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Where should private credit investors put their money when the going gets tough?

Leading LPs gathered at SuperReturn Private Credit Europe earlier this year to discuss one of the most important issues in this sector: what should we invest in? Competition is tight, while the risks are climbing higher. In this article, we find out LPs' strategies in these uncertain times.

GPs and LPs alike were keen to hear from leading LPs on some of the concerns that are keeping investors up at night. Key themes at SuperReturn Private Credit Europe included smart investing throughout the cycle, competition, diversification, manager selection and return expectations. We take a look at some of the central points brought up in our first LP panel on Day 1.

SMEs in the spotlight

A number of LPs are favouring the smaller end of the market with a preference for SME direct lending and more opportunistic strategies. Competition in the busier, larger end of the market is a growing concern for investors but it was also pointed out that Europe is not a particularly homogeneous region and so competition really varies across different sectors in different countries.

When looking closer at the smaller end of the market, LPs find that they are faced with mangers that have more of a domestic or regional approach rather than the pan-European funds which typically serve the larger companies. One panellist pointed out that larger GPs will often argue that risk-wise, larger companies are more stable and so you pay a higher risk premium for the smaller companies. As a counter, it was remarked that although the risk might be higher in one single case, there are ways to mitigate that risk, such as through building a diversified portfolio of the best managers to lessen the risk that might be associated with a single portfolio company.

Manager selection challenges

As competition increases and manager selection becomes ever more challenging, many LPs are taking a more serious look at the niche strategies which tap into unserved areas. One LP speaker cited Preqin’s statistics as showing venture debt to provide a good risk/reward ratio and coupled with the fact that there aren’t many players in European venture debt, it offers a favourable opportunity compared with some of the more mainstream and thus more competitive strategies. Some established fund managers are also diversifying into niche areas that don’t fit in the typical buckets, including aircraft leasing and ship financing, which can offer some interesting opportunities.

As established managers diversify into new areas and emerging managers try to break into a competitive market there is an increasing need for LPs to ensure that they only support credible managers with a real chance to provide them with good returns. As we move into the next generation of funds, it’s the managers with a proven track record and workable business concept that are starting to stand out. It’s very hard for new managers to achieve success in the more popular strategies and they really need to carve out a niche and ensure their strategy is sufficiently specialised.

Due diligence and ESG

Challenges in manager selection result in LPs and consultants upping their due diligence process and taking a closer look at the fund manager teams. Given the amount of dry powder in the market and the fact that managers launching the next generation of funds are doubling or even tripling their fund size, LPs can’t afford to put a foot wrong. One panellist posited that a huge red flag is if a fund doesn’t have a hard cap – LPs and consultants appreciate that they can’t dictate the fund size, but they can vote with their feet and not invest. Another concern is where we are in the current cycle – given the recently benign environment, there is a growing need to do more ‘what if’ analysis and question how much restructuring experience the team holds.

Another way to differentiate managers is by looking at ESG. ESG is a way to mitigate risk – that message hasn’t fully filtered through to all stakeholders, but it is starting to percolate according to our panellists. There are still managers using ESG as more of a marketing tool and LPs need to be aware of the distinction between true sustainability and merely ‘ESG conscious’ measures and be weary of ‘greenwashing’. In this regard, debt can be seen to be lagging behind equity and similarly the US lags behind Europe but ESG is becoming more of a material consideration and less of a box ticking exercise.

Despite these concerns and the challenges ahead, the LP panellists remained positive on the market. It was agreed that although we don’t know what the next crisis will hold, investors have made multi-year commitments and are positive about opportunity set going forward.

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Want to learn more about private credit?

SuperReturn Private Credit Europe 2020, to be held in London on 3-4th June, delivers two days packed full of content and networking for attendees. The 2019 agenda featured new topics such as the impact of technology, stressed investing and co-investments. Data rich presentations track the evolution of private credit across the globe and interactive discussions give the lowdown on private credit across the European hotspots. With speakers and attendees travelling from the USA, emerging markets and across Europe, the insights are truly global.