Direct lending has been a fruitful hunting ground for return-seeking limited partners ever since the last financial crisis, and there has been a steady increase in activity in this part of the market globally over the last 10 years. According to Preqin data, in 2010 some 92 debt funds globally raised $42.8 billion, while in 2020 there were 204 such funds raising a total of $119.2 billion.
However, 2020 was the year of the COVID-19 pandemic, which has impacted all facets of the direct lending market, including fund managers, LPs and portfolio companies, on both sides of the Atlantic. Indeed, Preqin's data show 2020's activity was a decline from 2019, when 222 debt funds globally raised $131.3 billion. Notably, of the 20 funds that closed a fundraising in the third quarter of 2020 on Preqin's global measure, none closed in Europe.
Testing times
So while the pandemic has not sapped the will of LPs to invest in private credit, it has cooled down conditions across the board, and Europe has definitely felt the chill.
"Fundraising is still challenging," says Ari Jauho, partner at Finnish private capital investor Certior Capital. "I think the main take is that we are in a wait-and-see mode. Allocations are definitely more conservative, because the market is still uncertain."
"During the pandemic there has been less investment at every level, so for instance, there is less money flowing in pension funds because of deferred payment, and therefore less investment," adds Jauho.
Certainly, the market held its breath at first, say a few participants. However, in the past few weeks several fundraising announcements emerged that have reassured general partners.
Market bifurcation
The big teams and big funds are definitely the winners in this new paradigm, especially if they have been around for a while, as Ares' recent fundraising demonstrated, according to sources.
The market is likely to see a bifurcation between larger, more established players and smaller fund managers, says Abhik Das, managing director and head of private debt at Golding Capital Partners. Das notes that larger fund managers (with a longer track record) are better positioned, although smaller funds can certainly take advantage of the ongoing bank retrenchment as well.
"You definitely need a story that differentiates your fund from the plain vanilla mid-market fund to attract LPs, maybe by having special situations or distressed funds," says Jauho of Certior Capital. "We are focusing on small niche funds with defined strategies that fit with the market situation at the moment."
"LPs are definitely doing fund mapping work at the moment, although there might be more attraction toward special sits/distressed funds, that won't nibble on unitranchers' allocations," says Thomas Liaudet, partner at Campbell Luytens.
Meanwhile, diversification across sectors and geographies should prove beneficial for LPs seeking the best portfolio returns, says a direct lender source.
According to the Deloitte Alternative Lender Deal Tracker Q3 2020: "In-line with other asset classes, the private debt market is experiencing a process of capital consolidation, with the ... large-scale fund managers and large-scale funds benefiting, at the expense of new fund managers. Where large fund managers have existing relationships, they can be leveraged, particularly in times such as now [when cultivating new relationships can be difficult]."
Thirst for discipline
One result of the pandemic in this part of the market is that it has brought along with it a thirst for more discipline. LPs are scrutinizing their investments more, and debt funds are required to be more compliant along those lines.
"There clearly is a greater level of transparency," says Golding Capital's Das. "LPs are receiving more granular details."
This presents a further opportunity for differentiation as some funds have become much more forthcoming, while others are more reluctant to share more detailed portfolio information, notes Das, with some funds maintaining a greater "open book" approach than others.
Implementation of environmental, social and governance criteria is also paramount for LPs and has been for a while, but the pandemic has further highlighted the necessity of ESG incentives. "European GPs have understood the relevance of ESG in due diligence and reporting in particular. They take this topic very seriously, while many US-based GPs are still somewhat behind the curve. In order to raise capital from European LPs, some might have to up their game [in this area]," adds Das.
"But now with Biden rejoining the Paris Climate agreement, it [the U.S. market] is going in the same direction," notes Campbell Luytens' Liaudet.
Growth opportunity
Despite such uncertainties, there are still a lot of opportunities for growth. There is also room for growth for LPs in Europe, as they have invested a lot in the U.K. and France and can now "hunt" in Germany, Italy or Spain, a market source suggests.
Ultimately, the yield curve in the bond market is very flat and will continue to be so for the foreseeable future, while the interest rate for banks is negative, notes Campbell Luytens' Liaudet. Indeed, the pressure on banks continues, and private debt has delivered consistent premium returns over liquid debt. "Yield is king for investors, and the best way to find return is to invest in private credit," he says.
"Of course, at the beginning of the pandemic everybody was worried but then all the government aid arrived, and you saw that portfolio companies were protected and then it was business as usual," Liaudet explains.
"In March 2020, 20% of investments were on hold, and 22% in April. In April only 34% of the investments were made but by July/August only 4% of the investments were on hold," Liaudet says.
Flexibility
According to the Deloitte Alternative Lender Deal Tracker Q3 2020: "Demand for private debt remains strong, as companies around the world refinance legacy debt, often extending maturities at significant discounts. Firms with a solid underlying business may be experiencing short-term COVID–19 induced cash flow issues and the private debt market is well placed to step-in and alleviate these pressures, often using varying structures depending upon the nature of the business."
Fundraising news
Looking at recent fundraisings, Kennedy Lewis Investment Management has closed a credit fund with $2.1 billion of capital commitments, exceeding a $1 billion target. More than 50% of the capital has been committed or invested. Kennedy Lewis Capital Partners Master Fund II LP will continue the strategy of a previous fund that closed in November 2018 with commitments of above $500 million. That fund invested in event-driven and opportunistic credit, both performing and distressed, to middle-market North American and European companies.
Ares Management has collected $11 billion (roughly €9.3 billion) for its European middle-market lending fund, according to a recent regulatory filing. The fund is on its way to a €13.5 billion total by the end of the first half, which would make it the biggest European direct lending fund in history.
Pemberton Capital announced on Jan. 11 that it had raised more than $2.2 billion at the end of last year for the first close on its third European mid-market fund in Europe. The firm is targeting a total of roughly $4.5 billion-$5 billion for this fund, a source said. Pemberton invests mainly in mid-sized private equity sponsored business in Europe and has roughly $10 billion under management.
Then there is Sixth Street, which earlier this month announced the final closing of its second fund dedicated to direct lending for middle market and growth companies across Europe. Sixth Street Specialty Lending Europe II reached its hard cap with €1 billion in equity commitments.
Anima Alternative Sgr, an Italian asset management company focused on the private investments market and entirely owned by Anima Holding, said on Jan. 8 that it has obtained underwriting commitments and approvals from professional investors for a total of roughly €117 million. The fund will start its operations in January.