The private debt market, still quite young in Germany, in the middle of its first test. Photo: petervician Source: iStock

Private Debt: an asset class not just for boom periods

Author: Dr. Sofia Harrschar

Private debt has become an increasingly popular asset class in recent years. The corona pandemic is the first major test for this relatively young market in Germany. One thing is already clear: close monitoring and comprehensive risk management are extremely important. Private debt is likely to prove its strength as an asset class in the long term.

Dr. Sofia Harrschar, Member of the Board, Executive Director, Head of Alternative Investments, Universal-Investment Photo: Alexander Habermehl Source: Universal-Investment

The relatively young market for private debt in Germany is in the midst of its first acid test. The markets for debt funds (loan participation) and direct non-bank lending (loan origination) are feeling the strain of the corona crisis. How will a potential increase in loan defaults as a result of the economic collapse impact the market? What effects will rising corporate liquidity requirements have? And how will investors react?

There is no historical data to draw on. After all, the market for private debt structures in Germany only emerged after the financial crisis of 2009. Private debt investments, initially regarded as niche products, have in recent years become an essential component of many institutional investors’ portfolios. There is good reason to believe that this will continue to be the case despite the crisis.

Prior to the corona crisis, the growth in private debt investments was impressive. The trend was triggered by banks’ reservation to provide financing as a result of tougher regulatory requirements. Financing shortfalls were particularly apparent in the SME sector. Alternative debt lenders were also increasingly sought after for infrastructure and real estate projects, as well as for financing in the shipping sector. Even the banks themselves started setting up debt funds in order to take the strain off their balance sheets. At the same time, low interest rates prompted investors to seek high-yielding investment and diversification opportunities. Even though the growth fluctuated and even though, according to the data provider Preqin, invested capital declined somewhat from its 2017 peak, investors still injected 107 billion US dollars into private debt funds in 2019.1

Debt structures doubled in three years

The amount invested in debt structures via Spezialfonds by Universal-Investment has also risen sharply in recent years: invested capital totalled 9.5 billion euros at the end of 2019, double the 4.7 billion euros recorded in 2016 (see chart 1). Corporate loans made up the lion’s share at 5.9 billion euros, with 1.4 billion euros attributable to financing for infrastructure projects, one billion euros for municipal lending, 869 million euros for real estate loans and 318 million euros for financing in the shipping sector – within a total of 45 active fund structures.

Zoom
Source: Universal-Investment As per: December 2019

Advantages for creditors and borrowers

The advantages of private debt include the following in particular: the asset class potentially offers higher yields than conventional bonds, additional diversification opportunities, a mostly low correlation to other asset classes and largely calculable income streams. Private debt is in general also particularly suitable for covering long-term payment obligations. Risks can be further mitigated by combining different private debt strategies - including within the different areas of corporate, infrastructure or real estate financing. For insurers subject to Solvency II regulation, debt instruments, including debt funds, are also in general less capital-intensive than private equity or direct investments in real estate.

Private debt provides an additional source of financing for companies - particularly for acquisitions and growth or in special circumstances. Although private debt is often more expensive than conventional bank loans or bond financing, as a rule it offers more flexibility. Loans are often granted more quickly, while the terms are frequently tailormade to the investors’ needs. Moreover, borrowers usually comprise small and medium-sized companies, whose rating is often in the sub- or lower investment grade range, and who therefore often have less access to alternative sources of financing.

Meeting the challenges of complexity

It is too early to predict what the long-term effects of Covid 19 on the private debt market will be. The initial reaction was clear: according to the BAI, fundraising in private debt declined sharply by 41 per cent in the first quarter, with direct lending counting among the preferred investments. Demand for venture and distressed debt plummeted meanwhile, according to the BAI.2

Even before the crisis, private debt was a complex asset class with particular challenges. For one thing, it is an illiquid class with limited transparency and, as a rule, a long investment horizon. A great deal of know-how is required to carefully select target investments. Last but not least, comprehensive risk management and reporting are important in order to mitigate risk. It is all the more important during this crisis to scrutinise valuations and the creditworthiness of borrowers, as well as to examine business plans in detail and monitor developments. The crisis has highlighted in particular how important it is for fund initiators and institutional investors not to be on their own.

It is helpful to have a partner with the right structuring and asset know-how, who provides competent support and has as much experience as possible in structural and operational set-ups. This applies to all target investments: to corporate lending, real estate or infrastructure loans, as well as to shipping or municipal loans. It is also important that partners are open to all manner of interfaces and that they work seamlessly with the service providers in the fund initiator’s team, such as legal and tax advisors or auditors.

Crisis proof thanks to support

It is worthwhile, not only for the structural and operational set-up, to rely on an experienced partner. In order to navigate a crisis as calmly as possible, it is important that there is an even closer exchange than ever between all parties involved. Following are a few examples:

  • an increase in the frequency of regular reviews of all loan investments as well as off-cycle checks.
  • assessment for all new investments of the suitability of market conditions for the transaction and of any potential special situations. New investments were postponed in consultation with asset managers and fund initiators if the pricing was difficult.
  • close consultation with asset managers regarding current developments and above all regarding areas which are/may be particularly affected by the corona crisis. Procurement of statements regarding fund strategy and the general market/risk climate.
  • close monitoring of the liquidity of funds and investments.

How will private debt emerge from the crisis?

It may be a platitude to say this, but opportunities lie in every crisis. The flexibility that private debt offers might prove useful if there is a renewed increase in financing requirements. If there is no further deterioration in overall economic conditions, there are still likely to be clear benefits for investors: the attractive risk/return profile, diversification opportunities and regular income (see chart 2).

The quest for high-yield investments looks set to intensify in this likely prolonged period of low interest rates. In some of the future-oriented sectors, financing requirements might increase again, for example in digital infrastructure and in the roll-out of the 5G network.

Zoom
Source: BAI-Studie Unternehmenskreditfinanzierungen 2019

The following appear to be problematic: the difficulty of assessing creditworthiness due to the highly uncertain conditions at present, possible loan defaults and the potential decline in the value of the collateral. Stringent monitoring is more important than ever. If all of this is achieved, private debt should pass the corona acid test. The asset class will then likely establish itself as an essential component of investors’ portfolios in the long run and help improve the risk/return profiles of portfolios.

1 Preqin, 09.01.2020; 2 BAI-Newsletter II/2020

 

Author: Dr. Sofia Harrschar
Date of issue: 9/18/2020