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amongst institutional lenders have seen “spreads tighten significantly”, she adds. A benefit of cutting out the middleman is that lenders have more control over the terms of a deal than if they issued a listed corporate bond. However, as more players enter the market lenders are losing some of their influence. This has led to a rise in loan agreements having fewer conditions on collateral, pay- ment terms and levels of income attached, being dubbed covenant lite, or “cov-lite” in industry jargon. Of loan issuance globally, 58% is cov-lite, according to Pictet, up from 30% in 2013. So the majority of private debt investors have less protection when the next downturn arrives. Borrowers are the beneficiaries of such competi- tion; the losers are the lenders, who are taking more risk for less reward. “The balance of power has moved against the creditor in favour of the debt- or,” Menon says. “Weaker covenants enable com- panies to raise more debt than would normally be the case and that reduces their


ability to re-pay [the


loan],” she adds. “This points to lower re- covery rates in a future default cycle.” Menon warns investors to be more cau- tious with this asset class. “There are good reasons for investing in it, it has had a good run, but the investment case is less compel- ling now. Valuations have moved against the investor.”


Low protection standards are a concern. They are, after all, lending to companies that the regulator considers to be too risky for banks to lend to unless they hold more cash in reserve. So is this putting savers’ retirement funds at greater risk? “The only thing that makes me comfortable about it is that private lend- ing is a small part of the global debt market and that the real money going into it is not highly leveraged,” Trow says, pointing out that direct lending funds in the US are lim- ited to only borrowing as much as they raise in their funding rounds.


“In terms of being a systemic risk, we are not talking about the same sort of thing as


the financial crisis, sub-prime and all the rest of it,” he adds. It is not just having fewer restrictions in loan agreements that are increasing the risks investors are taking. Some managers are reported to be stretching the definition of a company’s earnings beyond the six times earnings before interest, tax, depreci- ation and amortisation (EBITDA) ratio to increase the amount of cash that they can lend a company. “It amounts to the same thing, a weakening of protections for inves- tors,” Trow says. Yet on the other side of the coin, too much influence over the terms of a deal could be a problem. “The risk with private debt is that you are creating your own model, set-


long-term needs of some companies. One issue with bank lending is that there can sometimes be liability mismatches. That is not the case with pension funds where there can be a better alignment of capital. This is unlikely to cause a credit crunch as a high number of defaults would have less impact on the economy, although it has repercussion for the schemes in question. “It is more of a slow burn, a slower removal of credit from the economy,” Menon adds. “This is probably positive because it is less of a shock.” This theory is largely untested as the sector has not experienced prolonged economic turbulence


since the financial crisis. Indeed, the average default rate in the In terms of being a systemic risk, we are not


talking about the same sort of thing as the finan- cial crisis, sub-prime and all the rest of it. Stuart Trow, European Bank for Reconstruction and Development


ting the terms of the deal, doing your own valuations,” Robertson says. “It is always good to have a third-party to independently review the credit and investment case for these private assets.” Phoenix uses Aber- deen Standard for this task.


PHOENIX FROM THE FLAMES It is not just commercial pressures that have seen banks retrench from lending to smaller businesses, there are regulatory constraints too. A drive for stronger bal- ance sheets by regulators means that banks are mainly focusing on lower risk and, therefore, lower yielding deals. While many banks focus on larger compa- nies, crowdfunding and fintech platforms have arrived to meet the needs of micro companies. This has opened a gap in the market for small and medium-sized com- panies needing debt financing, but can find it expensive to raise cash in the bond mar- kets. It makes sense for pension schemes to enter the private debt market to align their long-term pools of capital with the


direct lending market is 2%, according to Pictet.


Other risks include illiquidity as this form of debt has no daily pricing and so is not easily tradable. But if the asset is generat- ing a regular, secure long-term return that is at a premium to the yield on government debt, why would they want to sell before the loan matures?


It is easy to understand the popularity behind directly lending senior debt to com- panies, not least because investors can understand it. They like it for its simplicity. Investors negotiate the terms of a deal and then collect


regular repayments, unless


there is a default. The returns are higher than those offered by traditional debt prod- ucts, but with lower protections and con- cerns over the levels of debt put into some companies, investors need to tread carefully. It does seem that the boom days of the direct lending market are over for now, but institutional investors can still receive secure and regular cash-flows if they agree the right deal.


October 2019 portfolio institutional roundtable: Private debt 29


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