Private Debt Investor: The year of junior debt

After a strong 2023, market sentiment around private debt remains bullish. Robin Doumar, managing partner at Park Square Capital, predicts that 2024 will be another good year for the asset class, though he cautions that managers who have failed to be sufficiently selective will be hit hard by an anticipated rise in defaults.

Doumar adds that the market is moving in favour of junior debt strategies, and predicts that the need for businesses to refinance senior debt loans, combined with a rise in private equity firms looking to return cash to LPs, means that conditions are primed for junior debt strategies to take off.

How do you feel private debt has performed over the past 12 months?

The asset class has performed strongly throughout 2023, partly owing to the dramatic movement in base rates. At Park Square, we have about $10 bil­lion invested in our portfolio and since base rates started moving up, we’ve been able to earn about $400 million a year in additional interest income, a massive boon for us and a reflection of the strong tailwinds that a ‘higher-for-longer’ environment offers the private debt industry.

In more normal times, we would be excited by a 0.1 percent move in net fund IRRs, so for the returns on each floating rate investment to move up­wards by around 500 basis points gives rise to a huge tailwind.

Another factor often overlooked is that the amount of time a loan is outstanding has a huge impact on our returns as private debt lenders. When the market is buoyant, we tend to see a lot of refinancing activity, but currently most borrowers don’t want to refinance because margins are wide and base rates are high.

As a result, hold periods have been getting longer, which significantly in­creases the returns we can achieve on each loan. It’s a trend that’s likely to persist for a while, even as markets re­cover.

Can positive performance be maintained in 2024?

Yes, private debt is going to continue to perform well and will remain attractive compared with private equity because private equity is still dealing with high entry valuations and the much higher cost of debt. That said, private equity deal volume is likely to increase – part­ly because the syndicated loan market has reopened – and consequently, we’ll see more volume at lower prices this year.

However, I expect 2024 will see in­creased divergence in how private debt managers perform. We’re in an envi­ronment where more and more com­panies are struggling, and some man­agers are going to be exposed because they chose to lend to riskier businesses. Too many managers take a formulaic approach and end up getting distract­ed from the fundamental question of whether they’re lending to high-qual­ity businesses.

In a potentially tougher macroeco­nomic climate for portfolio companies, management and execution become more challenging. Private debt manag­ers that can draw from the experience of investing through multiple cycles clearly have an advantage in these con­ditions and are going to be rewarded for their experience.

What strategies are best suited to the current market?

This is going to be the year of junior debt. We’re coming off a spectacular period for senior debt, which of course benefited from the effective shut-down of the broadly syndicated loan mar­ket throughout 2023. But now the opportunity set is shifting into the jun­ior space – we’re coming into a golden era.

The key driver is the demand for deleveraging transactions, where com­panies need some form of non-cash pay junior capital to pay down their senior debt. This applies for companies who took out loans before the rise in base rates and have found themselves strug­gling to pay their debt interest, while also investing in growth. So that cre­ates a fabulous opportunity for mezza­nine capital or junior debt.

Another trend that works in favour of junior debt is the longer hold peri­ods in private equity. Given the down­turn in valuations, it’s not a good time for private equity firms to exit their portfolio businesses, but firms need to find a way to return capital to their LPs in order to start raising their next fund.

How can they do that without sell­ing a business? Private lenders can help provide solutions through junior debt recapitalisations, enabling firms to pay dividends to their LPs. But there’s still work to do around educating investors about the benefits of junior debt. Peo­ple entering the asset class tend to start with direct lending and then as they get more sophisticated, they become more attuned to the opportunities offered by junior debt.

February 2024