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Private debt: bumps are coming but the road will stay open

The thriving modern private debt market has germinated and grown in a greenhouse — the post-crisis shrivelling of banks and central bank stimulus of debt markets. But already, the banks are coming back. Next, central bank support will disappear — and sooner or later there will be a recession. Will private debt markets cope? Jon Hay reports.

Private debt is a growth market. The asset class has been expanding ever since the financial crisis, and participants expect that to continue.

In the past decade, it has enjoyed a near-perfect set of following winds: banks contracting; companies seeking new sources of funding; and low interest rates driving investors to seek yield, while making it as easy as possible for borrowers to repay.

All good things come to an end. The US Federal Reserve is tightening monetary policy, while the European Central Bank is gradually easing its foot off the accelerator. All big economies are expanding at once, but the bull run in equities is nine years old and benign periods rarely last longer than that. The US stockmarket has fallen 9% since its January peak.

The question for specialists in private debt is: what will happen to their brave, big new market when the financial cycle turns?

“The big test will be, when rates are going up, is the market stable?” says Jürgen Michels, chief economist at BayernLB in Munich. “If it holds, it will be a very popular tool in future as well. The acid test is: does this whole structure hold, and we don’t get a huge amount of defaults?”

The D-word is much used in private debt circles at the moment, because of Carillion, the UK construction group that went into liquidation in January, and Steinhoff, the South African retail empire fighting to stay solvent after its share price collapsed in December amid accounting irregularities.

But so far, the market shows no sign of slowing down. Preqin, the research group, counts $638bn of private debt assets under management globally in June 2017, up from $205bn in December 2007. The asset class is now nearly a quarter as large as private equity, having been only a seventh as large on the eve of the crisis.

The money is accumulating fast: private debt funds raised $107bn in 2017, and more than a third of all the capital has not yet been invested.

But private debt is not one market: it is many. Preqin tracks five types: direct lending, mezzanine, distressed debt, special situations and venture debt. But these do not include swathes of other lending. The US private placement market and Germany’s Schuldschein, traditionally investment grade markets, both scored record issuance in 2017, of $75bn and €27bn.

“This is not a homogeneous market,” says Richard Waddington, head of loan sales and private debt at Commerzbank in London. “There are different elements of the private debt ecosystem. The Schuldschein and US PP are skirmishing in investment grade territory. The Schuldschein dips into crossover, then at double-B the Euro PP is active and in the single-B space you’ve got unitranche and direct lending.”

Fresh pastures

Beyond those, European insurance companies and asset managers are exploring many other new niches in search of attractive assets.

“The world has always divided into what banks will do and what they won’t,” says Andrew McCullagh, head of origination at Hayfin Capital Management, one of the early movers into the direct lending market that sprang up after the crisis in 2009. 

When banks are eager to do a particular kind of lending, their capital structures and economies of scale often mean they can beat institutional lenders. But the combination of Basel II, the crisis and then Basel III meant banks pulled back from many kinds of financing they had dominated before 2008. 

When it came to smaller and more leveraged corporate loans, says McCullagh, in 2009 “banks were being very cookie-cutter. Anything north of 3.5 times leveraged, or outside their geographical target area, or wanting flexibility around documents, they were not interested. So you could be thoughtful and have a competitive advantage.”

M&G Investments, which had been the first European investor to join the US PP market in 1997, expanded into direct lending at the same point.

But, fortunately for the European economy, banks — at different speeds in different countries and asset classes — have been recovering their appetite for credit.

Straightforward corporate loans, especially investment grade ones, were the first asset they took back. That meant the swelling direct lending market became what William Nicoll, co-head of alternative credit at M&G in London, calls “very much a high yield market, with no particular norms of documentation”.

Direct lending now typically refers to deals of €20m-€300m at leverage of three to five times Ebitda, to companies with Ebitda of €15m to €60m.

Specialist funds have raised so much money that the competition has become intense. Banks are fighting to get into deals, too, especially in Germany, the Benelux and France.

McCullagh dates to around 2013 the time when “most banks across Europe began to stop worrying about whether they had enough regulatory capital to survive and more about making money”. 

M&G and Hayfin are still interested in vanilla direct lending, but both have cast their nets wider.

“I never want to be in a fashionable market, because that’s an awful thing,” says Nicoll. M&G has cut back on seeking new money to invest in direct lending and instead is originating deals in less crowded areas, such as leasing and trade receivables factoring, usually partnering with independent finance companies. Nicoll says banks can no longer be bothered to spend months structuring complex deals, opening a space for the skilled and patient investor.

Hayfin has diversified into shipping loans, non-performing consumer debt, niche real estate portfolios, some tranches of securitizations and financing companies’ inventory. It even has a strategy focused on the healthcare industry.

Change is coming

When the interest rate and economic cycles turn, these many kinds of private debt are not all going to perform in the same way. The first challenge will be the withdrawal of ECB stimulus, expected by the end of this year, and likely to affect all credit markets.

“It will change to a buyer’s market,” says Thomas Leicher, head of capital markets at Helaba in Frankfurt. “Credit spreads will widen and issuers may be more reluctant to borrow money.”

Could investors that began exploring private debt when yield drained from public bonds turn away again?

“No one is quite sure how institutional demand is going to play out,” says Waddington. “I don’t think money is going to disappear. Clearly some will, but the products are embedded — people like them. It’s likely that as one of the biggest buyers is removed, there’ll be a normalisation of credit spreads and rates. The demand will remain but there will be a repricing of risk.”

The pain is likely to come later, when the economy slows and higher rates become hard for weaker firms to bear.

Parts of the market, notably the US PP and Schuldschein, have borrowers of mostly high credit quality and have been through many recessions before. Specialists in these markets are quite calm about the prospect of the next downturn. “We try to do everything to make sure we have high quality issuers, with the same quality as in the past,” says Jörg Senger, global head of sales and origination at BayernLB in Munich.

“So we are focusing on midsize and big companies. When SMEs try to tap the market we have to do due diligence. My feeling is the clients we reject usually don’t come to the market with another bank.”

Because of their confidence about the credit cycle, the US PP and Schuldschein markets are more focused on the processes that could make them more efficient and enable them to attract even more deals.

In the US PP market, recalibrated risk charges from insurance regulator the NAIC could improve the incentives for lending to companies of slightly lower credit quality.

Meanwhile, a clutch of second tier investors are starting to ape the biggest buyers by learning to engage in currency swaps, meaning that even though they only manage dollars, they can lend to European companies in euros or sterling.

The Schuldschein market is wrestling with how to bring itself up to date, without losing its old-fashioned virtues: very light, flexible documentation, a large number of small investors and careful gate-keeping of credit quality by the arranging banks.

“The number of companies that will use the Schuldschein will increase, because they are moving from bilateral credit to the capital markets,” says Leicher. “What you need to accommodate this is platforms, digitalisation of the process, so that you can reduce the cost and therefore place Schuldscheine for smaller sizes, like €20m.”

Helaba has launched a new platform, open to all dealers, investors and issuers, so that all documents can be shared and signed online, and the book can be built there.

Rudolf Bayer, head of private placements at UniCredit in Munich, says: “In the bond market we have seen a lot of technological development, especially on the administrative side, which has had a positive impact on speed and costs for banks and issuers. It would be a positive development if the Schuldschein also became faster at handling deals for issuers and investors.”

Down is not out

For issuers and investors in the more leveraged parts of private debt — including direct lending, which has never been through a credit downcycle — the next recession, when it comes, is bound to cause casualties.

Direct lending borrowers are usually smaller than classical leveraged loan issuers, which tends to make workouts harder. Direct lenders will often have to negotiate workouts on their own, and may have to bail companies out with more cash.

Direct lending and other kinds of private debt will take some knocks, but they are likely to survive — just as high yield bonds have now weathered two recessions in Europe.

Four things have changed in the debt landscape since 2008 — all fundamental reasons for private debt to exist, which are unlikely to be removed by the next crisis.

Savings allocated to credit continue to rise. Meanwhile, liquidity has declined in public markets, so the sacrifice made by investors switching to illiquid credit is less. The sophistication and knowledge of corporate treasurers has greatly increased. “We have just done a marketing roadshow to Asia where we spoke to potential issuers,” says Senger. “I was really surprised how deep the knowledge was already and how eager they were to tap the market.”

Finally, the stricter regulation and more conservative balance sheets for banks are not going away, so there is likely to be room for institutions to lend for a long time to come.

“In the long term,” says McCullagh, “this is an asset class that will deliver good premium, low volatility, sensible cash yield to investors and is here to stay.”    

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