The rise of private debt

Following the global financial crisis, private debt has become a rapidly growing asset class. It is particularly interesting for return-oriented institutional investors. Peter Bezak of Zurich Invest looks at the growth drivers and explains how pension funds can take advantage of market opportunities.

Private debt is arguably the youngest asset class in the private equity universe. It has also seen strong growth since the global financial crisis, with global assets under management rising steadily each year, reaching a level of. US dollar. This means that private debt is now the third-largest asset class in the private market investment sector.

However, not all private debt is the same: In essence, the segments corporate private debt resp. Direct lending), real estate (real estate debt), and infrastructure financing (infrastructure debt).

Direct lending as an alternative to bank financing

How can interesting returns still be generated at an acceptable level of risk in the current low-interest-rate environment?? This question is also on the minds of institutional investors – and in response, they have increasingly turned their attention to investing in direct lending in recent years. "This trend is primarily seen in direct lending to middle-market companies. Due to the increased regulatory requirement, this is an interesting alternative to traditional bank financing", explains Peter Bezak, investment expert at Zurich Invest. This direct lending to small and medium-sized enterprises, known as middle market lending, is the most recent form of financing, is mainly financed by private equity sponsors. Often strategic acquisitions, takeovers of private equity firms or growth financing are the target.

Fragmented European private debt market

Banks in the U.S. have gradually withdrawn from the private debt business since the 1990s. "This gave the corporate finance market room to maneuver and, with the financial crisis, a significant forward thrust. The single economic space and especially the single insolvency law have contributed to the positive development of this market in the US", Bezak comments.

Currently, the U.S. corporate private debt market is larger and more developed than its European counterpart. But in Europe, too, the expert observes how regulatory requirements are being increased and at the same time the need for flexible financing solutions is growing. "On this side of the Atlantic, too, banks have gradually withdrawn to their core markets. As a result, direct lending managers have been able to visibly establish themselves thanks to their short response times and individualized financing solutions", according to Bezak.

However, the European market remains more divided than in the U.S. due to different legal systems and language challenges. Therefore, managers in Europe either focus on one legal system or rely on local presences in several locations. The largest direct lending market shares in Europe are currently in the United Kingdom, France and Germany. Managers have also expanded their presence in the Nordic countries, the Benelux countries and Spain, for example.

Low interest rates boost demand for private debt

In Europe, the number of corporate private debt transactions has multiplied over the last few years. This is due in particular to the increasing number of investments available to non-bank investors and to SMEs that do not finance themselves through a bank. "But especially the continuing low interest rates favor the demand of institutional investors for private debt. With annual returns between 7 and 9% in the euro area, this segment offers an attractive "illiquidity and complexity premium" from an investor's perspective, thinks Bezak. In addition, the loans are often based on a variable interest rate, which protects investors well against an increase in interest rates. There are now 50 direct lending managers offering their services in Europe. This heterogeneity of the investments is a great challenge for the institutional investor.

Meeting heterogeneity with expertise

In addition to many niche players specializing in individual countries or sectors, there are only a handful of players that cover the entire market. Their size offers decisive advantages: Thanks to their broad network, they have good access to the companies, and they can also grant larger loans. Last but not least, they have the necessary resources. "However, to be present in Europe, they also need local offices and a large team of experts who maintain the network of relationships with private equity sponsors and companies", notes Bezak. In addition, experience is needed in restructuring smaller companies because they are more susceptible to defaults. Often only established direct lending providers have this expertise. That's why the expert's recommendation to investors goes beyond adequate diversification across borrowers, sponsors, sectors and countries: loans to companies from established private equity sponsors with a focus on companies with high free cash flow in defensive sectors are particularly attractive, he says.

Investment vehicles for institutional investors

"Given the specialized expertise required in loan selection and loan portfolio management, it is advisable to implement the investment through indirect investment vehicles or mandate solutions. Implementation is possible through open or closed fund structures, which are structured and managed by professional investment managers", says the expert. Typically Swiss investment foundations or structures domiciled in Luxembourg offer themselves here. Swiss pension funds invest mostly through closed-end private debt investment solutions. The investment period extends over the first three to four years, during which the capital is gradually drawn down and invested. Interest payments and loan repayments are then distributed to investors as cash flows over the life of the loans. The closed-end structure fits the illiquid nature of such investments, which are typically held to maturity.