Private Debt Investor: Private debt set to prove value.
The market offers unprecedented opportunities for disciplined lenders, says Park Square’s Robin Doumar
With the rise in base rates, investors in private debt are set to enjoy some of the highest returns ever achieved in the asset class. The downside, of course, is that dealflow is down, while more borrowers are struggling to service their debts.
Robin Doumar, founder and managing partner at Park Square Capital, believes this market will produce a divergence in managers’ performances. Lenders that have maintained discipline will ride out the distress cycle, he says, while achieving returns that rival private equity even on an absolute basis.
How does the outlook for private debt in 2023 compare to other alternative asset classes?
This is the most interesting time for private debt I’ve seen in over 30 years working in credit markets. Virtually all the structures in this asset class use floating rates, which in this environment of higher rates is a really big deal. As fund managers, in normal times, we’re happy if we can move a fund return by 0.1 percent. And yet, the backdrop over the past year has been this 300-400 basis point rise in rates. It’s hard to overstate the benefit – it’s truly gigantic.
It’s a massive tailwind for private debt – but of course it’s generating a significant headwind for private equity. I used to say that high returning private debt strategies compare very favourably to private equity, on a risk-adjusted basis. Now, I’m saying that it’s very attractive relative to private equity – but on an absolute return basis.
If we can deliver up to a 15 percent net return in some of our strategies, that is going to be very strong compared to what most private equity funds can generate currently. Plus, we have some measure of security or preference in the capital structure, and we have a floating rate that protects us against any further rate rises.
I’m sensing from institutional investors that there’s more interest in the higher returning elements of private debt than ever before. In this environment, they’re realising that they’re better off taking a chunk of their private equity allocation and putting it in high returning private debt strategies.
So, what are the best ways to pursue high return seeking strategies at this time?
Mid-market direct lending, both unlevered and also with leverage, is very interesting. With leverage, some of these strategies can be very high returning indeed. Junior debt is very attractive right now because secondary markets are dislocated and there are opportunities to pick up pieces of debt that are trading at a deep discount.
But there’s also going to be a wave of companies that need to find ways to restructure their debt. These are borrowers who are loaded up with highly levered unitranche financings. They might have been paying 6.5 percent interest just over a year ago; now, they’re looking at 11 or 12 percent.
A lot of companies will not be able to cope with that. They’re going to need some junior debt that’s non-cash pay to come in and de-lever the cash pay senior debt. Many of these businesses are very established businesses with stable and predictable revenues – but they’ll need a financing solution.
I really like going for high returns within the private debt space in this environment. Low returning strategies are less attractive, frankly, because bonds are now yielding again. When the 10-year treasury in US dollar terms is hovering around 4 percent, you get paid something just in the bond market. So, I like that extra premium in the higher returning private debt strategies.
What is the longer-term outlook for private debt?
I think it’s going to be a really, really exciting investment environment. The share of the market that is held by private debt firms is increasing.
For society, it’s a very good thing to have long-dated, locked up capital owning these risk assets. If we look at where we were before the global financial crisis, there were a lot of risky loans on bank balance sheets. In many cases, the banks were not diversified and had outsized commitments to single deals, which was really unwise.
What’s happened, as a result of pretty effective regulation, is a lot of that risk has been transferred to fund managers where there’s a deep alignment of interest. We have capable risk managers in this asset class holding nicely diversified portfolios, and we’re holding them in a way where mark to market shocks that have nothing to do with underlying performance are easily weathered. We’re creating a better shock absorber in the system for society.
This is an environment where banks find it incredibly difficult to lend, because they know the mark to market could be down 10 points tomorrow. Whereas, in private debt, we’re fundamental lenders and can hold to maturity without worrying about the daily marks, and this is a fabulous market in which to lend. So, the growth and development of the industry is a very big deal and a really positive step.