Borrowers go private in hunt for credit

The deleveraging process of banks in combination with a low interest rate environment in many developed economies is creating a range of investment opportunities in the private credit space. Investors willing to sacrifice liquidity will look at an interesting yield pick-up as the liquidity premium is high.

In Europe in particular, the ECB’s long-term refinancing operations supported banks and kept forced de-leveraging in control, but with Basel III regulations imposing more stringent capital requirements, banks are increasingly looking to shrink their balance sheets in order to increase their solvency and are moving out of risky assets.

“Particularly in Europe, banks have been willing to refinance or extend existing loans, but as they take a more forceful attitude with clients, borrowers will need to find alternative sources of debt capital and private credit will be one of the solutions,” says Marc Ciancimino, managing director at KKR Asset Management.

While banks are very aggressive and keen to be involved in straightforward financings, they really shy away from more complex deals, opening up opportunities for private credit providers, says Mr Ciancimino.

Funds, generally closed ended, which lock up investors’ capital for three to five years typically, offer access to such deals.

These loans, which are senior debt, yield annually between 8 and 12 per cent before fees, he says, which is much more attractive than the returns offered today by most comparable products of that risk profile. Leverage can further increase returns.

These transactions are bespoke and managers have to be able to originate deals through their network, do good quality credit judgement and then manage the portfolio and deal with any loans having issues.

“Private credit is emerging as a major asset class in Europe, as the European financing landscape is going through structural changes,” believes Mr Ciancimino.

Unlike the US, where the biggest share of the lending is typically provided by institutions such as pension funds or insurance companies, credit in Europe has traditionally been mainly provided by banks. Increasingly, it will come from private credit investors.

Tread carefully

Multi-family office Stonehage has been carefully assessing private credit opportunities in Europe for the last year, where some of the middle tier companies are struggling to raise capital, says John Veale, CIO at Stonehage Investment Partners. But a lot of care is needed, as the level of debt in some of European economies could flare up again.

In the private credit space, the majority of Stonehage’s clients’ allocations are in the US property credit, including mortgage-backed securities.

US property prices have fallen significantly since the end of 2007, in some regions by up to 50 per cent, as many banks and lenders shed real estate assets, which created excess supply. It took until early 2012 for inventory levels in many US regions to return to pre-crisis levels, and today they are beginning to lag demand, pushing up prices. “Our focus last year was on credit financing backed by real estate in the US; that was a very compelling space and we still have exposure,” says Mr Veale.

Opportunities are found both in the secondary market, with investors buying loans made against existing properties, and in the new financing such as mezzanine financing, at the high risk end of the spectrum offering better yield.

Investors searching for yield are gradually recovering their confidence in investing in illiquid assets, which offer good premia, he says. “Depending on the level of risk of a fund, the leverage and skillset of the manager, in private credit we are expecting returns to be 6 to 8 per cent better than we perceive in more liquid credit markets, at the equivalent level of absolute risk.”

In private equity (PE), the growing consumer market in Asia is appealing. “Whilst we still see that investing through large cap international companies is still a reasonable way of getting access to the growth in Asia, prices have gone up and the opportunity available in private equity is starting to look very compelling,” he says.

For a number of years, the allocation to private credit and equity was down to around 5 per cent mark, today it is substantially more, with some clients having 10 to 15 per cent in total in private capital commitment, explains Mr Veale.

Stonehage identifies specialist managers and invests in them directly. Funds of funds (FoF) add another layer of fees to deal with, require much longer commitment and investors will have no say on where they are going to lock up their money. Many of Stonehage’s clients can afford to take individual positions and still diversify exposure, and thus are able to assess the situations on a case by case basis, he says.

“Private equity is one of the few asset classes where a fund of funds approach really makes sense, notwithstanding an additional layer of fees,” says Paul Vittone, head of the $750m (€568m) PE FoF investments at BNY Mellon Wealth Management in the US. 

Successful managers of private equity, and particularly venture capital (VC), cannot raise bigger and bigger funds the way a hedge fund or mutual fund would do. As a result, many of the best funds are closed to new investors. PE fund managers tend to go back to their existing investors when raising new money, which is an advantage for an established fund of funds manager.

The other benefit is diversification, given that minimum investment thresholds in single PE funds can be anywhere from $2m (€1.5m) in a smaller VC fund to $5 to $10m or higher in some of the larger buy-out funds. The size of commitments that a FoF manager will require can be as low as $200,000.

Accessing the best managers is particularly important in this asset class, he says, as performance among PE managers, unlike every asset class, tends to persist. PE managers have the ability to influence the outcome of their investments, as they not only pick the best companies, but improve them operationally and generate value. Developing a brand also impacts deal flows, as the best PE and VC managers tend to get access to better entrepreneurs and companies.

 “We are looking to identify areas that are either inefficient or where there is a significant growth opportunity,” says Mr Vittone. Historically, the core of private equity portfolios at BNY Mellon WM has been made of venture capital, growth equity and leveraged buy-outs, particularly in the lower and middle market, where today there continue to be opportunities. The US continues to be a key segment for investments in the PE space but China is also looking increasingly interesting, whereas Europe is less attractive, he says.

Opportunistically, sectors positioned to outperform this year include private real estate, as well as real assets or infrastructure, globally. “While trophy assets trade near all-time low cap rates, there remains a significant flow of distressed properties due to over leverage or debt maturities,” agrees Rhian Horgan, international head of alternative investments at JP Morgan Private Bank.

“Opportunities exist to buy attractive assets at a discount to replacement cost at a time where improving fundamentals may produce a sustained recovery in commercial real estate prices and volumes. Commercial mortgage-backed security issues have not recovered, driving a gap between equity capital and financing availability.”

Better outlook

Today large public companies, particularly in the US, are still sitting on very large amounts of cash by historic standards, earning relatively little return and they are facing a low growth environment. This bodes well for private equity funds that have rapidly growing companies in their portfolios, which become acquisition targets for these big companies.

M&A is the primary avenue for PE funds to sell their portfolio companies.

In Europe, the PE market outlook is also improving, according to says Peter McKellar, CIO at London-based fund of funds firm SL Capital Partners, specialising in buy-out equity investments in Europe.

“M&A activities started to increase during 2012 and our feeling is that they will continue in 2013,” he says. “This will mean more deals being done by private equity and also by corporates. Whilst that potentially provides competition for private equity, it also provides a very important source of exits.”

Because of the economic and debt crisis as well as companies’ weaker growth, managers have held on to their underlying investments for longer, as it was not easy to exit them. The traditional holding periods have increased to six to seven years from the typical four to five year period.

While the macro-economic environment is still weak, there is a greater political resolve to deal with ongoing issues and some signs of thawing in the debt markets. “In Europe we are starting to see more interest in primary lending and we continue to see a very robust high yield market, which is a very important source of capital for PE managers,” says Mr McKellar.