Private debt is on a roll; the trend has been visible for several years and has accelerated as a result of the covid pandemic. While the range of large and smaller transactions is growing fast, private debt co-investments are increasingly becoming an interesting asset class in their own right. The option of investing directly in individual transactions alongside a private debt fund offers great opportunities, but also makes high demands of the co-investment partner.
Corporate private debt – direct lending to companies by private debt funds, so not by banks – is on track to become the most important form of funding for mid-market companies in Europe too. The main reason for the shift is the disappearance of traditional corporate loans. Banks are coming under ever greater pressure from regulators to increase their core capital, and at the same time are struggling with what are still relatively large volumes of bad loans on their balance sheet. As a result, they are increasingly concentrating their lending business on the largest groups among their corporate clients and so are making ever fewer loans to medium-sized businesses.
At the same time the banks are under severe cost pressure and they often do not have the capacities to advise even their best borrowers. The covid pandemic has only exacerbated this development. When companies encountered cash flow difficulties and ended up breaching their covenants, the loan was often called in – even if the company had a sustainable business model and a strong position in the market. In fact, the average leverage at many companies is now lower than before the pandemic – so there is no objective reason to cut off this source of financing for all mid-market companies across the board.
Funds step into the breach
Private debt funds are increasingly stepping into the breach. They are happy to take on the job now abandoned by the banks of lending to robust businesses, whose risk-return profile has kept getting better in recent months. Now the funds often turn out to be the loyal partner, rather than the traditional local bank. They are the ones who support the company’s long-term development, do not bail out ahead of schedule, and even provide extra capital when things get tough, especially if they are convinced by the business model.
On the back of these developments the number of private debt transactions in Europe has gone up by almost eight times in the past eight years – to 155 in the final quarter of 2020. Britain, traditionally the biggest market for private debt, is falling back and Germany is well on its way to overtaking France as the second-largest market. Around the world the individual deals are getting bigger too. The average deal size was more than US $80 million last year – a fourfold increase on 2008.
The trend for financing Mittelstand companies by private debt funds in Europe is likely to continue, because businesses are increasingly dependent on funding that does not come from classical bank loans. This applies in Germany too, which is behind its European neighbours, particularly the Nordic countries, in terms of the relative importance of private debt. A clue about where things could go from here comes from the USA, where private debt has long been established as the dominant form of financing for smaller companies, i.e. all companies which do not have access to capital markets or the more liquid syndicated loan market.
Easy access
It is generally only large institutional investors that have the capacities to shoulder this kind of transactions on their own, but smaller investors can get exposure to this dynamic asset class via commitments to private debt funds – although of course the fees charged do absorb part of the forecast return. An increasingly popular alternative has recently proven to be co-investments, in which private debt funds (the general partner) give the investors in their current fund (the limited partners) the opportunity to take a direct piece of a specific transaction, in addition to their investment in the fund. As transaction volumes continue to rise, this enables the general partner to avoid any excessive concentration in their portfolio, or sometimes even to raise the necessary capital for certain private debt transactions, which now frequently have volumes of several hundred million euros.
The co-investor invests alongside the general partner, i.e. directly in the individual transaction, and generally avoids the fees that would be incurred with a fund investment. As a limited partner they have full access to all the information about the borrower’s business model, financial data and forecasts. This transparency is a decisive means of improving the risk-return profile of a private debt portfolio. It also means the due diligence work can be split between the two partners. So a co-investment has many advantages, but an investor has to meet a number of criteria to qualify as a suitable limited partner. It starts with the fact that the lead investor generally expects a relatively prompt response to a proposed co-investment. To review a transaction quickly and ensure a reasonable level of selectivity in view of the wealth of opportunities, a co-investor needs considerable in-house capacities in the form of employees with experience of private debt transactions, who are also able to evaluate various markets and business models.
In-depth assessment of borrower and partner
The due diligence for a private debt co-investment involves a detailed assessment of how stable the borrower’s business model is, its position on the market in which it operates, and the barriers to entry that safeguard this position. The opportunities and growth prospects of the market are examined, and trends in society and regulatory affairs that may have a positive or negative impact are also factored in. Of course the analysis also looks at company’s capital structure, whether the forecast cash flows are sufficient to cover the interest and capital repayments, and which covenants and collateral are required to provide security against default. Covenants in the lending agreement have to be examined particularly carefully, because they may not always offer the intended protection against losses if things do not go to plan.
Sustainability aspects have a special place in the due diligence. Although ESG (environmental, social and governance) criteria are increasingly important parameters for an investment decision, the corresponding regulations are only just emerging and reporting on performance is still rudimentary and uneven. So it is all the more important to be able to inspect the borrower directly, in order to assess the weight given to sustainability in the company, for instance, and to detect any ESG risks that may be lurking in the background.
Although both partners in a co-investment carry out their own due diligence on a transaction, they do of course make use of the opportunity to compare notes and exchange information. For the co-investor particularly, this means that there is considerably less work involved than if they completed a private debt transaction on their own. However, it also makes sense to do some internal research on the general partner, because the growth of the private debt segment has brought new funds on to the market which do not always have the necessary experience for the task.
So it is advisable to focus on how the fund behaved during the covid pandemic, for example, and not only to look at its longer-term historical performance. It is exactly this kind of crisis that separates the sheep from the goats, in fact, and ultimately also makes it possible to come to a much more precise assessment of the performance of individual funds. The experience and references of the team members and their performance in previous roles may also provide valuable information. Finally, their incentives play a key role: if the fund managers are investing their own capital (which is almost always the case), this ensures that their interests are aligned with those of the co-investor.
Diversification is vital
High minimum commitments and the level of expertise and due diligence capacities that are called for mean that smaller investors do not generally have direct access to co-investments with private debt funds. In this case a good alternative is an investment in a co-investment programme, like those offered by some asset managers with private debt expertise and good contacts to the corresponding funds. Investors in programmes like these benefit from a “double due diligence” by both the general and the limited partner. Co-investment programmes also make it easier to avoid concentration risks, because they have a portfolio made up of several private debt co-investments. Such a portfolio ideally offers diversification across different managers, sectors, strategies and geographies. The following diagram illustrates various kinds of private debt strategies. Some of them differ significantly in terms of their risk-return profile. Whereas asset-backed strategies have a lower credit risk and modest return expectations, making them comparable to traditional bonds, venture debt is a more speculative strategy in which the ambitious target returns are offset by higher default risks. In the middle is a strategy focusing on corporate senior private debt, which provides direct first lien loans to companies.
In the medium-term, private debt funds are likely to depose banks as the main providers of capital to mid-market companies in Europe – also when it comes to funding companies with a strong business model and a leading position in an attractive market. Co-investing will become even more compelling as an alternative to a fund investment, because it has a positive impact on the cost structure and returns of a portfolio and also makes the transactions and the borrowers more transparent. Larger volumes and a growing number of private debt transactions on the market improve the chances of finding attractive deals. But greater diversity also means that professional due diligence on both individual transactions and the lead investor will increasingly make all the difference.
