Private debt funds are attractive, but they aren’t a straight route to strong returns
With the pandemic rendering conventional equity-bond portfolios unfit to generate stable yields, investors are increasingly turning to private debt funds – vehicles that lend to businesses that may find it challenging to access bank loans and other traditional forms of finance – to secure consistent returns.
The Coronavirus Business Interruption Loans (CBILs), Bounce Back Loans, tax deferrals and numerous grants have prevented a systematic default but have changed the lending landscape. More generally, with QE lowering bond yields and companies cutting dividends, investors are finding it hard to implement their income strategies.
Unlike established equity and bond-based income strategies which have suffered from mass dividend cuts and sweeping emergency monetary policy measures, private debt funds are likely to benefit from Covid-induced disruption given there is unmet demand for loans among small and mid-tier corporates – and investors are considering alternative asset classes.
Investors should ensure that they choose the investment strategy that meets their risk-return profile and a manager who can navigate this highly complex credit landscape.
CBILS has changed the lending landscape
CBILS has altered the SME lending landscape, with over £20 billion now having been lent to more than 80,000 companies.
It has provided low-cost longer-term funding for companies, but it has altered the structures of the portfolios of non-banks that became accredited lenders under the scheme and now account for approximately 20% of CBILS lending.
The quality of portfolios has generally improved and maturities have been extended, but average returns have gone down. Sectors such as invoice discounting have been particularly impacted as borrowers have been able to term out their debts on more competitive terms.
Due to the scale of CBILS, it is possible that some form of partially government-guaranteed lending remains within the SME sector for the foreseeable future. Investors who entered the private debt sector after the 2008 financial crisis given the opportunity to replace bank lending with convenient but expensive funding may have to adjust their return expectations.
Nevertheless, those who arrange private debt transactions are creating new structures to meet today’s needs – securitising CBILS loan portfolios, for example. Some managers might focus on borrowers that do not meet CBILS lending criteria or sectors that have been hardest hit by lockdown. Distressed debt funds might become more prominent as they were after previous crises.
Support needed to navigate the complex credit landscape
Many companies have attempted to set up in-house teams to pursue alternative lending opportunities.
However, doing so isn’t as straight forward as it may seem. This is where credit funds run by investment specialists add value. There are five main areas where they do so: finding or sourcing the right opportunities, monitoring and reporting, negotiating and structuring terms, managing risk through diversification, and intervention when things go wrong.
In the short term at least, physical interaction between lenders and borrowers and between borrowers and their business counterparties has been made near-impossible by the pandemic. It has also made business investment and infrastructure projects more difficult as suppliers and contractors also have to manage their compliance with Covid measures.
Managers of credit funds must decide to what extent they can conduct due diligence and make credit decisions on video conference calls. As a result, sourcing the right opportunities, monitoring investments and intervention have all been particularly tricky over the last twelve months or so.
The pandemic has also complicated the negotiation of terms. Many credit funds must achieve double-digit IRRs from loans to achieve target returns net of credit losses and fees. This requires interest rates of 10% or more and often the inclusion of an equity kicker.
The availability of these terms reflected demand since the financial crisis from private equity funds to leverage their investments. Although expensive, debt provided by credit funds came at a cost that was perhaps half the expected returns of the PE funds.
The increase in the volume of credit funds also requires managers to propose such terms to companies that do not have a financial sponsor. This was already challenging before the pandemic, but government support measures such as CBILs and the fall in interest rates and bond yields have highlighted the high cost of loans offered by credit funds.
If negotiations become difficult, managers must decide between failing to deploy sufficient funds to achieve diversification and achieving lower returns.
Another consideration is the type of loan utilised. Most managers have proprietary loan documentation. At LGB we arrange the establishment of medium-term note (MTN) programmes.
Traditionally used by large corporates, we´ve tailored ours to growth companies seeking diversification of lending sources as well as the flexibility of funding.
MTNs establish common documentation for multiple issues of securities, and their key feature is the access they provide to a diverse group of lenders. Companies can develop relationships with loan noteholders, who make independent buying decisions. This means that companies are not reliant on the lending decisions of a single bank or fund.
Choosing the right manager is key
Undoubtedly, many experienced and talented fund managers will be able to navigate their way through current difficulties, but investors should look beyond the attractive marketing documents.
Instead, they must identify the expertise and differentiated features that support each product offering in order to make an informed investment decision.
Ultimately, whilst time-consuming and perhaps difficult without the necessary advice or prior knowledge, choosing the right manager will be key to investors achieving the returns promised by the private debt sector.
This article appears in TheWealthNet. To read it online, please click here.