Private debt – Feature


for International Settlements argued in a recent article. Rising default levels resulting from the four-month shut down of the global economy could lead to an escalation in some sec- tors, Lyon predicts. “The obvious one is energy, certainly in the US. We saw that in 2014 and 2015 when a sharp fall in oil prices led to a significant increase in defaults. But there will be a broader economic impact from Covid – with retail, real estate and some auto manufacturers having challenges.” Kapur also believes that interesting times could be ahead. “What will be key when problems start to emerge is the band- width some of the private lenders have to deal with credit is- sues and how that impinges on their ability to deploy fresh capital.”


Outlook “History never repeats itself, but it often rhymes,” is a famous quote, rightly or wrongly attributed to Mark Twain, but an axiom that many private credit investors might be able to relate to. While the volatility in recent months may have been remi- niscent of the 2008 crash, there are some crucial differences, argues Lyon.


“2008 was a banking liquidity crisis which caused an economic downturn,” he adds. “This time you have an economic down- turn, but central banks have stepped in to try and mitigate any liquidity crisis.


“It has had more of an impact on the real economy this time. The other key difference compared to 2008 is that debt levels are a lot higher and covenants a lot lighter.” This is aggravated by the fact that most private loans have float- ing interest rates which could lead to rapidly rising funding costs for smaller firms in particular. Most debt is held in closed- ended funds which could offset some of the cyclicality. The flip- side is that the end investors would not be able to withdraw their cash if funds offer poor returns. But investors are also keen to stress that the sector should not be painted with a broad brush. Doug Heron, chief executive of the Lothian Pension Fund, argues that diversification could offset some of the risks. “While it may be convenient to label the entire class as exposed to elevated default risk, the reality is that, like most risk asset classes, there will be a wide range of good to bad exposures today that could remain stable, deteriorate or improve. “Much depends on the borrower’s sector, level of total gearing and structure of the credit. Our approach has been to diversify by fund manager and vintage, with underlying sector diversifi- cation also helping to provide protection from widespread default.” Lyon believes that recent volatility has created opportunities. “We were cautious before we started deploying capital as we felt that we were somewhere close to the top of the cycle. We had no


It’s inevitable that when you have a lot of capital in a certain part of the market you will see weak- ening returns and it becomes very much a borrower’s market.


Rohit Kapur, Centrica


idea of the disruption Covid would cause but we felt that there were enough pressures in the market that made us cautious. “Deploying capital just after a market correction gives our investors a real opportunity,” he adds. “While our core focus is on the senior secured parts of private credit, with some expo- sure to opportunistic and mezzanine credit, we have an alloca- tion to distressed debt as we wanted to take advantage of pres- sures in the market as they arose.” By focusing on sectors such as consumer stables and industrials, the local government pen- sion scheme pools hope to offset some of the risks in the sector. Centrica pursues a similar approach. Having been cautious to deploy capital for the past year, Kapur argues that now might be the time to do so. “Prior to Covid, we were more focused on the niche, specialist parts of the market because we wanted to focus on those parts where there wasn’t an oversupply of capital because that brings down returns and puts pressure on lenders to put money to work under less than ideal terms. We also focused on distressed debt, thinking quite carefully about which part of that market to deploy into. “Niche strategies for us include specialist lending, such as in healthcare, for example. While we had no idea about what was about to hit, it is not the worst area to have exposure to at the moment because of its defensive characteristics,” he adds.


Issue 95 | August 2020 | portfolio institutional | 41


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