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Direct Lending Specific Factors 3.3 Portfolio Positioning through the Credit Cycle 4 Risk Mitigation and Success Factors When Investing in Private Debt 4.1 Market & Loan Level Data 4.2 Investment Control 4.3 Lender of Record 4.4 Deployment 4.5 Flexibility 4.6 Diversification 4.7 Workout Capabilities 4.8 Economies of Scale Bibliography

1 Introduction

      Private debt is a fascinating and rapidly evolving asset class. In market penetration and maturity, it is quickly catching up with its older sibling, private equity. It is also following many of the historical trends around fundraising and evolution of co-investments and secondaries in the private equity asset class.

      Part of the strong growth of private debt is driven by the inflow of capital from institutional investors identifying higher yields in a low-interest-rate environment, finding a product that mitigates the J-curve for their private equity investments and concluding that debt funds solve a financing gap left by banks. This trend is further driving the migration of capital and talent from public to private markets.

      However, we believe the asset class is still in its early days. The near-to mid-term market challenges implied by the COVID-19 outbreak will prove a true stress test for General Partners’ (GP) track records and for the performance of different strategies. Such dislocations, though unlikely to change the fundamentals supporting the long-term growth of private debt, will have a significant impact on the evolution of the asset class, for existing GPs and prevailing strategies.

      This contribution aims to provide the reader with some helpful insights about successful private debt investing. The analyses presented hereafter should help investors to construct robust portfolios and navigate through stressed periods comfortably. We make use of a large proprietary database to add colour to some of the concepts presented in this contribution and to demonstrate the value of data in what remains an opaque asset class. Partnering with GPs and other market participants proves to be a valuable strategy for private debt investors. Besides being a precious source of information, these relationships can also provide the investors with investment opportunities reserved for a limited number of participants.

2 Investment Case

2.1 Introduction to Private Debt

Until recently, banks were the primary provider of debt capital to corporations. Using an “originate to distribute” model, a single bank underwrites an entire loan facility and finds other lenders (a syndicate) to share the risk. Since the Global Financial Crisis (GFC), the number of commercial banks in the United States has fallen by more than a third, from 7,200 to less than 4,450.[1] Congress passed major reforms that limited the amount of risky assets banks could have on their balance sheets. The combined effect of fewer commercial lenders and more stringent capital requirements left a significant void in global capital markets. The middle market, consisting of companies with EBITDA below USD 75 million, was particularly affected, as banks turned their attention upmarket. Institutional lenders, in search of attractive yields, filled the gap left by banks. Lower capital supply as well as higher demand from investors and more flexible terms for issuers explain the growth of private middle market direct lending since the GFC.

Over the last decade, corporate private debt in the middle market – also referred to as direct lending – has matured into an institutional-quality asset class. In 2018, 182 private debt funds raised USD 119 billion. Not only have more funds been raised but deal sizes and volumes have also grown markedly. Private debt managers put more than USD 145 billion of capital to work across 1,345 transactions in 2019.[2] However, these numbers are probably understated; we estimate the overall middle market in the United States to be USD 1.25 trillion. With an average loan life between three and four years, this results in annual issuance of more than USD 350 billion. The European market is approximately a third of the US market, totaling around USD 410 billion.[3]

      Private debt covers a large and diverse universe of strategies in the three main asset classes: corporate, real estate, and infrastructure. This universe has broadened to encompass the burgeoning field of specialty finance. Exhibit 1 serves as an extract of some of the main private debt strategies, comparing gross asset yield levels with public credit on a risk-adjusted basis. On that basis, the attractiveness of direct lending becomes obvious.

      Exhibit 1: Indicative gross and loss-adjusted returns across various credit asset classes

      Source: Bloomberg Barclays Indices, Credit Suisse, Thomson Reuters Quarterly MM Private Deal Analysis, StepStone Calculation

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