Increased competition in the private debt market and decreased regulation of banks brings new challenges as well as new opportunities.
Despite the prevailing positive outlook on this asset class, investors should nonetheless get ready to climb the risk curve without a corresponding increase in expected returns.
In this scenario, managers will prioritize maintaining robust deal flow to adjust their fees and targets, as the current mid-pricing does not reflect the equivalent prospects of the private debt market in the long term.
With no one expecting the cycle to end, the market will see an increase of players and a resulting decrease in the overall quality of deals made, as the amount of dry powder sitting on the sidelines is likely to provoke more aggressiveness in chasing deals.
Covenants will thus play a crucial role in hedging transaction risks, rather than being caught clueless in times of insolvency. Although late-cycle behaviors such as covenant-light transactions are unlikely to affect the mid-market, they are rising in occurrence in the syndicated market, where companies with higher EBITDA can drive returns and new players can find a valid alternative for cash.
At the same time, illiquid private equity style funds, with their fixed life spans and formal fundraising cycles, are growing in popularity. This scenario comes as an indirect result of the banning of proprietary trading by banks, which still holds significant impact on the degree of liquidity in the bond markets.
Moreover, investors seem to have switched to private debt markets that offer floating rate returns. This can be seen as a consequence of the increase in fixed-rate bonds that benefit issuers when rates rise. Getting out of fixed-income into loans allows for variable rates protection, but the 7% rate of return that has been consistently advertised by fund managers will get progressively harder to achieve.
Much will depend on the ability to underwrite single assets and holding it through the life-cycle of the business. Alternatively, funds are increasing their activities in secondary transactions, where companies who were cut off the public markets can be granted with complex refinancing opportunities.
Rather than acting as a game changer, the current softening of the regulatory framework will back-up these scenarios. The US House of Representatives recently passed the bill which would raise the threshold at which banks are considered systemically risky, from USD50 billion to USD250 billion.
The bill also exempts banks with less than USD10 billion in assets from rules banning proprietary trading, going against—to a certain degree—the new Capital Requirements Directive IV under Basel II, which exacerbated banks’ need to beef up their capital base and shrink their loan book.
While this process still has a long way to go, the impression that private-debt funds might have seen their best days remain. After all, one of the underlying drivers behind the growth of the non-banking lending industry has been, and still is, the set of rules that pushed banks to exit the mid-market.
This in no way implies investing in this asset class is no longer worthwhile. However, balance sheet strength and competitive borrowing rates and conditions are two significant advantages that traditional banks have over private debt managers, especially in the US.
Deregulation in the traditional lending segment might also pave the way for a tighter stance on an unregulated private debt market. The pass regulators have given to the industry does not stem from the belief that no systemic risks can arise. Rather, the lighter stance reflects the generally cautious attitude of managers underwriting assets. Competition will also play a role in pushing funds to innovative ways to meet their targets.
Thus, experts are expecting a higher degree of asset diversification. Infrastructure, in this sense, is expected to be the industry attracting the highest level of investment within the next two years, given the larger deal size. Technology, healthcare, and SMEs have so far been touched very selectively and remain a preferable choice when it comes to ETFs or other equity options.
Having taken all these factors into account, the narrative is still relatively bullish. Private debt still is one of the biggest success stories to emerge from the global financial crisis as opportunistic managers filled the vacuum left by the retreat of traditional banks.
Almost two-thirds (63%) of the professional investors surveyed by Intertrust expect the private debt market to grow in 2018, up from 60% last year. Of these, about one-fifth (21%) expect a significant increase.
The market has become more established; performance expectations have dropped though there is also more appetite for private debt in 2018.
This is equally true with other alternative asset classes. Infrastructure debt, real estate debt, and credit-focused special situations are likely to remain the favored strategies, while private debt funds will stay the most attractive to private sector pension funds, insurance firms, and sovereign wealth funds.
Last but not least, although the industry remains anchored on the developed markets of North America and Europe, the rate of involvement from investors based in Asia is remarkable. At the start of 2018 there were 3,100 institutions investing in private debt, up from 2,400 at the start of the previous year and an increase of 1,200 from the start of 2016.
In the past 12 months, the number of private debt investors based in South Korea and China has risen by 36% and 52%, respectively.
In the same timeframe, the number of India-based investors in private debt has risen by 110%. Definitely more behind in the credit cycle, the rise in prominence of new players acting in a different market may provide skeptical investors with an extra reassurance coming from the East.