Private debt funds are now receiving first calls from private equity firms, as the pandemic reinforces the relative safety of the asset class
In 2004, when Park Square Capital had launched its first private debt fund, the only viable option for a private equity
firm that needed senior debt financing for a large deal was to work with a bank and accept its default deal structure. This year, banks are no longer receiving that first call. Private credit firms have become the relationship lenders to private equity firms and have the capacity and flexibility to support buyouts of all sizes.
Since 2004, assets in private cred-it have grown from under $100 billion to more than $800 billion, developing from a peripheral market segment to playing a fundamental role in the economy and society. This growth will continue over the coming years, given the factors that are driving the market.
“It is difficult for CLOs to form new capital, and their ability to play a key role in the market has been curtailed”
Managing partner Park Square Capital
The demand from LPs to invest in private credit has been fuelled by the search for yield. As global interest rates remain historically low, pensions and insurance companies need to find alternatives to traditional fixed-income strategies. As a result, private credit is playing an increasingly important role in society by helping these institutions to meet their liabilities. As the understanding of private credit and its low levels of volatility versus equities has increased, so has the capital allocated by investors to the asset class.
The pandemic has also demonstrated the relative safety of credit. Prudent managers, focused on high-quality companies operating in stable industries with recurring revenues, have fared well. The ability to show a track record of reliable credit selection through multiple crises is key, and we expect the pandemic to spark a flight to such quality debt managers.
The decision by regulators after the global financial crisis to discourage banks from taking risks with depositors’ funds has also driven the growth of private credit and contributed to the stability of the banking system during the current upheaval. Private credit firms have largely replaced banks in the leveraged loan market, which has led to improved risk assessment and capital allocation.
Collateralised loan obligations have also grown significantly in recent years, and now account for around 54 percent of the US loan market. However, CLOs are experiencing unprecedented pres-sure because of their exposure to ratings downgrades – it is estimated that 51 per-cent of US CLOs are exceeding their CCC-rated bucket – and CLO liabilities are trading at significant discounts. It is difficult for CLOs to form new capital, and their ability to play a key role in the market has been curtailed.
As a result, deal structures have become more robust through the pan-demic, with CLOs in need of high-er-rated credits and private debt firms focused on downside risk protection. This improvement in pricing and terms will drive strong risk-adjusted returns for credit managers, as the primary market reopens following the lockdown.
Firms must act responsibly when negotiating deal structures, loan documentation and pricing to ensure that risk is correctly evaluated, and that investors’ capital is both protected and properly rewarded.
Source: Private Debt Investor