The voice of private debt managers

Do you think the private debt fund market will continue to thrive in the current macroeconomic and geopolitical environment, and if yes, why? Which strategies do you expect to perform better in the coming months?

Matthew Maguire (Director, Finance & Strategy and Head of ESG at Park Square Capital, LLP): The current macroeconomic and geopolitical environment can be characterised by two primary themes: high interest rates and inflationary pressure. At Park Square, we believe this environment has created one of the most interesting periods for private credit investors across our twenty-year track record. To have nearly all credit structures floating rate in a rising rate environment is truly phenomenal, as long as we pick the right businesses to lend to.

Whilst higher interest rates are generally positive for private credit managers, higher interest expenses and inflationary pressures can significantly impact borrowers who are unable to easily pass price increases on products and services, or those with unsustainable capital structures.

Thematically, across the private credit market, there is likely to be a step up in defaults, with the Lincoln Loan Index default rate reaching 4.5% in Q1 2023, more than doubling from 2.2% in 2021. We believe that beta managers who have been chasing market share over disciplined investment opportunities, particularly during the last few years, are likely to be exposed by an inflationary environment.

Against this backdrop, private credit managers must remain focused on rigorous portfolio monitoring, with a specific focus on interest coverage and understanding the risk of supply chain disruption and rising input prices. As we have seen in previous financial crises, private credit investors who have remained disciplined – having stuck to stable, predictable, and high-quality businesses – will be well placed to weather the macro-economic storm and capitalize on market volatility. At Park Square, our focus on data and thoughtful use of technology to gather and monitor portfolio performance has allowed us to react quickly in times of uncertainty, providing us with a live day-to-day view of risk across the portfolio.

With the syndicated loan market largely dormant for the last 18 months, banks hamstrung by hung syndications, and appetite for risk in flux, the private credit market has thrived and gained further market share. Private debt funds were able to position favorable term structures and pricings for their investors, particularly in the mid-market space, and there was a surge of activity in the secondary market. However, eventually we do need to see a return of new deal activity, which still represents the largest component of the leveraged loan market.

As the syndicated loan market shows signs of awakening, in addition to senior debt lending opportunities, the need will grow for creative junior debt credit solutions. With rising rates and input prices, we expect to see several large, well-capitalized leverage buyouts unable to service their cash-interest debt burden, and be forced to refinance with junior non-cash credit solutions.

We believe higher-yielding junior debt strategies are in a terrific position to match the private equity market’s returns, not only on relative risk return but also on an absolute basis. As an example, Park Square’s junior debt funds generate net returns of 13–15% despite taking substantially less risk than private equity. This is by virtue of the approximately 50% equity cushion beneath our debt tranche, as well as in-built inflationary protection from its floating rate structure. We believe this is a golden era for private debt, presenting a fantastic investment opportunity.

What is the view of private debt market players regarding the current implementation of ESG and SFDR? Do they see a challenge in implementing ESG-related key performance indicators (KPIs)?

Valeria Merkel (KPMG Luxembourg): For several years, we have stated that sustainability regulations would trigger a major evolution for private debt fund managers, who must integrate ESG factors into their decision-making process.

Over the past few months, EU asset managers have been busy reshaping their investment strategies to ensure they are compliant with the SFDR, as well as improving their data quality to meet future reporting obligations.

SFDR’s Article 6 covers funds that do not integrate any sustainability into the investment process. In comparison, Article 8 funds must promote environmental and/or social characteristics, and Article 9 funds must have a sustainable investment objective.

Recently, we’ve seen a drop in funds classified under Articles 8 and 9. However, some market players confirm they will continue with Article 8 funds in their senior lending platforms, a trend that is not yet reflected in this year’s survey figures. We’ve also seen some funds move from Article 8 back to Article 6 in the market, largely due to high data requirements that could not be met in the current implementation phase. However, we do not believe this to be a trend.

Based on our discussions with private debt market players, the ESG review now plays a significant role in the investment process, requiring additional data software and professional involvement to analyze the ultimate borrower’s ESG standing.

This additional round of analysis to integrate ESG-related KPIs into deal strategies generates extra costs for private debt asset managers, who must increasingly rely on technologies to increase efficiencies and keep costs manageable.

However, we expect to see a pick-up of ESG strategies due to the inevitable rise in market demand.

Speaking of technology, what is the future of the private debt fund market regarding digitalization? Do you think the use of blockchain and the tokenization of alternatives will increase efficiency and improve accessibility to the private debt fund market?

Julien Bieber (KPMG Luxembourg): When exchanging views with private debt market players, most believe that technology is a key driver for the future success of the private debt market.

Technology will be crucial to absorb the significant market growth that is expected, with digital tools increasing efficiency and productivity while reducing administrative costs. Market players have confirmed that technology investment will be a major focal point in the coming years, and AI and tokenization are a clear part of the private debt market’s future.

AI will accelerate the various processes of the investment lifecycle. It’s likely to revolutionize the private debt market in many ways — from deal origination and due diligence, by instantly extracting data and analyzing it through algorithms, to investor reporting, by reducing the administrative burden of risk management and purely accounting tasks. AI will deliver a myriad of additional outlooks to support asset managers’ processes and reduce the costs and time required.

Tokenization will also help democratize private credit and investments beyond institutional investors, making them more accessible to a wider and more diverse range of investors. It can translate private debt assets that are mainly targeted to institutional investors into a tradable instrument that is open to a wider pool of investors.

Our discussions with private debt asset managers often include the need to reduce costs through technology. The ever-evolving regulatory framework and rising reporting obligations have led to spiraling operational costs. Higher margins and income levels are needed to cover these costs, which can put additional pressure on asset managers. Technology can help managers reduce these costs while continuing to comply with new regulatory challenges.

What is your opinion of the potential rise in the distribution of AIF to retail investors? Do you think the revised ELTIF regime could achieve this target?

Valeria Merkel (KPMG Luxembourg): Our surveys of the last few years have recorded a slight bump in retail investors in the private debt market.

While retail investors dropped slightly from 9% to 8% compared to last year’s survey, we expect to see these numbers grow next year due to the revised ELTIF framework (ELTIF 2.0). As this regulation is likely to come into force in 2024, its influence on the market is not yet reflected in this year’s figures.

We believe that most fund managers in Luxembourg will consider it too costly to distribute AIFs to retail investors. Therefore, most players will wait and see which moves their competitors make before entering this playing field. Some global players have managed to raise only minimal amounts from EU retail investors.

However, we also think EU private debt market players will be keen to re-explore distributing AIFs to retail investors soon. Digitalization and blockchain technology will revolutionize the private debt market in the coming years, lowering barriers to entry and increasing liquidity, which will allow players to target retail investors more easily.

We’re seeing a deepening relationship between private debt and private equity, with LBOs increasingly relying on private debt funds. What do you think about this trend? Will private equity’s success drive the growth of the private debt fund market?

Andrew Haywood (CFO, COO and Partner at Park Square Capital, LLP): For the past 18-months, the syndicated market has been in a hiatus; an environment where the cautiousness of the banks has opened the doors for private credit providers to offer the much-needed LBO solutions for their private equity counterparts. In comparison to banks, private debt firms can hold debt to maturity and do not need to worry about the daily mark to market. Private debt funds are reliable and – more-importantly – open-for-business to private equity sponsors looking for credit solutions.

Although the syndicated loan market is starting to reopen for high-quality borrowers after its 18-month hiatus, the established inroads created by private lending are likely to be sustained, with private debt growing with private equity. Over the last 20 years, Park Square has built up long-term mutually beneficial relationships with our private equity sponsors, such that we are the first-choice credit provider, receiving favorable terms and risk-adjusted returns for our investors.

The relationship between the two asset classes is, to an extent, symbiotic. Private equity growth is certainly favoring the growth of the private debt market. However, the nature of the market we currently find ourselves in, may just give private debt the edge in the eyes of investors, and create challenges for private equity. Comparing apples to apples, whilst private equity remains an attractive market, on a risk-adjusted basis, private debt is doing phenomenally well. From an investor’s perspective, to be floating rate, inflationary protected, earning a high-current cash yield with base rates rising is extremely attractive. Despite defaults on the rise, disciplined junior debt managers are seeing returns on par or exceeding private equity in the region of 13-15%.