarity and transparency, and it will be interesting to see if the private debt space embraces this approach.
Q7
With the private debt market expected to expand and continue following a strong growth trajectory, the need to stand out from the crowd is increasingly important. Many managers are broadening and diversifying their propositions, with geographical diversification high on the list of strategic considerations. While investor demand for infrastructure debt, for example, is expected to remain focused on OECD countries for the foreseeable future, the ask is much wider for other private debt strategies, in particular direct lending, with Asia seen as a promising market going forward. That diversification is also seen as an important factor for ensuring future resilience.
The focus on sustainable investments is gathering pace, not least because of measures like the EU’s Sustainable Finance Disclosure Regulation imposing ESG disclosure requirements on fund managers. But there is still a long way to go. Unlike equity markets where ESG compliance can add value to the company and where shareholders can impose an ESG direction should they wish to, there is limited leverage for lenders to influence how ESG is embraced by borrowers. The availability of accurate and meaningful data to monitor and track ESG practices and performance is central to driving positive change.