[ M A R K E T
low interest rates and market volatility,
institutions want to diversify their portfo-
lios away from equities and fixed income
products. “Increasing interest in such
products is also being driven by clients
wanting greater diversification from their
private equity managers,” says Joe Patel-
laro, managing director and head of SS&C
Global Private Equity Services.
A report by HSBC Global Banking and
Markets highlighted the Internal Rate
of Return (IRR) at direct lending funds
typically as standing anywhere between
10% to 15%. Such high returns are quite
difficult to find in other asset classes. Bal-
looning client demand has predictably led
to private equity and hedge funds scoping
out private credit, but their interest is also
a response to the challenges threatening
their own existing business models.
For hedge funds, performance has been
weak for almost a decade and many see
illiquid assets as a potential revenue gen-
erator, which could offset poor returns
and make it easier to raise capital. Re-
turns have not been a problem for private
equity, but there is a growing recognition
that their strong performance cannot last
forever, mainly because the asset class
is managing too much money, making
it harder to source deals at reasonable
prices.
Entering a new asset class is not always
seamless. The expertise that comes
with researching an equity security or
a company’s financial statements is not
as applicable in private credit, meaning
hedge funds and private equity firms need
to hire people who know what they are
doing and have credit backgrounds other-
wise managers put themselves at risk of
underwriting loans to weak or un-credit-
worthy SMEs.
Most managers have avoided this trap.
“From a knowledge perspective, private
equity managers are in a strong posi-
tion to move into the debt space. While
there are different processes in terms of
systems, data collection and risk man-
agement, there are a number of service
providers who can help managers should
they choose to diversify their businesses.
It is important to partner with the right
provider,” explains Holz.
Risks to watch
The chief risks nowadays for private cred-
it is twofold, namely that NPLs (non-per-
forming loans) in Southern Europe
default en masse, and that interest rates –
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especially in the US – rise. The latter scenario could usher more
competition into the private debt and direct lending sector.
For a decade now, banks have veered away from writing loans,
primarily because the low rates made them fairly uneconomical.
“The reality is private debt is a relatively new asset class, and
investors simply need better education about how it works.”
MARC DE KLOE, ADAMAS ASSET MANAGEMENT
With higher rates looming, banks may start issuing more loans,
and potentially taking away business from fund managers.
Looser regulation could also incentivise banks to lend out
more. The US Office of the Comptroller of the Currency said
banks should consider providing more short-term, lower value
loans, a practice that was discouraged in 2013. Experts dispute
this will impact private credit though. “While US regulation
may decrease, it is not a really a problem because most managers
have established deal teams and deal flow, which many banks
have dismantled,” says Marc de Kloe, COO at Adamas Asset
Management, a private credit manager.
Private credit is also facing a similar risk to private equity and
hedge funds, namely surplus cash is moving into the asset class
too quickly. As loans and debt are finite – much like money-mak-
ing deals and trades – managers could struggle to find invest-
ments going forward. Dry powder in private debt is steadily
rising, and currently stands at a record $236 billion, according to
Preqin.
Clients are at least conscious that this is happening, with 45%
telling Preqin that investment opportunities would be harder
to come by moving forward, and 40% said they were concerned
about valuations in private debt. However, if private debt capital
is not spent, investors may start reconsidering the asset class.
Equally, it could lead to some private credit managers– hungry
for yield - channelling loans in the direction of weak borrowers,
leading to widespread defaults, particularly if rates go north.
Not everyone is apocalyptic about what the future holds for
private credit strategies though. “Private debt is a very diverse
asset class, and covers a gambit of products including NPLs,
high-yield and syndicated loans. The reality is private debt is a
relatively new asset class, and investors simply need better edu-
cation about how it works, so they can become more comforta-
ble with it,” concludes de Kloe.
Private Equity Issue 2018
globalcustodian.com
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