In a rapidly shifting economic landscape, leverage presents a distinct challenge. The private debt market emerges as a beacon of adaptability, with expertise and tailored solutions becoming crucial determinants of success, writes Yvonne Narin serves, senior manager risk controlling at Universal Investment Luxembourg.
The latest ESRB annual report offers an insightful overview of the rise in systemic risk throughout 2022 and beyond. Companies, already weakened by the Covid-19 crisis, are now encountering a geopolitical environment that has led to rising inflation, surging interest rates, and widening credit spreads. Early indicators suggest that short-term interest rates may have reached their zenith for the moment, and credit spreads may have peaked. Yet, the high-interest rate environment remains burdensome, highlighting the importance of individual assessment of credit exposures. It is evident that not all market participants have navigated the Covid-19 crisis successfully, and some lack the robust business models needed to endure the rapid and substantial market changes.
In addition to shifting geopolitical dynamics and the resulting repercussions, major industrial sectors in Europe are facing structural change. Factors such as skilled labor shortages, ongoing cost pressures, increasing sustainability risks, and the strong political commitment exemplified by the «European Green Deal» are driving this transformation. Amidst these changes, it is crucial to examine the specific conditions of credit exposures.
Given this backdrop, leverage presents a distinct challenge. The business landscape has become more unpredictable and relying on «business as usual» no longer guarantees success. Consequently, a heightened focus on the private debt sector becomes essential.
Expertise as an antidote to increased risks
Private Debt funds, especially those focused on Direct Lending, are confronted with these specific challenges. Yet, they are well-equipped to address them:
- Refinancing risk: The shift in the interest rate environment has amplified the refinancing risk, a concern that was previously almost negligible for several years. For funds, this raises critical questions: How certain are bullet repayments and what options for collateral realization have been negotiated in the contract? Is it feasible to extend terms with well-known counterparties, and if so, how can it be ensured that it is executed at arm’s-length pricing?
- Greenfield projects: Initial-stage projects, particularly those involving construction risks, require thorough due diligence. Infrastructure or real estate debt investments that are still in the construction phase often face rises in material and labor costs. Such increases are often due to significant delays caused by COVID-related lockdowns and supply chain disruptions. Managing the financing of these projects requires deep and extensive expertise.
- Regulatory risks: The swift evolution of sustainability regulations is exerting pressure on data collection and reporting design. Notably, Private Debt often serves small to medium-sized borrowers. Many of these entities may lack experience in reporting or corporate responsibility strategies. This contrasts sharply with the necessity for comprehensive and precise data sourcing.
The advantages of Private Direct Lending are both evident and compelling. One of its foremost benefits lies in its adaptability, allowing for custom-made solutions tailored to distinct challenges. Since loan agreements are negotiated bilaterally or between a small number of parties, there is significant opportunity to adjust terms to suit individual needs and risk scenarios. Covenants can be adapted to the specific situation of a company or project, and any renegotiations can be made in response to a changing environment. This provides security in terms of execution and pricing. Furthermore, this flexibility enables financing to be continued, especially under the current volatile market conditions – without jeopardizing the cash flows for the funds.
Additionally, there are managers with expertise in specific submarkets who are adept at navigating the challenges mentioned. These specialists can address the fund’s specific needs while unlocking value through in-depth due diligence of companies and projects. Through professional and knowledgeable management of funds, there is a seamless alignment of regulatory requirements with these tailored solutions.
Outlook: Niche products and sustainable infrastructure
In our ongoing analysis of the financial landscape, we continue to see attractive opportunities within the Direct Lending sector. Our confidence is based on the resilience displayed by conservative senior structures, which have performed well amidst economic downturns. As a result of specific challenges, we anticipate a growing share of specialized lending funds focusing on the mezzanine, special situations, and distressed segments.
This trend can be attributed to two main factors:
- Shifting landscape of private debt: The appetite for private debt, especially combined with private equity, is undeniably growing. A significant catalyst for this shift is the gradual pullback of banks from this segment, spurred by stringent regulatory requirements such as Basel IV. Concurrently, we are observing a trend of categorizing credit into ‘good’ and ’bad’ segments.
- Customization in contract design: One of Private Debt’s most compelling benefits lies in its capacity for tailored contract design and specialized management of terms and conditions. Such granularity in design is advantageous in transactions that come with specific risk elements.
Looking ahead, there will be a growing demand for experienced asset managers and service providers who are proficient in implementing an optimal risk-return profile for the financing. Investors will continue to find value in third-party ManCo models, which are uniquely positioned to bring together the right partners based on the specific needs of each asset class.
Apart from niche products, infrastructure debt projects will be gaining traction. Supported by the European Green Deal regulation, sustainable infrastructure is on the rise. In contrast, debt funds presently struggle with the wide strange of ESG strategies adopted by asset managers and funds. Data requirements are manifold; data generation and preparation still come with a high manual effort. In addition to this, many databases have not yet been audited or certified, leading to concerns about their reliability.
In this context as well, a customized approach proves advantageous: Contracts can be set up with “margin ratchets” that encourage debtors to meet their sustainability ratios. Moreover, data prerequisites for sustainability risk reporting or SFDR classification compliance checks can be integrated into a debt project at the contractual phase.
Given these dynamics, we are very confident that the Private Debt market has the flexibility and expertise to skillfully navigate these multifaceted challenges, and that collaborating with trusted partners on this journey will be key to creating value for investors.
Dr. Yvonne Narin serves as senior manager risk controlling at Universal Investment Luxembourg, a knowledge partner of Investment Officer Luxembourg.