Friday Letter Another reason why debt’s not a dirty word

The recent proliferation of debt funds can be attributed to the well-documented retreat by traditional lenders (who would retreat completely if a German politician has his way). But the compelling risk/return profiles on offer are also playing a large part – and attracting a number of private equity firms.

You can hardly move for new debt funds at the moment. Together with long-standing credit fund managers like GSO Capital Partners and ICG, both of whom raised funds recently, new managers and products are entering the market on what seems like a weekly basis.

Partners Group, for example, concluded fundraising for its maiden debt fund last week with a healthy €375 million in commitments, while Metric Capital Partners recently held a first close on its debut vehicle on €100 million and HIG debt platform HIG Whitehorse set up shop in London.

So why all the interest in debt all of a sudden? We’ve argued before that private equity firms need to address the looming maturity of the debt used to underpin boom-era buyouts. We’ve also spoken about the dangers of overleveraging. But we’ve less frequently focused on the opportunity these trends present to investors, which is a large part of what’s driving activity.

It’s well understood that traditional lenders – namely banks – are reining in issuance as they continue to deleverage and divest non-core assets. And if the latest bit of tub-thumping political grandstanding by a European politician is anything to go by, some banks may find themselves under pressure to avoid lending to private equity deals altogether. That’s admittedly a bit extreme, but there’s little expectation for banks to ramp up lending anytime soon. And in regions like Europe – where the CLO market has been hampered by regulation and the high-yield market is volatile – that’s particularly concerning for private equity firms that need to finance deals.

That, of course, is where private debt funds come in. And they expect to make some healthy returns for investors, judging by research Partners Group (itself a new entrant) produced last month, which compared the returns on offer from various credit instruments, including government-backed debt.

The typical return yield for privately-issued senior debt was 5-7 percent, with mezzanine offering 12-15 percent, Partners said. Importantly, increasingly common equity kickers mean private debt issuers are boosting upside still further [a recent CEPRES report supports this]. By comparison, senior debt issued by the more stable European countries returns between 0 and 2 percent, with the troubled trio of Spain, Italy and Portugal offering debt that will yield 6-8 percent returns.

Traditionally, government bonds had a rock solid risk profile. But the economic travails in Europe have weakened that position significantly. Government bonds from the likes of Italy or Spain will become subordinate to ECB, IMF and ESM loans in the event of default, which makes them significantly less attractive. Yields are also artificially suppressed by ECB and domestic bank purchases.

By contrast, private debt funds offer downside protection through equity components, and the legal frameworks for repayment in the event of default are clear and well established. Importantly, they’re not subject to political meddling as with government bonds. Lastly, the supply/demand characteristics are favourable too.

So the returns are appealing, as is the risk profile. In many cases, the flexibility private debt funds offer allows them to react quickly to market trends. And they typically lend to, and invest in, the capital structures of not only private equity but also infrastructure and real estate deals too.

No less a light than Carlyle Group co-chief executive William Conway argued this week that debt products were the most attractive opportunity out there at present. “My specific advice would be, I would look to do more in yield products. I think CLOs generally [and] some distressed products are good places where [LPs] can earn their greater return,” he said.

It will be interesting to see how the market for private debt develops further, and in particular, how it impacts private equity. On the one hand, private equity GPs badly need financing options at their disposal. On the other, investors’ allocations to debt could potentially come at the expense of private equity. And for GPs that have both business lines, it will be interesting to see whether one eclipses the other. Expect more coverage from PEI in the future.