Increasingly complex models of unitranche loan agreements are being brought to market by managers offering direct lending products, a research paper has found, demanding careful governance from pension scheme investors.
Private debt, both as direct lending and leveraged loans syndicated by banks, has become an increasingly attractive asset class in the hunt for greater yields.
You have to go in with your eyes open and make sure that where you are in the debt structure is something you’re comfortable with
Tony Baily, Cardano
A report released on Monday by consultancy bfinance found significant opportunities do still exist in the asset class, with most managers of unlevered senior private debt funds still expecting internal rates of return of more than 8 per cent.
However, core senior debt allocations now return between 5 per cent and 6 per cent, according to the consultancy, driving managers to include unitranche components in their senior products.
Unitranche debt is technically classified as senior debt and first lien, but can involve a variety of structural dynamics, including partners agreeing to let one creditor recover their debt first, and therefore increasing risk for the “second-out” party.
Bfinance’s manager research found that the “vast majority” of senior funds open to investors now include between 30 per cent and 80 per cent unitranche, and between 15 per cent and 30 per cent subordinated loans.
Within the unitranche components, more than 80 per cent used relatively simple ‘agreement among lender’ documents, but a growing minority are using complex agreements and incorporating riskier financing elements, such as mezzanine debt or payment-in-kind, which increases the debt constraint on borrowers.
PIK debt instruments pay out interest in the form of more debt, with the principal and interest paid at the end of the contract. This involves greater duration risk for the creditor.
Choose your risk level
“The awareness of what’s defined as senior is still developing, and the uniqueness and nuances of unitranche are still quite unknown to a lot of investors,” said Niels Bodenheim, director of private markets at bfinance.
However, the introduction of these riskier and more complex structures did not necessarily concern him, as they will offer attractive options for investors with a healthy risk appetite.
“The key is, don’t set the return expectations too high if you’re a conservative investor,” he added. “You can certainly find a fit-for-purpose solution.”
Bodenheim suggested lower returns may also drive managers to employ more leverage when lending, necessitating further scheme caution.
Crowded market?
The report also highlighted evidence of record levels of dry powder, or capital invested in funds but yet to be put into deals, in the senior direct lending sector.
Preqin Private Debt Online data showed $224bn (£184bn) unused capital sitting in private debt funds as of June 2016, compared with $371bn in unrealised value.
“In certain parts of the market, the UK and maybe parts of France, you do see signs of a lot of capital, but also you see signs of the banks being very competitive,” said Mike Anderson, head of investor relations at Pemberton, an asset manager focused on credit and direct lending.
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He added that direct lenders find it difficult to compete with banks, advocating strategies where direct lenders work alongside banks in a “pari passu” or “club deal” approach.
Anderson said it was “inevitable” that the returns on offer from core senior debt strategies had come down as the market became more efficient.
But he argued that rather than stretching the strategy to include elements of subordination, managers should simply target more realistic returns, especially if the credit cycle turns.
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To avoid yield compression caused by crowding, he advised schemes to pay careful attention to manager selection and finding specific expertise.
“You have to be able to demonstrate that you can find... unique deals, not just from the same places everyone else is looking,” he said.
Stick to the fundamentals
For Tony Baily, client director at consultancy Cardano, the importance of scrutiny does not make direct lending or broader private debt an unusual asset class.
“The key thing with illiquids is making sure that you’re getting adequately rewarded for locking up your money,” he said.
Cardano has a distressed debt manager and a direct lending manager on its portfolios, which according to Baily are used to target specific sectors.
“You have to go in with your eyes open and make sure that where you are in the debt structure is something you’re comfortable with,” he added.
