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Margin Hold Period Gross IRR Direct Lending into Complex Situations Upfront fees: 2 to 3% 700 bps + 6 months to 3 years 10% + Secondary Discount to Par: 15 to 20% 350 bps + 6 months to 5 years 13% +

      Source: StepStone estimates

      The key levers behind the target IRR for the opportunistic deal flow are (i) upfront fees/discount to par, (ii) margin and (iii) hold period. Other factors that can boost the IRR are triggering call protection, exit fees, and preferred equity/warrants as part of the structure.

      The return range will also vary depending on where the investor focuses in the capital structure. For example, the return for first-lien transactions will be at the lower end of the range, with returns increasing as you descend the capital structure to second-lien transactions.

      Our expectation is that loss rates will largely reflect the syndicated loans, first-lien and second-lien direct lending of 0.7%, 0.8%, and 1.6% respectively, with an additional premium of 0.3% to 0.5% for complexity.

2.3.4 Investment Considerations

      We observe that the deal volume for direct lending into complex situations is relatively consistent through an economic cycle with a potential uptick during a downturn. Complex situations arise through idiosyncratic as opposed to systemic risk. For secondary transactions, the deal volume will significantly increase during periods of market volatility and is heavily timing dependent.

      For the reasons exposed above, we deem it important to diversify across different credit strategies within opportunistic lending to achieve target returns throughout the cycle, while accessing enhanced deal flow and returns during a market downturn.

2.3.5 Outlook

      As investors build up experience and expertise within the private debt asset class, they will try to diversify their portfolios with other sub-strategies. Opportunistic lending offers a more attractive risk-adjusted return profile for investors looking to expand their portfolio beyond a pure play on direct lending. The COVID-19 crisis will provide an extended opportunity set and could serve to demonstrate the relevance of this strategy in a well-diversified portfolio.

      Opportunistic lending is also likely to attract private equity investors seeking double-digit returns but with a lower risk profile and the downside protection provided by debt financing structure, especially in a late-cycle environment with high valuation multiples.

2.4 Co-Investment and Secondaries in the Corporate Private Debt Space

      For most of its limited history, private debt (direct lenders in particular) provided facilities to companies in the lower and middle markets, where loans are typically too small to be of interest to a lending syndicate. As the asset class has grown, however, some private debt managers are seeking partners so they too can lend to the upper end of the market.

      There are two primary options when it comes to finding partners:

       The first option follows the co-investment model that has become popular among private equity investors. Here, the GP identifies one or two like-minded partners – often a Limited Partner (LP) – to provide the capital necessary to close out a deal.

       The second option is the club deal whereby the private debt manager looks to put together a small syndicate made up of four to six co-lenders. Club deals are attractive because they can accommodate larger deals than co-investments can.

      However, because the syndicate is often made up of competitors, club deals can be complex, resulting in greater governance risk. In fact, lack of alignment is one of the reasons private equity managers soured on club deals and moved toward the co-investment model. By some estimates, co-investments make up approximately 20% of the private equity market. In contrast, the co-investment market in private debt is significantly smaller. While co-investments have been around in private debt since well before the GFC, they are just now gaining traction. Of the USD 350 billion in annual corporate direct lending, we estimate that co-investments represent only 5%.

      StepStone expect this proportion to grow over time. One can already observe an increase in both the number and the amount available for co-investors during the COVID-19 outbreak. To better diversify their portfolios and limit their exposure to individual companies, underwriting GPs have given to making smaller investments. To maintain their underwriting capabilities and compete for interesting opportunities, they are turning more toward like-minded partners to secure the necessary capital.

      Co-investments provide financial benefits for the GP and LP alike. From the GP’s perspective, the most obvious advantage of co-investments is the ability to access capital needed to complete a transaction. Maintaining control over an investment, something notably absent in most club deals, and staying within the investment parameters set forth by the fund are other important considerations.

      Also, co-investments offer several financial advantages to LPs:

       First, they are typically done on a no-fee, no-carry basis, thereby improving returns.

       Second, co-investments accelerate capital deployment and hence improve the dollar return for the investor.

       Third, co-investments provide more flexibility for evergreen structures to reinvest capital returned by borrowers, thus mitigating the opportunity cost of fund investments.

       Lastly, co-investments give investors greater control over their portfolio.

      In particular, LPs can achieve benefits from diversification since they can access deals with managers of varying sizes, in different regions, with different sector specializations. As a result, co-investments are more efficient in terms of cost, capital deployment, returns and diversification.

      Exhibit 7: Benefits of Co-Investments

      Source: Preqin, StepStone Private Debt Internal Database

      Like co-investments, secondaries provide many financial benefits. In a secondary transaction, an investor will buy a portfolio of seasoned loans, thereby reducing the overall deployment duration and ensuring a faster turnaround on distributions and higher returns. In addition, it is usually possible to buy secondary portfolios at a discount to the net asset value (NAV), which creates immediate value for LPs. Discounts can come about for a number of reasons including from sellers who require immediate liquidity.

      Currently, the secondary volume in private debt is quite small, but as the asset class matures, we expect secondary volumes to grow and follow a path not unlike the one laid out by private equity. The COVID-19 crisis may act as a short-term catalyst for secondary transactions. Were prices in public markets to drop for an extended period, some LPs may be forced to sell part of their private market exposure to remain in line with their asset allocation guidelines. For levered portfolios, a deterioration in fundamentals may trigger margin calls by lenders and hence the need to sell assets to raise cash.

      Investors ramping up their private debt exposure or with less stringent constraints will benefit from this selling pressure. A growing set of opportunities will also allow potential buyers to be more selective and better

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