After a choppy 2020, US private credit markets were incredibly active in the first half of 2021, as fundraising rebounded to beyond 2019 levels and M&A activity surged.
North America-focused private debt funds raised more than $40 billion in the first six months of the year. That was a sharp increase from the $27 billion raised in the first half of 2020, with an average fund size of nearly $800 million, which far exceeds anything seen in recent years.
As fund sizes continue to escalate, the opportunity to do ever-bigger deals is playing into the hands of larger credit managers.
“We’re continuing to see the expansion of the addressable market as larger companies are increasingly seeking the speed, flexibility and certainty of closing that large direct lenders can provide compared to what a bank or syndicate-led solution can deliver,” says Kipp deVeer, head of credit at Ares Management Corporation.
With so much sponsor-led M&A activity, there is also a growing willingness on the part of private equity firms to embrace private debt. “We continue to find attractive relative value among larger companies given our market position, and the increasing acceptance of private financing solutions in the upper end of the middle market,” deVeer says. “We believe these larger companies have scaled platforms, diversified business models, sophisticated management teams and generally created less competition, which makes them highly resilient.”
Two industry sectors that have stood out ahead of others are technology and healthcare. “Technology and healthcare M&A and LBOs remain very active,” says Craig Farr, a senior partner at Apollo Global Management. “Both sectors are thematically strong and typically have high recurring revenue, high growth and good macro trends, which support higher valuations, large equity cheques and manageable leverage. Investor demand is strong for these sectors both in the private and liquid markets.”
Farr goes on to say: “Within this M&A-driven opportunity set we have seen attractive opportunities to invest in companies that thrive in today’s market, including many technology and tech-enabled healthcare businesses. While rates and terms are tight, many of these deals have significant equity as percentage of the capitalisation, are backed by leading sponsors, offer forward-looking views on contracted revenues, and exhibit top-line growth at rates that should enable faster deleveraging.”
In fundraising, there has been increasing specialisation in strategies, with placement agents reporting a flurry of activity around tech lending, healthcare lending and speciality finance unrelated to corporate credit.
Senior debt strategies and those focused on subordinated or mezzanine debt accounted for more than three-quarters of the dollars raised for US private debt in the first half, at a combined $32.3 billion. Senior debt strategies continue to dominate, accounting for 42 percent of the market.
“This has been a really busy year and an active time for all our clients, both in terms of transactions and fundraising,” says Melissa Bender, a partner at law firm Ropes & Gray. “On the fundraising side, we are seeing activity across all parts of the credit spectrum, within all different strategies. One area of particular note is the increasing interest from high-net-worth individuals in the asset class.
“The activity we saw about a year ago was largely associated with taking advantage of market opportunity in terms of dislocation strategies. Over the course of the past 12 months that has altered, and we have seen more traditional fundraising.
“Managers have been very active and able to fill capacity in their funds and deploy capital pretty quickly, meaning they are returning to the market with further funds on shorter timetables.”
Jeffrey Griffiths, co-head of global private credit at Campbell Lutyens, also sees a surge in activity. “Last year the fundraising numbers were down about 25 percent in private debt, in line with other alternatives markets like private equity,” he says. “We are seeing quite a significant rebound right now, which is not surprising given the performance proved so resilient through the pandemic and dealflow has come back strongly.”
Griffiths notes that managers are running short of capital. “They are burning through their funds and coming back quickly to raise new funds, which is a symptom of a lack of capital in the market, with fund sizes arguably not big enough,” he says. “Most of the scale in the market is driven by private equity dry powder, which is very high, and a large proportion of private equity deals must be financed by private credit, so private credit fundraising needs to follow on from that.”
With sponsor-led deal activity on track to reach the highest level in a decade and the market flush with capital, it may be tempting for some lenders to execute deals with aggressive terms and looser documentation standards.
Ares Capital Corporation, Ares’s largest US direct lending fund, reported a record level of $4.9 billion of new commitments in the second quarter of 2021, with the growing breadth of its pipeline enabling it to look at a larger and more diverse set of investment opportunities. Still, the fund finances only about 5 percent of the new deals it looks at.
“Our most important focus is to be highly selective and invest in what we believe to be the best companies,” deVeer says. “We also use our ability to commit larger hold amounts and our long-term relationships to negotiate the best deal terms for our protection. Overall, we continue to invest on terms that are favourable compared to the broader market and believe that we are able to do so because of our positions of incumbency, scale, flexibility and our partnership approach to relationships.”
Apollo’s Farr agrees there is a need to address the erosion of deal terms and a need for underwriting discipline. “We focus on good credits that we expect to perform in the near term, we partner with our best sponsor relationships and we look for deals where our domain experience can give us a competitive advantage,” Farr says.
“In evaluating more aggressive deals, we want to see good credit quality, significant equity cheques and typically emphasise things like cashflow sweeps, restricted payments and limitations on debt. Basically, we look to draft credit agreements that bring borrowers back to the table based on performance, corporate activity and general M&A. And we’re examining any issues or historical gaps in credit agreements that could impair seniority in the future.”
The need for credit managers to up their game on ESG has been a significant theme in the first half of 2021, in part driven by the advent of the EU’s Sustainable Finance Disclosure Regulation pushing the asset class to take a uniform approach.
Another theme has been a renewed spotlight on the private debt secondaries fund market, which has been growing slowly for some time. “We see growing interest in secondaries strategies, with funds being raised to acquire interests in other credit funds and potentially GP and manager stakes,” says Bender at Ropes & Gray. “Credit secondary funds really haven’t taken off in quite the same way as in private equity in part because the tax structuring around them tends to be quite complex, but people are very interested in getting into that space and figuring out how best to manage that and other challenges unique to credit.”
In April, Apollo announced the launch of a new credit secondaries unit, co-headed by former Goldman Sachs partner Earl Hunt. The firm’s $1 billion of initial capital comes from its insurance clients, with a third-party fund coming at an undisclosed later date.
In the next 12 months, it looks like scale will continue to be a dominant feature of a bullish private credit environment. “We believe private credit managers will continue consolidating and scaling to serve as a one-stop shop for investors,” deVeer says. “We believe scaled, multi-strategy alternative investment managers can drive outperformance and differentiated returns by sourcing unique opportunities across asset classes through a large, global origination footprint.
“With respect to the credit markets, we believe large-cap sponsors and upper-middle-market issuers will continue to favour a private financing solution over broadly syndicated facilities. We see this as a permanent trend in the market as issuers favour more flexible, partnership-orientated investors in their capital structures versus the syndicated bank market or the high-yield market, where there is less certainty and less flexibility.”
The past 12 months may not have been plain sailing for alternative investors, but private debt funds have proved their worth as agile, supportive partners to both sponsors and management teams, and can expect to reap the rewards with heightened dealflow for some time to come.
Healthcare and tech are the post-pandemic favourites
Direct lenders are always keen to focus on defensive, non-cyclical industries, so it isn’t surprising that two covid-resilient sectors came to the fore over the past 12 months: technology and healthcare.
As both sectors demonstrated their ability to withstand an economic downturn, sponsors piled into tech and healthcare deals. Private equity firms spent a record $80 billion on companies in the global tech sector in the first quarter of 2021 alone, according to Bloomberg. The rapid acceleration in tech adoption across every industry has driven up valuations as businesses have far exceeded growth expectations.
“Consistent with our focus on high free cashflow, non-cyclical companies, the largest two industries for our commitments this year to date are in software services and healthcare equipment and services,” says Kipp deVeer, head of credit at Ares.
“Within our diversified portfolios, we tend to be overweight in the software and services, healthcare services, commercial and professional services and consumer durables industries. We believe these sectors are currently the most attractively positioned industries and sectors of the economy.”
While the healthcare market benefited from its own technology transformation, private equity interest in the sector was also at an all-time high. Not all parts of the industry appeal to lenders, with some getting their fingers burned on physician-practice management companies, where state regulations can limit the protections available to creditors.
However, with healthcare accounting for 18 percent of US GDP, the need for continued innovation, efficiency and scale across the sector is driving significant sponsor interest going into 2022.