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Source: StepStone Private Debt Internal Database
Looking at the first percentile of these distributions (i.e., the 99th percentile Value at Risk), one notices that the values in the first-lien segment vary from 4.5% to 5.5%, whereas the second-lien value is 1.5%, showing the risk carried by junior capital instruments. Nevertheless, these figures also illustrate the defensive nature of private debt investments because the values stayed positive even for second-lien loans.
In the post-GFC period, riskier instruments benefited from the economic expansion whereas first-lien instruments demonstrated their robustness through the cycle and outperformed their pre-crisis returns. In both periods, the upside potential of the upper middle market was limited but the sector is important in the portfolio construction process as target returns have a higher probability of materializing. Among the three first-lien market segments, lower-middle-market loans offer the best relative value across the cycle. Indeed, they delivered higher returns in both the pre and post-crisis periods without exposing investors to excessive volatility.
4 Risk Mitigation and Success Factors When Investing in Private Debt
There are a few key success factors investors should consider when investing into private debt. To benefit fully from these factors, two main drivers are crucial: implementation efficiency and access to high-quality data.
An efficient implementation process ensures high and rapid deployment levels as well as effective cash management. These two factors combined improve the US-dollar return at a given level of capital commitment. Also, granular and reliable data ensure that investment decisions are based on proper insight into the strategy and characteristics of each GP considered.
4.1 Market & Loan Level Data
Given the nature of private markets, access to transaction-level data is less straightforward. Close interaction with GPs and other market participants can provide data for investors to identify market trends and assess a GP’s strategy successfully. Gaining information on deals previously originated by a GP can help identify the market segment in which the manager operates. Knowing a GP’s “sweet spot” allows investors to avoid undesirable risk- factor concentration or select a GP based on how well it fits the portfolio’s broader objectives.
Data on individual loans are harder to obtain and require a closer relationship with the originating GP. Still, this level of granularity is essential if we are to effectively compare managers. Exhibit 11 illustrates this point by providing a clearer picture of the segments in which different GPs source most of their transactions. This is an important tool for manager selection and monitoring as well as for portfolio construction.
Exhibit 11: Average Yield and EBITDA per GP
Source: StepStone Private Debt Internal Database
4.2 Investment Control
In recent years, the amount of capital as well as the number of GPs in the market have grown significantly. This increase in competition has led to an environment that generally favours borrowers. In that regard, investment guidelines are a useful way to prevent managers from chasing unattractive deals. With these guidelines, thresholds can be applied to certain credit metrics such as leverage, LTV or effective covenants.
Exhibit 12 demonstrates that covenants can effectively protect lenders. Indeed, imposing just one covenant can reduce losses by more than half on average, based on historical figures. Covenants are also helpful to identify the borrower’s underperformance earlier thus mitigating the loss rate.
Exhibit 12: Average Loss Rate by Number of Covenants for Corporate First-Lien Loans (2004-2016)
Source: StepStone Private Debt Internal Database, based on more than 8,000 US and EU first-lien loans
4.3 Lender of Record
Being the lender of record (e.g., through co-investments or managed accounts) further strengthens the position of investors. The lender of record owns the loan, has a direct relationship with the borrower, and reserves the right to enforce, settle, compromise, amend the loan, or sell a participation. Participants, on the other hand, have no direct rights under the loan agreement; they can neither enforce the loan nor proceed against the collateral. In most instances, the borrower does not even know the participant exists.[11] The ability to control and drive negotiations with underperforming companies determines the final recovery.
4.4 Deployment
When investors evaluate GPs’ performance and track records, they often look at the managers’ gross and net IRR. However, it is equally important to assess the deployment rate at that IRR, as this dictates the absolute cash return to the investor. Simply put, if a GP cannot identify enough transactions, an investor’s capital sits idle in a bank account where it provides low or even negative returns.
As can be seen in exhibit 13, having the ability to put capital to work sooner leads to significant differences in the cumulative US-dollars-earned amount over the relevant period. These differences mostly stem from different implementation strategies. The chart compares the US-dollars earned on capital committed under three different investment scenarios: an evergreen vehicle, a closed-end vehicle and a single fund.
Exhibit 13: Cumulative US-dollars-earned Comparison
Source: the estimates for the evergreen platform and the closed-end platform are based on StepStone vehicles and on Preqin data for the single fund
4.5 Flexibility
Investors should consider an investment structure that provides the flexibility to shift allocations from one GP to another. This cannot be achieved with investments in funds but requires a Separately Managed Account (SMA) with individually negotiated terms. The need for flexibility may be driven by return, risk, regional focus or capital deployment considerations.
Investing through a flexible SMA platform on which LPs’ commitments can be shifted between GPs allows investors to manage their portfolio based on exposure rather than commitments. By targeting an optimal deployment level, investors can avoid opportunity costs faced in a traditional fund rollover strategy across vintages, as demonstrated in exhibit 7.
4.6 Diversification
Direct lending investors typically seek stable returns at a defined target level, looking for neither excess returns nor excessive losses. As in public markets, diversification is the simplest and cheapest way to reduce risk within a portfolio. This is even more important for investments such as private debt. Only a handful of managers have track
