In an environment of rising rates and lower growth, investors should have senior-secured, floating-rate loans in their portfolios.
Capital is the lifeblood of any business organization. Equity capital provides a foundation for companies’ balance sheet, but efficient day-to-day operations, as well as any larger investments in machinery and property, or expansions through M&A, all typically require long-term financing from various lenders. Traditionally, banks have had a significant role in intermediating financing, but due to the tighter regulation after the great financial crisis, the banks’ ability – and willingness – to lend to companies has decreased.
Large companies with access to bond and syndicated loan markets have been able to finance themselves through liquid markets, but smaller companies do not have that option and thus have started to seek alternatives for long-term loans. These small and medium enterprises, typically with enterprise value between 100 million and 1 billion euros, play a significant role in Western economies, and they have been very active in utilizing a new source of capital called Private Debt.
In addition, more and more large-cap companies have started to take financing from Private Debt providers, too, because Private Debt managers have shown their willingness to provide financing not only in good times but also in challenging times. As we had in 2020 or in recent months, when markets face uncertainties, banks and financial markets will typically not provide new financing for companies. In contrast, Private Debt has remained an active lender even in more volatile times.
Private Debt has grown into an asset class of its own
During the last 15 years, Private Debt has grown from a small, tactical, and opportunistic investing as a minor part of Private Equity or Hedge Fund allocations into an asset class of its own with more than USD 1.2 trillion AUM today (Source: Private Debt Q2 2022 | Preqin).
A significant part of Private Debt is to issue new, bilateral loans to companies. Typically, they offer senior secured, floating rate loans to companies with organic or non-organic growth plans. Before Private Debt managers lend any money to companies, they conduct thorough due diligence on the borrower’s financial status and the entire business model – a deep fundamental, company-specific underwriting process like business owners would do. However, they are very efficient in the process and can quickly provide an opinion on loan terms. And borrowers can rely on the certainty of getting the financing as long as parties agree on terms.
Speed, certainty, and term flexibility are virtues valued by owners – entrepreneurs and private equity sponsors. However, these do not come without a price. Typically, a private loan is more expensive than loans from other sources, but owners are happy to pay a bit more for efficiency. And, if things go as all parties hope them to, the next round of financing with the same lender is even smoother than the first one. This flexibility has been even more valuable during recent years when a larger part of private equity managers’ business has been in buy-and-build strategies, where they conduct a series of buyouts to grow their companies. Securing financing for multiple transactions at once is very efficient.
Evli's Private assets team. Starting left: Richard Wanamo, Nina Skogster, Ville Toivakainen, Roger Naylor, Emma Honkanen, Oskar Karlsson, Ben Wärn.
Private Debt is a multi-dimensional alternative asset class. Companies’ balance sheets and capital structures can be complex, financing needs are unique, and the health of the companies varies from healthy growth companies building new platforms to companies with a distressed balance sheet and need for a significant change in the capital structure to gain a new, fresh start for the business.
Not to mention geographical differences; each country has their corporate laws, and creditors’ rights can be completely different between countries. All this requires a specific skill set from lenders. They must have enough resources and capabilities to assess the long-term risks properly, select only the most attractive opportunities and structure the loans to protect them in worst-case scenarios. Credit investing is not about maximizing upside; it’s about minimizing downside.
Selecting the right manager requires a lot of time and effort
For Private Debt investors, there are more than 500 funds raising capital every year. Selecting the right managers requires a lot of time and effort. It is vital to understand the whole value creation process, starting from loan sourcing to underwriting to deal closing and all the way to the maturity of the loan, not only on an absolute basis but on a relative basis as well.
Even if funds claim to invest in similar strategies, there can be significant differences in risks – and returns – between them. Reviewing large amounts of funds before any investment decision improves the portfolio quality and increases the probabilities for attractive, long-term returns for a private debt portfolio.
In addition, just like in all credit investments, diversification is the cheapest lunch available. Diversifying to different strategies, geographies, target funds, and vintages is the best way for a good private debt portfolio. Of course, all this requires enough resources, time, brainpower, and capital from investors.
Evli has a successful 20+ year history of investing in private markets funds, and today its alternative investments team comprises more than 20 seasoned investment professionals. Leveraging its scale, thorough investment process, integrated ESG evaluation, and dedicated fund selection expertise, Evli’s global private debt investment strategy is designed to capture all the benefits of the asset class, while lowering risk through proper diversification across strategies, geographies, managers, and vintages. First established in 2021, Evli’s private debt fund of funds program has a successful track record of implementing this strategy and accessing best-in-class funds, thereby giving clients a practical way to build a solid cornerstone portfolio of attractive private debt assets.
Read also
Infographic: Time to rethink the 60/40 allocation strategy
When in dire straits – hoist the sail labelled diversification
Unlisted infrastructure offers unrivalled downside protection
Forestry leads the way towards a carbon-neutral portfolio
Private equity allows access to attractive sectors and companies outside listed markets
Unlisted real estate adds stability to the portfolio in the long run
Growth capital helps companies grow and investors diversify
NB! Evli's alternative investment funds are intended for professional investors and a limited number of non-professional clients who make an investment of at least EUR 100,000 and who are considered to have an adequate understanding of the fund and its investment activities.
