Private debt has finally outgrown its niche existence in Europe, says Patrick Hug of Zurich Invest. According to the expert, direct lending in particular is likely to grow even further and offers attractive advantages for institutional investors. However, when selecting investments, he said, it is necessary to take into account important key aspects.
According to Preqin, the global private debt market is expected to grow to 887 billion euros by June 2020. U.S. dollar grown. This makes it the third largest private market behind private equity and only slightly smaller than the real estate market. While in earlier years the market was dominated by mezzanine and subsequently also distressed solutions, direct lending now accounts for the lion's share of almost 50%. "Originally far behind the U.S. market, the direct lending market in Europe has had a brilliant catch-up campaign. Further growth in this segment is quite realistic, which will continue to provide attractive terms to investors in Europe", Patrick Hug, Senior Investment Analyst, Investment Management at Zurich Invest, is convinced. Moreover, direct lending has the most defensive orientation of the asset class and is therefore suitable for supplementing traditional fixed-income investments with a high-yield component.
Not even the outbreak of the Covid 19 pandemic has been able to influence the interest of investors in the long term. Many direct lending managers have been adept at leveraging the current lending environment in favor of their investors. They, in turn, appreciate the higher interest income compared to public loans, coupled with reduced volatility. Hug believes that the stable development of direct lending investments during this turbulent period has further strengthened investors' confidence in this asset class. The sharp increase in capital committed by clients and yet to be invested, or drypowder, reflects recent market growth, but has declined both relative to overall market size and relative to private equity drypowder. The demand for private credit financing can therefore be expected to remain high in the future as well. This need for debt capital also exists for companies that have not been affected by the pandemic or have even benefited from it.
Previous restraint as an opportunity for pension funds
The average private debt allocation at Swiss pension funds remains very low at around 1.4% (Complementa Risk Check-up 2020). This ratio also includes allocations to syndicated loans. In addition to investors who have many years of experience with such allocations, Hug observes that two other groups are emerging: On the one hand, there are investors with a low quota who have only gained a few years of experience and whose allocations are in the process of being established. On the other hand, there are investors without strategic private-debt requirements.
"However, when building and shaping their fixed income allocation, institutional investors can no longer avoid considering the merits of private debt and especially direct lending", says the expert. Be it in terms of maintaining the allocation, i.e. the degree of investment, and risk diversification across different vintages, so-called vintages, or managers, the expansion and extension of an existing allocation as well as the first-time inclusion of a private-debt ratio in the strategic asset allocation. Allocation offers all three of these groups the opportunity to benefit from attractive credit premiums on senior secured loans in Europe.
A look at the history is also worthwhile: Those private debt vintages that were launched during market downturns have so far achieved the best results – although each market downturn had its own dynamics.
Successful implementation generates attractive net returns
Success in the private market investment sector, he said, depends heavily on the implementation chosen. "With currently more than 500 active private debt funds from around 2,000 providers worldwide, according to Preqin, investors are spoilt for choice. If we focus on Europe and further on the largest sub-segment of direct lending, the offer becomes more manageable", says Hug. Despite this, more than 50 managers remain with very different investment solutions. According to the expert, a particularly important role is therefore played by the careful selection of the asset manager as well as the consideration of key aspects in implementation. A focus on the core of the market on middle market companies – borrowers with EBITDA between ca. EUR 10-50 million. – For example, reduce competitive pressure with other lenders due to the required loan sizes. In addition, the direct lending specialist's expertise benefits when it works with experienced private equity sponsors with specific industry and operational expertise.
In Europe, due to increased concentration and average loan size, only about a handful of direct lending managers can offer broad access to this segment while maintaining blocking majority and control. "The risk taken is a key driver of returns, along with access to allocations and credit underwriting expertise. It is important to carefully consider whether subordinated loans, mezzanine loans, equity components or leverage justify the additional risk taken," says Hug, Hug explains. Ultimately, by choosing the right structure and appropriate fees, it is possible to keep costs as low as possible and thus achieve attractive net returns, he said.