Opal Group – Private Debt Forum
Members of the Old Hill team attended the Opal Group 2019 Private Debt Forum on June 3rd in New York City. The speakers, which included Old Hill’s Chief Operating Officer, Jeff Haas, provided firsthand insight into the current conditions and trends in one of the fastest-growing asset classes in the investment management industry– private debt. Henry Owainati, a member of the Old Hill team who attended the forum, reports below on some of the key takeaways from the event.
Speakers noted that today’s low interest rate environment and the corresponding low yields in the public markets represent the new normal which is impacting allocation weightings to traditional fixed-income assets and driving investors to seek alternative yield strategies, namely yield from private credit investments, that generate alpha and are less or non-correlated in order to diversify their portfolios. It was also noted that although we are in the late stages of the economic and credit cycles, the “distressed” cycle has not begun but there are some managers that are starting to create investment vehicles to address distressed opportunities when they present themselves.
Private Debt Asset Class
An important theme was that private debt is a broad asset class and investors are becoming increasingly experienced in its many subclasses, including distressed, mezzanine and asset-backed lending (ABL), Old Hill’s investment strategy. Speakers emphasized that not all subclasses are equally attractive on a risk/reward basis. Most of the capital that has been raised in private credit funds is being deployed in the cash flow-based, private equity sponsored large balance transactions— the standard direct lending strategies. The extraordinary amount of dry powder accumulated within these direct lending funds and the resulting increase in competition for deals has translated into a willingness to loosen covenant standards in order to put capital to work and a compression in yields generated by these mainstream strategies.
Meanwhile, the dominant theme at the forum was that the niche strategies represent a more attractive risk/reward given the lower competition for deals and the fragmented nature of the opportunity universe – a strategy pursued by Old Hill’s small balance, sub $25 million ABL focus. In addition, rising valuations at this late stage of the credit cycle are resulting in significantly more yield compression in cash flow-based transactions than in asset-backed transactions, and that ABL strategies represent a more defensive allocation given its higher recovery rates.
The Gatekeepers’ Views
Several speakers from investment consulting firms, the so-called “gatekeeper” firms, mentioned that they are increasing their coverage of niche strategies as this asset class is maturing; a pattern similar to what has historically happened in private equity as investors looked beyond leveraged buyouts. The gatekeepers said that allocation decisions to niche private credit strategies should ultimately come down to manager selection, which is particularly important given the smaller sized firms that are engaged in these strategies. The strength of a firm’s management team - including having the right experience, alignment of interest with investors and a demonstrated track-record - were cited as some of the criteria they look for when evaluating managers. They also warned against new entrants that have limited experience in lending across the credit cycle.
Old Hill’s Views
Jeff Haas presented Old Hill’s views on several timely topics. He discussed the importance of fund structures in matching the duration of fund assets and investor capital, and how some managers’ advertising of easy liquidity in order to attract investor capital will become problematic when redemptions become necessary. This happened to the industry ten years ago and it happened to one fund just a few months ago. Haas also contrasted the stable valuations of private credit investments with the extreme valuation volatility of public market investments, and why investors should be increasing their allocations to private market asset classes given the illiquidity premium that can contribute approximately 400 to 700 bps to performance returns. Finally, he discussed concerns about the health of the consumer, the non-prime lending businesses focused thereon, and why it is actually a source of additional risk-adjusted return for Old Hill. Jeff eluded to the fact that Old Hill provides credit on a senior secured basis and requires its borrowers to contribute their own capital on a subordinated basis to Old Hill’s lending structures and that it is the borrower who takes the first losses. He also explained that during times of economic distress, default rates for prime borrowers tend to increase by a substantially greater percentage compared to default rates for non-prime borrowers. These default assumptions are built into Old Hill’s underwriting discipline and provide a source of alpha for investors.