The future of Private Credit
By Marianna Tothova, Dechert LLP
Published: 28 September 2020
The private credit industry emerged in the aftermath of the last global financial crisis and has grown strongly ever since, both in terms of capital raised and the strategies in which it is employed. It is logical to ask questions about the future of private credit in the context of the COVID-19 pandemic, both in terms of the immediate and longer term effects.
In a downturn, managers typically try to harvest immediate special credit opportunities. Analysts have reported that the window for distressed opportunities has been very short but a second, more sustained opportunity set is expected once state interventions come to an inevitable end, and companies reassess the state of their finances and need for liquidity, in light of the new market conditions. Competition for deals in an already saturated market will doubtless become even more intense.
To take advantage of distressed opportunities, timing and speed will be of the essence. Large managers will likely be better positioned to seize such opportunities, given their scale and resources, allowing them to perform quicker due diligence and invest on the back of wider access to capital.
While a large number of pooled distressed debt funds was raised in the first months of 2020, we believe that many managers will act on an opportunistic basis, matching the right deals with the right LPs, housed in single-deal or co-invest vehicles with bespoke management and performance fee structures. In all likelihood sophisticated LPs which have long-established relationships with managers will benefit from these opportunities the most. However, we have seen more traditional private credit funds managers (typically targeting risk averse LPs) loosening their investment restrictions to allow for opportunistic investments without, however, making the distressed debt the main component of their strategies, or offering more focused funds that sit between the generations of a manager’s established credit fund offerings to take advantage of immediate investment opportunities.
Smaller managers might gain a competitive advantage in certain sectors or jurisdictions, where their specific knowledge will outweigh the scale at which the industry giants operate.
For existing deals liquidity is key. Some managers are already wrestling with breached covenants or requests to apply EBITDA “C” in quarterly calculations. While such requests may appear easy to refuse, private credit is personal; the relationship with the borrower is a long-term one and deals are tailor-made. Keeping the dialogue open and the relationship unharmed is essential to unlocking further opportunities, and such requests might be more difficult to handle than one might think.
In some sectors, loan origination has become more difficult, such as in the senior loan space. Due to delays in due diligence caused by the pandemic, some managers may need to request an extension to the investment period in order to deploy commitments. Such extensions might, in turn, affect the timing of the launch of new funds or cause issues in terms of deal exclusivity in case of concurrent investment periods running for similar funds at the same time.
Funds may also need to seek additional liquidity for follow-on investments and to cover ongoing expenses or deal restructuring costs. While newly raised funds may still obtain a subscription line (although the market has somewhat toughened and might be inaccessible for first-time managers) existing funds with limited or no uncalled commitments to pledge will have to use NAV facilities secured by their assets. The cost of such financing might reflect negatively in fund returns.
From a long-term perspective, the industry has started showing signs of consolidation and gradual sophistication over the past few years, a trend which we expect will be accelerated by the effects of the pandemic. The scale of the market means that managers must distinguish themselves from others through the quality and scale of their resources (where additional restructuring expertise is particularly valued), better access to large high-quality deals, and capacity to provide tailored reporting to the LPs. As perceived economies of scale bite, investors might start expecting lower management fees.
The pandemic has caused a fundamental shift in global perspective on a number of key issues. These include the inefficiencies of healthcare systems and their impact on certain demographics, the sustainability of various industries and the related green economic recovery, and how racial and gender inequality negatively impacts, among other things, many people's economic opportunity. While sensitivity to these issues has been on the rise over the past decade or so, the pandemic has helped to propel them to the forefront of investors’ and managers’ minds. This trend has crystallised through various industry initiatives and ESG regulations. We expect that regulators and investors will increasingly require adherence to high ESG standards, or, at least, detailed ESG assessment and reporting in relation to investments. Putting aside the feel-good factor of the ESG aspects of an investment, high ESG standards will be increasingly important simply from a risk management and profitability perspective.
Technology and Transparency
Whilst the deployment of technology and wider digitalisation in the private credit space is resulting in the emergence of new business models, like retail peer-to-peer lending platforms, the impact of new technology does not seem to have been felt quite yet in the traditional private credit space, where the business remains personal and tailor-made for both LPs and borrowers.
Due to the private character of the industry and the lack of globally applicable data it is difficult to develop widely usable and cost-efficient technology solutions resulting in each manager forging their own path, which puts additional pressure on operational costs. Appropriate technology solutions could provide insight to industry players by augmenting deal modelling, data analytics and intelligent reporting to investors, especially if built on "bigger" data. To the extent that anonymised data could be shared across the industry, any increased transparency would allow for more efficient supervision and regulation of the industry.
Systemic importance and regulation
Due to its size and increasing popularity in Europe and the US (and elsewhere), especially with pension funds and insurance companies, the private credit industry is steadily becoming of interest to regulators. While, to date, the private credit industry remains largely unregulated, it is unlikely to remain so for much longer. Hence it is important for the industry to work closely with regulators to ensure that new regulation will not hinder, but rather stimulate, healthy development of this asset class which is and might continue to be the primary source of financing for many businesses in the years to come.