European Private Credit Set To Continue Bull Run
A lack of liquidity is often cited as a reason not to allocate to private credit strategies but that’s not stopped investment managers of these products raising massive amounts of money in 2020; data from Preqin shows that globally, $117.7bn was added to the industry last year, and that’s only the closed-ended funds.
The lockdowns designed to stem the spread of Covid-19 have impacted many private companies’ ability to make the repayments on their loans. Whilst that provides challenges for existing direct lending portfolios, on the flip side it is leading to a potential feast for distressed debt strategies. Ross Allardice, a Partner at Dechert in London, says that 2020 saw a slew of managers eyeing up the space.
“We saw more in terms of distressed debt funds coming to market last year. Some companies are already struggling and when furlough schemes expire in Europe, we’ll see more good businesses start to struggle which will bring opportunities to distressed debt sponsor clients,” he said.
Direct lending is by far the largest of the sub-sets of private credit; globally, direct lending closed-ended funds raised $50.1bn last year, with the remainder of strategies tracked by Preqin – distressed debt, special situations, mezzanine, venture debt and private debt fund of funds – raising $67.6bn in aggregate. David Miles, also a Partner at Dechert in London, says that, despite the increased interest in distressed / special situations opportunities, the healthy direct lending space should remain the largest subsection of the industry.
“With the ongoing economic impact, there will no doubt be an increasing opportunity for distressed or special situations lending and yes, we are seeing increased appetite in this space. But the scale of healthy lending situations should well outweigh the distressed or special sits – frankly, it would be difficult to foresee distressed situations reaching a level – with corresponding investor appetite – comparable to the funds lending to healthy situations,” he said.
Chris Gardner, also a Partner at Dechert in London, says that despite the challenges faced by direct lending funds’ existing portfolios, all is not doom and gloom, and has an interesting observation as to where direct lending strategies will prosper in the coming years.
“Indications to date are moreover that private credit funds have so far weathered the pandemic well – which validates the thorough approach they take to diligencing lenders and structuring deals,” he said. “And in terms of geography, we’ve seen some funds having better strike rates in Southern Europe than Northern Europe.”
The increase in people working from home – largely enforced – has led to plenty of questions around the future of work from the perspective of whether people will still go back to the office when life returns to something resembling ‘normal’. In August last year, Schroders said that it had ‘permanently embraced flexible working’ across its business. Facebook said that it expects half of its staff to work remotely in the next five years. High-profile decisions like these have led to questions around whether businesses will actively look to downsize their offices – or eliminate them altogether. According to Gardner, the alarm bells shouldn’t be ringing too loudly for commercial real estate investors.
“There is always going to be investor demand for exposure to real estate assets in certain geographies, and so there will be managers raising funds to satisfy that desire. We’re still seeing activity in commercial real estate funds coming to market,” he said.
Allardice adds that history shows that commercial real estate has always survived crises, and this one is no different.
“Blackstone made a name for itself in the space by buying prime real estate in down markets. After the global financial crisis and the dot com bubble, there was still plenty of appetite and it’s not going away now,” he said.
Private credit funds come in both open-ended and closed ended formats. Whilst the former option has become less popular in recent years and the majority of products nowadays take the latter form, the open-ended structure still has a place due to the nature of the asset class.
“In some ways private credit sits between long-dated private equity and short-dated hedge,” said Gardner. “The problem is that raising a small amount of capital is both expensive on a relative basis and can reduce the universe of investment opportunities. Newer managers particularly may consider raising an evergreen fund or single deal vehicles, build a track record and then start to do larger, closed-ended funds. It’s not cost efficient to raise a £100mn closed ended fund so we still see open-ended structures and expect that to continue. That said, I’m doing more closed ended funds because they are investing in underlying opportunities which have a 24–48-month tenor, so it’s not consistent with the underlying investment portfolio for these funds to have, say, a quarterly redemption cycle. But we’ve also done funds with characteristics of both open-ended and closed-ended which give the manager more flexibility, as well as purely open-ended. We definitely see both.”
Much has been made of government bonds not delivering the diversifying properties that their evangelists say they do, and the zero lower bound interest rate environment occupied by many Western countries means that yield is not being delivered by these assets either. Private credit strategies have been touted by some as being a potential bond replacement, but liquidity concerns and credit rating concerns make this unlikely. Instead, they’re carving out their own niche in portfolio construction.
“Five or six years ago there was an amorphous bucket of ‘alternatives’ and private credit competed with private equity for allocations,” said Gardner. “What we are seeing now is that sophisticated LPs and allocators have a segregated bucket for private credit.”
Preqin data also shows that there are 546 closed-ended private debt funds currently in the market globally, looking to raise $285.2bn. Whilst the macroeconomic climate largely dictates the subsets of the private credit industry that are in favour at any moment in time, the amount of capital being raised, and the depth and breadth of the industry means that the private credit growth story still has plenty of legs.
“As we move into vaccine territory, it’ll be interesting to see which opportunities become a distressed, or special situations play, and which remain a traditional play,” said Miles. “Private credit’s infancy in the European market was in the SME space, and even then, only a relatively limited number of transactions took place. But in a short time period it has grown in scale to become a key provider of funding for many PE-backed transactions across the value range and a notable feature in recent years has been its increasing ability to scale up and compete against liquid credit markets for large cap transactions. Private credit opportunities exist across the capital structure, and funds are raising money to enable them to take advantage of many of these opportunities. Private credit has become an important feature of many European deal processes with market participants welcoming the single counterparty exposure and the flexibility and execution speed private credit can offer. It is fair to say I think that European private credit it is fast catching up the US private credit market.”
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