What's all the fuss about private debt funds?

What's all the fuss about private debt funds?

Private debt as a separately recognised asset class has been growing in importance over the last five years. According to data from Preqin, the number of private debt funds was close to 400 by the middle of last year, and the sector as a whole is outpacing the growth in private equity funds – no small feat.

According to the Alternative Credit Council, an industry body affiliated with AIMA, assets under management in private credit vehicles are projected to pass USD 1 trillion by 2020. In many ways this rapid growth is comparable to that of the hedge funds industry in its early, pioneering days. But what is fuelling this growth?

At the core of private debt growth lies the transition in the way banks lend: the Great Financial Crisis and the subsequent reforms to bank capital ratios have compelled banks to exit many traditional forms of finance since 2009-10. This has starved some sectors of industry of much-needed cash, but it has also created an opportunity for smaller, leaner businesses to make money from lending.

In many ways private lending operations are simply stepping into the shoes of the banks – they employ commercial finance teams out of leading banks and finance organisations and follow the same risk management and approval procedures that the banks have done. The difference is that they are creating an investment opportunity at the same time.

The diversity of private credit funds in the market is substantial, ranging from closed-ended, general purpose funds, through to open-ended, highly targeted strategies. Frequently, funds will be absolutely specific about the geographical area or deal type in which they are active.

Craig Reeves, founder of Prestige Funds, has been active in the market for over 10 years. While many fund managers have been fairly late to the market, Prestige began its lending activities not long after the Great Financial Crisis and has acquired specialist finance firms in the UK which lend into the SME and agricultural markets.

Since 2007 Prestige has raised over USD 1.5 billion for lending in the UK and has recently launched a Luxembourg fund that has the mandate to extend that activity to the Republic of Ireland.

“Investors are approaching this asset class as a real alternative to public markets,” Reeves explains. “Foreign investors looking at the UK appreciate a strategy which can be diversified across thousands of individual loan agreements, which features lending secured against assets like prime agricultural land which has predictable cash flow, regardless of the volatility in, for example, UK equities or gilts.”

The growth of the private debt market has been gradual, but significant. It is filling an important niche in the economy, replacing banks which are withdrawing from all but the most lucrative areas of lending.

Trade finance is another sector from which banks have retreated, particularly from the smaller sized deals. Yet loan finance is still required here. Trade finance is becoming a more important part of the private lending landscape.

Gulf International Bank (GIB), for example, is using a fund structure to lend in the trade finance space, typically in the region of USD 500,000 up to USD 10 million. It has both a fund and managed accounts which lend on a short-term basis across numerous sectors and geographies.

“This is an area which requires specialist skills and knowledge,” explains Ian Henderson, a trade finance specialist with GIB. “We see few institutional scale managers active in this space, but there are a few private companies, some backed by banks or insurance companies.”

Trade finance can be a complex area, but participants such as GIB are creating the opportunity for investors to access these potentially uncorrelated returns through a process of co-lending and funded risk participation. In this case trade deals are sourced through carefully selected counterparties rather than lending directly.

In trade finance the typical returns to investors fall into two categories – the higher yield, more structured transactions offering 6-8 % p.a. and the vanilla trade finance (bank risk and top tier corporates) offering 2.0-3.5%.

Private debt is becoming a viable alternative to private equity too, particularly in regions where private equity funds have tended to focus on specific types of deal, or where banks have been lending to government-backed entities. GIB’s Henderson sees more consultants looking seriously at private debt opportunities.

According to the Emerging Market Private Equity Association, debt is growing in popularity as an asset class to access economic growth in regions like Africa. In the African context, funds are becoming active in a variety of areas and lending projects where previously banks were the main players, including trade finance, mezzanine finance and corporate debt.

For the investment community, private debt has created a new alternative to hedge funds and private equity, and it is an asset class that is swiftly growing in both its level of acceptance and overall importance to the global economy.