Why have institutional investors gravitated to private debt? Monroe Capital’s Ted Koenig weighs in on the subtle differences between traditional private equity funds and the growing universe of independent sponsors.
How would you describe today’s environment for investors?
There are a couple contradictions evident in the market today. On one hand, the U.S. economy has quite a bit of momentum. Unemployment is down, GDP is accelerating, and inflation remains close to the FOMC’s target range of 2%. This is the reason why the Fed has followed through on its planned rate increases this year, with the most recent hike coming in September. Assuming Fed Chairman Jerome Powell implements one additional rate hike, as expected, the Federal Funds target rate will reside between 2.25% and 2.5% to close the year. This economic backdrop has obviously been positive for corporate profits, as S&P 500 companies, for two quarters in a row, have delivered earnings growth of 25% year over year.
The good vibes around the economy, however, overshadow some of the uncertainties that we saw bubble up in early October when the global equity markets experienced a two-day selloff. And I’d argue that many discerning investors have been cautious for some time, particularly as asset valuations for all asset classes escalate in both public and private markets.
“Longevity, track record and credit experience are key ingredients for a successful private debt allocation, especially today.”
I’ve quoted Howard Marks in the past, but I think his most recent client memo speaks to themes that are really important, today, particularly in the credit market. He highlighted, for instance, the importance of experience at this point in the cycle, writing that “newly minted investment managers haven’t had a chance to learn first-hand about the importance of risk aversion, and they haven’t been tested in times of economic slowness, prolonged market declines, rising defaults or scarce capital.”
I only mention this because it reflects the environment as I see it today in which those who have been here before can recognise similarities to past cycles. Those who have not, however, are doing whatever they can to put money to work as quickly as possible to maximise assets under management. This is not a recipe for success over the long term. Among private equity sponsors, many continue to pay exceedingly rich valuations. And among the new crop of lenders that have emerged over the past few years, we’re seeing a tendency for deteriorating underwriting standards, looser terms, and rising debt multiples, generally. So while the economic picture remains appealing, more experienced investors seem to be attuned to the risks that accompany the 10th year of an extended upcycle.
What is driving investor interest in private debt?
Very simply, performance. In the 2018 Annual Report published by pension consultant Cliffwater, the firm outlined its long-term, 10-year forecast for expected returns across asset classes. To highlight a few key takeaways, Cliffwater projected long-term U.S. stock market returns to be approximately 6.5% and private equity buyout returns to be approximately 8.75%, which is down from an actual return of 10.57% for private equity over the previous 10 years. Notably, the consultant also projected private credit returns to reach approximately 7%, unlevered, and as high as 9.45% levered. These projections seem to be consistent with the long-term views of most asset owners, which speaks to why so much capital has gravitated to private debt in recent years.
A growing proportion of asset owners also consider private debt to be an attractive alternative to lower-yielding traditional fixed income, which is important considering the kind of demands facing institutional investors today. Many pension plans and endowments require annual cash returns of between 7% to 8% to pay their current retirement obligations, and that is just to stay even and not erode the underlying principal value of their investment assets. Based on the expected returns over the next decade, though, this will be a very difficult task, which is why so many have gravitated to private debt.
This return-seeking mentality has been one of the primary drivers behind the growth of the private debt direct-lending market, which has been one of the fastest growing asset categories over the past few years. This growth is also being driven by several other factors, from the expected returns and lower volatility compared to other asset classes to the mitigated “J-curve” effect, due to immediate returns in the form of current cash yield. Many investors also see private debt as a hedge against rising rates since floating-rate structures allow yields to increase as interest rates rise.
Given the growth of private debt, what considerations do new investors need to keep in mind?
As with any actively managed investment strategy, the asset manager is the critical determining factor in generating “alpha” and returns. Direct lending is no exception. Investors should select a manager that has a long and established track record and has actively managed private debt throughout a variety of credit cycles. This reinforces the point Howard Marks made in his client memo.
Only a few of the asset management firms active in private debt today even existed prior to the 2008 financial crisis. There has been considerable turnover among firms and personnel in this area. Furthermore, many of the large, Wall Street asset management firms have amassed outsized private debt businesses in just the last few years, post-financial crisis. They’re gravitating to credit because they see the private equity industry becoming a much more challenging place to aggregate assets and generate better-than-benchmark returns. But as we’ve seen in past cycles, experience will matter.
Having never been battle tested during periods of distress creates a distinct disadvantage for newer players in the space, as economic challenges will put underwriting capabilities under a microscope and reveal the strength of a lender’s relationships with its borrowers. That’s why longevity, track record and credit experience are key ingredients for a successful private debt allocation, especially today.
Do lenders generally have a preference between sponsored and unsponsored deals? And how do you characterise the difference from an investment and underwriting perspective?
That’s an interesting question. I would not say we have a preference, but we have seen some relevant trends. You do not hear as much about the growth of the independent private equity universe, but in the small and middle market, the independent sponsors have very quickly become a player in competing for and winning transactions. There used to be this perception that independent sponsors could not raise a fund; but there is a growing recognition, industry wide, that these investors generally prefer an independent approach because it eliminates some of the artificial constraints that dictate how capital can and cannot be invested.
From a lender’s perspective, there is one school of thought in which traditional sponsors can be considered a safer bet because they have a committed pool of capital available to provide additional equity if necessary. The conventional wisdom also states that general partners with funds are more agile in terms of transacting and can close on deals quicker than independent sponsors. But I don’t believe these generalisations necessarily apply today or are as pronounced as they might have been 10 years ago.
“The ecosystem supporting independent sponsors has evolved considerably and has levelled the playing field.”
As independent sponsors become more active in the market, I think the benefits of the structure become more apparent. Many, for instance, bring true specialist capabilities to bear, be it a deep sector focus or something else. They also don’t have the pressure that comes with a fund to put money to work, whether valuations are reasonable or not. Many independent sponsors also invest a significant amount of their own money in their deals. From an underwriting perspective, this can give us some added comfort.
I’d note, too, that the ecosystem supporting independent sponsors has evolved considerably and has levelled the playing field. We recently launched an industry vertical that offers a one-stop solution specifically for independent firms seeking debt and equity financing. So as the larger ecosystem has taken shape, independent sponsors are no longer at a disadvantage as it relates to perceptions around the certainty or speed of closing.
Given our experience and tenure in the market, we’ve developed some strong relationships over the past 15 years with private equity funds, independent sponsors and other market participants, such as strategic acquirers. Beyond our experience, though, I think it’s our flexibility and certainty of execution that tends to stand out for borrowers, regardless of category.