Written By: Cécile Mayer-Levi
Cécile Mayer-Levi of Tikehau Capital discusses Direct Lending and the hunt for secure income in the wake of the pandemic
As the world recovers from the Covid-19 pandemic, investor priorities have shifted and the hunt for secure income has become a renewed area of focus. Despite some positive indicators in global equities markets, general risk appetite remains bridled and demand for “all-weather” solutions with downside protection and upside potential has soared.
Uncertain times call for fresh thinking. Yield-starved investors are retreating from traditional fixed income and turning towards the expanding alternatives universe in search of superior returns. The hunt for income has placed direct lending firmly under the spotlight in the first half of the year. This systemically important and complementary asset class has established itself as the largest, fastest growing segment of the private debt market and an important addition to the traditional leveraged loan market.
Direct lending proved its robustness under the test of Covid-19
Direct lending has proven itself as a critical agent in addressing the financing needs of the systemically important mid-market sector and has grown rapidly in recent years. Notwithstanding its successful development, associated concerns about an overheated market leading to deteriorating underwriting conditions, and the fact that it had never been tested in a downturn, were expressed with increasing frequency. The Covid-19 pandemic certainly provided that test.
While it is still too early to understand the true impact of the pandemic on direct lending, we believe that its role is of systemic importance in the financing of mid-market companies, and in the provision of stable real returns to global savings pools as an alternative to traditional public debt. Given the private nature of direct lending and the relative lack of publicly available information we therefore want to offer a view from our “ground zero” to address some of the key questions on investors’ minds – how will the winners and losers from the crisis be determined? Will direct lending continue to deliver attractive returns, and how can investor confidence be retained? How important are ESG considerations?
Winners and losers of the crisis
There is a general perception, supported by experience, that post-crisis vintages for private market strategies represent a good opportunity to generate above average returns. But that still leaves allocators with the challenge of identifying which horses to back in circumstances where the caveat “past performance should not be taken as a guarantee of future returns” is particularly important. Broad views on default and recovery rates, sector impacts and return prospects may be too generic, and we anticipate significant dispersion in performance among alternative lenders in the years ahead. We therefore propose some indicators which may act as a guide to future outcomes.
Pre-crisis lending decisions matter more than recent returns. All managers can claim to start with a clean sheet to capture post-crisis opportunities, but legacy decisions speak volumes about ex ante views of the market and attitude to risk. For example, to what extent were investment base (not stress) cases prior to the crisis factoring in late cycle conditions and a prospective economic downturn? How did those assumptions inform decisions on acceptable margins and leverage? And what ancillary lender protections were applied in areas such as financial maintenance covenants and acceptable EBITDA adjustments, at a time when competition and trends in the broader credit market were beginning to seep into the direct lending market? A single turn of leverage can make all the difference between debt sustainability for a given decline in profitability and the need for debt restructuring, so disciplined investment criteria in leverage and documentation should make up the gap.
What are the top considerations for income-focused investors?
We are confident that the impact of Covid won’t derail the long-term growth of direct lending in Europe. Positive and timely government liquidity support, together with alternative lenders’ remedial actions, have provided significant mitigation against risks and market shocks. Despite positive indicators for the asset class, investors want a clearer roadmap of the outlook ahead and guidance on how to identify the best managers.
We must remember that this is not a normal crisis and investors must consider how a direct lender adapts and manages its portfolio and engages with its investor base. This will determine the stability and longevity of its franchise.
Most notably, we predict that restructuring activity will increase, causing significant dispersion in returns among managers. Competition factors have been magnified by the crisis, favouring local sourcing, incumbent lenders, and those with established origination networks and track records.
It is also important to remember that pre-crisis lending decisions, in terms of pricing and leverage, sector allocations and portfolio diversification will be more important than immediate valuation impacts. Finally, in the wake of the pandemic, the focus has shifted back to borrower fundamentals – business model, liquidity, cash flow and debt service capacity.
What are the major determinants of potential returns?
Portfolio construction is critical but difficult to optimise. We suggest that diversification and sector allocation will prove to be the major determinants of long-term potential portfolio returns. Reduction of risk through low average individual exposures, allocated across a range of sectors and geographies, and the avoidance of highly cyclical sectors will be the strongest mitigants in a downturn.
Yet achieving this is no easy task. It requires a critical mass of AuM, spread among many investment vehicles and managed accounts, to be able to act as sole or majority lender to retain control rights. An established origination network must generate a very significant pipeline of transactions to achieve the diversification targeted. A high degree of discipline is required to avoid excessive sector concentration, given that specific sector experience naturally attracts additional opportunity.
Operational resilience will also be a key differentiator, and not only in the context of challenging market conditions. Capital, to support the maintenance and development of in-house rather than outsourced operational infrastructure across critical functions such as fund operations, legal (at both fund and transaction level) and technology, and the ability to demonstrate a strong alignment of interests with investors through having “skin in the game”, will also enable managers to be agile in capturing new opportunities.
At individual business level, the resources required to manage portfolios under stressed market conditions should not detract from expansion of a strong origination pipeline to maintain efficient deployment pace in times of lower activity and increased competition. Given the rapid expansion of the market and exponential rise in the amount of data generated by what is still considered by many to be a rather opaque asset class, digital transformation is a “must have”, not a “nice to have”.
The importance of ESG
The pandemic has brought ESG considerations very much into the spotlight. Emerging interest in what may have been considered a philanthropic adjunct to the main asset management activity has now acquired an urgency and tangible relevance to the investment management process. Pre-crisis, highly efficient supply chains, centralised production and cheap labour generated cost competitiveness, productivity gains and expanding margins and profits, and may not have put climate considerations high up on management agendas. Post-crisis, the disruption wrought on supply chains through lockdowns and reduced mobility, aggravated by trade tensions and protectionist tendencies, has set in motion a re-localisation trend where a significant mitigation to higher cost structures will have to come from energy efficiency to maintain competitiveness.
It is now accepted that environmental (climate concern, efficient use of scarce resources), social (job creation, diversity and talent retention and training), and governance considerations (impeccable business ethics, independent oversight and CSR commitments) can have a positive economic impact on the reduction of risk and the improvement of potential investment returns.
However, in an evolving landscape of multiple ESG labels and “best practice” standards, managers will need to engage actively with investors to provide evidential assurance that positive noises made about ESG commitments represent more than “greenwashing”. Allocators will rightly wish to see both a robust framework (top leadership engagement, dedicated ESG managers and governance processes) and understand how policies and guidelines are practically applied in the investment process at individual investee company level.
This will require managers to communicate in a granular way on issues such as exclusions, criteria applied in ESG risk screening and management, its role and weight in the investment committee process, and the extent and manner in which the adoption of ESG commitments and goals may be enshrined in investment contracts. While certain ESG and CSR factors will have a wide commonality across all types of business, the most advanced managers will be mapping specific prospects to those Sustainable Development Goals (SDGs) which are most relevant and working constructively with companies in setting and monitoring realistic and meaningful targets. A quid pro quo in this process will be the adoption of incentives for borrowers, for example in the form of a downward margin ratchet, as reward for a lower risk profile achieved through meeting ESG objectives.
A final word
Direct lending has firmly established itself as an asset class offering a wide opportunity set and diversification, a stable income stream and premium returns with modest drawdowns over the long term, and as a systemically important contributor to economic growth through its support of the mid-market. Yet its private nature and the massive amount of data that is generated by the activity has raised calls for the establishment of industry benchmarks and standards, and key performance indicators.
We support such initiatives as having a role to play in expanding the availability of capital. But here we would add a note of caution. The breadth, diversity and flexibility of direct lending, which is the source of its attractiveness to sponsors and management teams does not lend itself naturally to commoditisation. Instead, investors who take the time to look further into the idiosyncratic drivers of performance, beyond the homogeneous, and those managers who are able and willing to provide the most transparent insights into their investment processes and portfolios, will in our view be well-rewarded through greater understanding and better returns.
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