The ups and downs of senior debt

Concerns over market conditions are prompting investors to seek relative safety, but there are dangers in following the crowd, writes Private Debt Investor senior editor Andy Thomson.

Going higher is normally associated with greater risk. Consider climbers hauling themselves towards the narrow summit of a mountain or – to borrow from Greek mythology – Icarus soaring fatefully towards the sun. In a curious inversion, however, moving higher in a deal’s capital stack means taking less risk not more.

Sitting atop the structure, and hence the least risky strategy in the asset class, is senior debt. If you are an active investor sitting atop that lofty perch today, what you will see should you glance down is a mad scramble from countless peers trying to join you. In the first quarter of this year, PDI recorded $13.1 billion of senior debt fundraising globally – representing almost half (42 percent) of capital raised across all strategies.

Since Q1, the senior debt proportion has declined slightly to 39 percent of the total. However, a PDI dataset going back to 2010 shows this is still senior debt’s largest share by a comfortable margin – double the 20 percent figure for the whole of last year and ahead of the previous peak of 30 percent in 2015 and 2014. In 2011, the senior debt slice was a mere 7 percent.

What explains this surge in popularity? Fraser van Rensburg of placement agent Asante Capital Group succinctly told us that “people know a correction is coming”. His view is backed up by plenty of other sources who believe the same thing. In the event of a stressed credit, investors in senior debt will be first in line to get paid in a bankruptcy or out-of-court restructuring scenario – often paid in full or receiving a minimal haircut on their claim. It is, in a nutshell, a safe-haven for those wanting private debt exposure but cautious about overall market conditions.

Investors may be right to be concerned, with debt often supporting increasingly aggressive private equity deals. Some deals today are being done at purchase price multiples to EBITDA of almost 11x, according to a Bain report. This compares with average multiples of 9.7x in pre-crisis 2007. Furthermore, as we have previously reported, the erosion of covenants has added to the impression of a market where the envelope is being pushed.

But in flocking to senior debt, investors may be in the process of discovering that you can have too much of a good thing. As the space becomes increasingly competitive, observers are noting the lack of deal flow relative to the money being raised and a tightening of spreads. Return expectations, even at a modest level of typically around 6-8 percent, may soon be out of reach.

Our figures indicate that the fundraising train is unlikely to apply the brakes anytime soon, with closed-ended private debt funds currently targeting some $216 billion globally. If today’s proportion of 39 percent were accounted for by senior debt, it translates to a potential $84 billion of fresh capital.

How safe is a mountain-top when it gets over-crowded?