Getting into debt

“Every day it seems a fund or two announces a debt business,” says one European LP. “It’s a real trend in the market.”

We’ve written about numerous private equity firms recently who have started getting into private debt: most recently mid-market shop Sterling Group.

There is logic to support such moves and it isn’t necessarily a worry for LPs (“as long as they keep it separate from their equity businesses,” says the same investor). Equity shops can expand their limited partner bases, increase their fee-paying assets under management and diversify their product offering. But peril may also lie in wait for those preparing to launch.

Data from our sister title Private Debt Investor show there are currently 139 first-time funds in the market targeting a combined $42.8 billion for private debt, with 30 initial credit vehicles launched this year alone seeking more than $7 billion. So far this year, seven first-time funds have closed, locking down nearly $4 billion. That number is on track to surpass the $5.5 billion raised last year by debut managers.

Anecdotally, any slowdown in first-time fund launches in the near future appears unlikely.

“There are still a lot of first-time credit fund managers jumping into the space that still believe there are opportunities out there, despite the fact that many experienced credit lenders believe we are in the later stages of the game,” says Stuart Wood, a managing director at fund administrator Cortland.

In total, 528 funds were in the market the first half of the year, according to PDI data, which hardly leaves LPs with a lack of choice. But first-timers keep popping up and, as the credit cycle lengthens, there’s a chance managers could be imagining an opportunity that proves to be illusory at worst or fleeting at best.

“In this market, you have to prove [yourself]. It’s not ‘if you build it they will come’,” one market source said.

He added that first-time managers need to build an internal track record through a vehicle backed by an anchor investor or by the firm itself, such as BC Partners did with its ‘friends-and-family’ $200 million opportunistic fund.

Mid-market lenders have become a dime a dozen, and it is becoming more difficult for firms to differentiate themselves. After all, not everyone can have the best downside protection. Specialised vehicles, such as those targeting a specific industry, can fare better on the fundraising trail.

There’s still appetite for debut funds, as the Illinois Municipal Retirement Fund proved last week when it made a $20 million commitment to The Sterling Group’s first mezzanine vehicle. But there is also a sense that moving a prospective investor to the “yes” column has got harder.

That so many vehicles are vying for a finite amount of dollars – even if that pool is growing – comes as funds may be struggling to find the deals that can produce the hoped-for results.

“We’ve seen funds that have gone through their fundraise and set their hurdle rate, but now they are sitting on a lot of dry powder. Many fund managers are not finding the deals out there that are going to meet their target yield requirements,” Wood says.

Deal terms have significantly eroded as well. They include a broadening definition of EBITDA addbacks and borrowers being subject to a net leverage test, rather than total leverage, allowing firms to take on more debt than may initially meet the eye.

As a result, covenant-lite terms have migrated well below the $50 million of EBITDA mark that is often the quoted ceiling for a mid-market company.

Fundraising competition is fierce and deal terms are loosening while each day more private credit practices are launched. It’s a potentially troubling mix.