This article is sponsored by MUFG Investor Services.
How would you describe the growth in private debt that you have witnessed in recent years?
I think private debt is technically one of the fastest-growing asset classes in the world today. Preqin valued the private debt asset class at $1.2 trillion in 2021, with predictions that it will grow to over $2.5 trillion over the next five years. Certainly, we are constantly talking with managers interested in getting private debt onto their platform.
And what makes private debt so attractive?
To answer that, you need to look at the history of the asset class. In the wake of the financial crisis, European banks, in particular, were heavily deleveraged, which means they found it hard to service mid-tier mezzanine loans. This is where we first saw private debt managers making their move. Initially, these were highly skilled managers that knew the direct lending and loans ecosystem well. But, pretty soon, everyone was becoming interested in private debt.
The appeal is clear. This is a high-yielding asset class with returns upwards of the high single digits. The ability to amend and extend means that it is also possible to manage your way out of trouble when compared to other asset classes that are more rigid in design. In addition, private debt is forward looking. We are increasingly seeing strategies focus on the high growth technology and life sciences sectors, for example, as well as sustainability and special situations, which you haven’t seen a lot of in the loans industry in the past.
How is the asset class likely to fare in a higher interest rate environment?
Loans in general will perform very well in a higher interest rate environment because they are tracked to floating reference rates, as opposed to fixed-rate bonds, for example. A rising interest rate environment just adds to the story of why this asset class is so great.
In addition, because these loans are private in nature, they are not actively traded. Our managers hold the loan until maturity, which also protects those loans against the fluctuations you see in the broader markets. In fact, we are increasingly seeing managers that have historically focused on equities looking to incorporate a debt element, precisely because the premium for direct lenders is the interest, rather than the valuation of the asset itself.
The macroeconomic situation may be working in private debt’s favor, but what are some of the challenges that managers in the space are facing?
When you have a fast-growing industry like this, there is inevitably a lot of competition. When direct lending first started, back when the banks deleveraged, lenders were few and far between and so they held all the power. That pendulum has swung. There are far more lenders in the space today and so borrowers can shop around, with implications for price and terms. Indeed, cov-lite became a hot talking point pre-covid, and I imagine it will again.
At the same time, managers are looking to expand into new sectors and geographies. We are seeing a lot of firms moving into APAC, for example, pursuing debt opportunities across India, Southeast Asia and China. We are also seeing a lot of growth in South America. When you move into new geographies, you have to ensure you understand the local rules and regulations. What are the tax implications? What happens if a loan goes into default?
You need to be crystal clear about what you are getting yourselves into.
It is great to see the speed of growth of this asset class and we are doing a lot of administration work in the space. But that growth is something that a manager has to be able to control.
As managers are expanding and internationalizing, what functions are they looking to outsource and what are they keeping in-house?
Managers are putting a lot of trust in their administrative partners as they focus their attentions on their core activities. They want their front office to be first and foremost about looking at new opportunities, managing portfolios and generating yield. That means they come to us to run their middle office, as well as independently run the books and records as a loan administrator.
Increasingly, managers also have bespoke reports that they want to include, or different systems that they want information to marry up with, in addition to the different accounting requirements of the various jurisdictions where they operate, and the different pools of commingled capital that they are investing from.
As well as focusing on core competencies, is outsourcing also about cost management?
Absolutely. We can take some of the full-time equivalency cost out of their business and with the Business Process Outsourcing (BPO) services that we provide, independently of our fund administration team, we can do everything on behalf of the managers. We can do the heavy lifting in terms of day-to-day operations, making sure everything is reconciled.
That is really important in the context of direct lending because, as a private asset class, there are fewer players involved – it is normally just the loan administrators, the BPO, the manager and an agent. So, you have to be very careful that you have the intellectual capacity available to do everything correctly, and without anything falling through the cracks.
Even in the syndicated loan market, there is an ecosystem that exists so that if the agent produces a note that doesn’t make sense, there are hundreds, if not thousands, of people looking at the same asset who could spot the anomaly. With direct lending, you really do have to be on point.
Does technology have a role to play?
You definitely need to have up-to-date technology to carry out all the bespoke reporting associated with direct lending. You have to be able to move that data, and visualize that data, and you need to ensure speed and accuracy. Having the right technology in place is far superior to trying to come up with solutions with old technology or, heaven forbid, going back to excel to try and validate information.
We spend a lot of time and energy making sure we have the best technology and infrastructure to capture all this data, from the direct lending assets themselves, but also all the other information we have access to that goes into producing NAVs and ensuring that managers have the tools they need to make business decisions and run their portfolios successfully.