The M&A market has been booming for quite some time now. Over the past few years, traditional institutional investors have clamored to get into the hottest private equity funds — resulting in record capital raises for those funds. Now, institutional investors have turned their attention to another opportunity: private credit funds.
Institutional investors made a record number of new commitments to credit funds in 2017, topping $10 billion to reach a peak of $28.7 billion in 2017, a 57 percent increase from the year before, according to Pensions & Investments. Additionally, in 2017, reported commitments to direct private debt strategies by pension funds, endowments, foundations, and insurance companies were up a whopping 211 percent from 2016. The $49.9 billion Teachers’ Retirement System of the State of Illinois, Springfield, for example, approved an investment pacing plan in December that earmarks annual private debt commitments of $350 million in the three fiscal years through June 30, 2020, with a total maximum investment of $950 million. Florida State Board of Administration, Tallahassee, committed almost $2 billion total to 18 varied credit deals on behalf of the $167 billion Florida Retirement System, while the $28 billion Texas County & District Retirement System, in Austin, allocated $1.9 billion to 12 different funds.
Since banks largely shuttered their lending arms after the financial crisis, others came in to fill the void. Finance companies took the lead at first, but now all kinds of firms are employing private credit strategies.
The interest in the space has been heating up for years, but only reached today’s frenzied pitch in 2017. According to date from Probitas Partners, fundraising soared by over 35 percent in 2017, reaching an all-time high. The largest most recognizable private equity firms are actually the largest debt providers to the industry today. Firms such as The Blackstone Group, KKR, The Carlyle Group, and Apollo have larger debt portfolios than private equity ones at this point. That is a marked turnaround from when debt funds accounted for about one-fifth of their assets only a short decade ago.
These big private equity firms have been eagerly building their presence in the space. And why not? Debt is in high demand among private equity dealmakers, provides solid returns, and is only lightly regulated. Average annual returns for private credit funds have exceeded 5 percent over every five-year period since 1992, according to figures compiled by Hamilton Lane. That’s a more consistent return than private equity yields. All told, private debt funds have amassed a $160 billion war chest of capital that has not yet been lent out, twice what it was decade ago.
“The debt market basically exploded over the past eight years. It’s been growing ever since banks had to back off from high-yield lending under regulatory pressure after the great financial crisis. Banks are not making high yield loans these days,” says Kelly DePonte, a managing partner with Probitas Partners. “After the banks pulled back there were all these lending teams without a home. They either spun out and created new firms or joined up with other financial institutions and started lending arms.”
More and more players are diving into the asset class: private equity firms are launching credit arms, new firms are launching private credit funds, more insurance companies are investing directly in the space, and more pension funds and endowments have allocated additional funds to the growing asset class as noted above.
Middle market private firms have also shown strong interest in private credit in the past couple of years. In 2016, Adams Street Partners saw the opportunity and pounced on it, as did others including The Sterling Group, The Riverside Company, H.I.G. Capital, Thoma Bravo, BC Partners, Silver Lake, and Gryphon Investors.
H.I.G. Capital’s Whitehorse Capital, whose team is largely comprised of former GE Antares professionals, closed on $1.1 billion for direct investing in 2017.. Stuart Aronson heads up the group and expects the next several years to present opportunities to partner with non-sponsor and sponsor-owned companies in need of debt capital.
“Having lending capabilities makes a lot of sense for middle market firms that have powerful origination teams like H.I.G. and Riverside Company. They have people scouring the country looking for their next deals. They sometimes come across founders that need capital, but don’t necessarily want to sell. It’s perfect to then be able to offer them a debt solution,” says Tod Trabocco, a managing director with Cambridge Associates.
Businesses need the loans and institutional investors want in on the funds. In 2018, Gryphon Investors, a middle market private equity firm based in San Francisco, closed its first mezzanine fund, Gryphon Mezzanine Partners L.P., with $100 million. At the time, Gryphon’s founder said the new fund made sense. “Over the past few years, a number of our limited partners seeking current-yielding investments have asked us about opportunities to participate in debt financings,” says David Andrews. “This fund is designed to primarily to satisfy that LP demand.”
The challenge for private equity firms will be having a potential competitor as a creditor. This situation will have to be monitored carefully. “There is a challenge that has to do with information leakage and it remains to be seen if the Chinese walls set up between the debt and equity sides of the house will work. If they are violated borrowers will not trust these lenders and it will set them back,” says Trabocco.
Insurance companies are also increasing their presence in the space. While many insurance companies already have lending capabilities, some are growing their offerings. In 2017, Manulife Financial Corp. expanded to provide senior credit in the middle market. The firm was already supporting the middle market as a mezzanine debt lender and an equity co-investor. The insurance company hired many professionals from well-known debt shops.
“Many insurance companies were active in mezz for years. The larger offerings are just an extension of what they were doing. It’s natural for them. What they have done makes sense,” says DePonte. “What will be worrisome is that some of these newer groups haven’t managed a fund over a financial crisis. And with the structures that are being set up today, it’s not so easy to just sell the debt off because if lenders do, the fees will drop significantly. The markets are not exactly the same as they were during the financial crisis, so things may feel different this time around, but it can still be horrific. There are a lot of newer lenders that do not have the experience.”
There is more debt available than ever before, market conditions feel different and the parties at risk are different as well. Instead of banks and deposits being at risk, now the risk lies with the institutional investors in the lending market. “They should be in a better position to assess the risks and manage it,” says Trabocco.“However, too much leverage is never a good thing. No one ever says, ‘Things are risky, let’s pile on more debt to derisk.’”