alternative capital - arbour partnersarbourpartners.com/acmv2016.pdf · we at acmv expect the lure...

market viewALTERNATIVE CAPITAL

ALTERNATIVE CAPITAL MARKET VIEW | H1, 2016

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4%

6%

8%

10%

12%

14%

16%

18%

20%

1975

19

76

1977

19

78

1979

19

80

1981

19

82

1983

19

84

1985

19

86

1987

19

88

1989

19

90

1991

19

92

1993

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94

1995

19

96

1997

19

98

1999

20

00

2001

20

02

2003

20

04

2005

20

06

2007

20

08

2009

20

10

2011

20

12

2013

20

14

2015

Moody's Global Spec. Grade LTM Default Rate

U.S. Federal Funds Rate

2nd Real Estate Crisis

Nikkei Crash

Asian Liquidity Crisis

Enron & Worldcom Fail

Continental Illinois Fails

Black Monday

LTCM Default

Drexel Fails

18% Fed Fund Rates

Basel I

Tech/ Telecom Bubble

S&L Crisis

Sovereign Debt Crisis

Brady Bonds

Credit Crunch

ChinaSlows

ECB“Bazooka”

Financial Crisis

Severe Recession

European

QE 1,2,&3

“Periphery” Debt Crisis

Oil PriceCollapse

Source: Arbour Partners

Figure 1: History of Private Credit

Market Context

• Prospect of negative bond yields spreads around the globe

• Historically bad New Year start for equity markets as S&P dips into correction territory

• Oil oscillates around $30 as glut continues

• ‘Real economy’ storm clouds gather as China’s deflationary debasement undermines developed market producers

• Banks suffer as business models burdened by financial market frailty

Capital market highlights

Credit Markets: Defaults on the Rise as Commodity Crunch Hits


Market update

T he market for sponsored transactions continued to see yield compression throughout most of 2015. The abundance of

capital chasing a diminishing number of borrowers saw a fall in returns across the spectrum – despite the loosening of covenants for so called “cov-lite” deals. Despite this, 2015 was once again a bumper year for private debt fund raises, with a series of mega funds closed - GSO came to market with their $2.5bn senior debt fund, Ares had a first close on their third private debt fund, while ICG amassed more than 3bn for their latest private debt vehicle.

The new year brought with it a rapid acceleration of the uptick in returns that concluded 2015, with the rise in risk-off sentiment that gripped financial markets cascading into tighter terms issued to borrowers. Whether a bounce-back in yields can be sustained is partly dependent on the uncertain outcome of the credit shake-out triggered by the collapse in energy prices.

The ramifications for the collision of credit market convulsions and ballooning fund balance sheets remain to be seen, but ACMV will be watching closely.

Table 1: Private debt (buyout) strategies – typical features and returns

Private Debt

In a nutshell


Private debt is best described as the provision of credit by investors to private equity firms to finance buyouts – the balance sheet complement to private “equity”.

The private debt market has been a big beneficiary of the low interest rate environment in Europe, as weak economic growth and central bank action suppressed yields in traditional asset classes. In particular, fixed income investors have been enticed by the floating rate loans and historically high recovery rates available in the sponsored sector of private credit, while many portfolio managers have shifted private equity allocations towards closed-ended funds that target liabilities higher up the balance sheet.

Cash interest

4-8%Floating

10-12%Fixed

5-7%Floating

4-5%Floating

LARGE LBO

Return

9-11%

9-11%

6-9%

4-6%

7-10%6-8%Floating

Mezzanine financing – Europe

Mezzanine financing– US

Unitranche – Europe

Senior loan

Cash interest

4-8%Floating

10-12% Fixed

5-7%Floating

MIDDLE MARKET

Return

13-16%

13-17%

6-8%

PIK, OID

PE, Banks

Deal source

PE,Investment Banks

PE, Investment Banks

PE, Banks

FEATURES

Additional returns

PIK,Warrants

Warrants

OID


Table 2: Direct lending strategies – typical features and current returns

Direct Lending

Market update

2 015 saw direct lending begin to establish itself alongside more traditional bank financing as a source of credit for European mid-market

corporates. On the lender side, the hunt for quality assets remains treacherous, with fund managers continuing to lean on banks as a major source of deals (see ACMV top focus).

Nevertheless, the vanguard of a new wave of sponsorless lenders has managed to assuage

investor concerns around origination, leading to a series of first closes. 2016 looks set for more of the same, with 68% of investors looking to allocate to direct lending strategies over the next 12 months. We at ACMV expect the lure of attractive returns from a senior secured lending strategy and the pent-up demand from a credit constrained European mid-market will continue to bolster the balance sheets of private credit managers.

In a nutshell


Direct lending is the provision of credit directly to middle market companies for growth or acquisitions without the sponsorship of a private equity firm.

Sometimes viewed as the capital market equivalent of traditional mid-market corporate lending, funds typically target the senior section of the capital structure – lending on a 5-7 year basis to match underlying fund liabilities. Because of the lack of a sponsor, loans in the direct lending market may be harder to originate, while borrowers often lack the sophistication of private equity firms. However, the post-crisis pullback of bank balance sheets means the potential is huge, with bank loans to European corporates still €600bn below their peak.

6-7%Floating

10-15%Fixed

7-9%Floating

7-10%Fixed

7-10%Fixed

SMEs

14-15%

14-15%

8-10%

6-8%

6-8% 5-7% N/A

N/A

Sponsorless mezzanine – Europe

Sponsorless mezzanine – US

Senior corporate loans

Private high yield bonds

4-8%

8-12%

MIDDLE MARKET

9-11%

13-16%

6-8%

Corporates,Advisors

ce

Corporates,Advisors

Corporates,Advisors

Corporates,Advisors

FEATURES

PIK,Warrants

Warrants

Cash interestReturn Cash

interestReturn Deal sourceAdditional returns


Growth Capital

Table 3: Growth capital – typical features and returns

Source: IPF Partners

Investment horizon

Structured growth capital 5-7 years €5-20m

Growth debt 3-7 years €5-20m

€1-10m

Varies (depending on fund size)

15-20%

9-15%

ReturnsInvestment size

Equity

Venture debt (Senior) 1-3 years

3-5 years target

20%

20-30%

Market update

L ast year saw a number of traditional debt and equity managers retool, looking to the quasi-equity strategies typical of growth

capital funds to boost returns. Harbert Management, a longstanding manager in the US sponsorless mezzanine sector, closed its debut European Growth Fund of €122mn, Kreos completed its Fund V at the €400mn hard cap, while John Sinik’s Metric Capital – initially founded after the crisis as a pure debt fund – is currently allocating its most recent €500m vehicle to hybrid debt and equity growth situations.

The pricing pressure that has driven down yields in mainstream private debt and equity markets presents an undoubted opportunity for providers of hybrid capital. The challenge for the growth capital sector lies in the central question of illiquid credit markets: “Am I getting equity return for debt-like risk or debt-like return for equity risk?” As long as they can show a sufficient flow of deal realisations, then the answer is the first one and this is a strategy that will continue to grow.

In a nutshellGrowth Capital is the provision of funds to high growth business on the edge of profitability. Typical instruments employed combine features of debt and equity as well as other exotic features that can be tailored to a company’s needs.

Growth Capital transactions have long been a relatively small subset of the alternative capital markets. This is somewhat surprising given the returns on offer. Borrowers are typically second-stage firms expecting high growth. They possess a strong-selling product but lack cash to fund the next phase of the business. Each transaction can be tailored to meet the

needs of the firm at that particular stage, incorporating bespoke components to better dovetail with business needs.


Management’s newly signed co-funding agreement with the UK bank RBS.

This approach has clear advantages but also drawbacks. On the one hand, the prevalence of bank referrals in pipelines is an encouraging sign for the market as a whole. The post-crisis spider-web of regulations and compliance is continuing to inhibit the ability of the banking sector to meet the demands of European businesses, as corporate lending is unable to provide the returns required to meet a traditional lender’s elevated cost base. By partnering with a direct lending fund, banks are able to outsource the funding of loans, while maintaining lucrative, capital-light businesses such as overdraft provision and private banking. Further, private lenders can supply a source of higher-risk capital, which the more conservative banks have no appetite to provide - widening the range of financing options available to mid-market firms. On the other hand, questions remain about adverse selection souring returns for bank-originated transactions. With funds only seeing part of the pipeline, banks may pick and choose the juiciest deals, only referring the riskiest or hardest to fund transactions.

Mitigating such concerns requires extensive due diligence and a strong handle on the credit process. Private credit funds employ experienced credit officers to arrange and negotiate deals, many of whom have many more years of experience than their counterparts at commercial banks. Amongst others Pemberton, for instance, not only has an experienced origination team stationed in offices throughout Europe – but also an independent credit analysis group which vets transactions brought by the deal team. For the insurance investor constituency served by Pemberton, this has been seen as an important line of defence despite the senior nature of the

W ith a reputed €35bn in dry powder, the focus for European private debt funds for 2016 looks set on the identification and

negotiation of attractive opportunities. 2015 was a bumper year in this regard, with capital deployment at record highs. The credit arm of the private equity group KKR loaned more than half a billion dollars of its private debt fund, Deloitte’s survey of 38 major alternative lenders saw a 14% year-on-year rise in transactions closed in Q3 of 2015, while Pemberton Asset Management had a stellar year – clinching a first close on their first fund, while simultaneously lending over €300mn to European businesses. Nonetheless, origination remains a major concern for any investor looking at committing to a private credit fund. In the sponsored space, the fund-raising bonanza of 2014 and 2015 continues to compress yields in the upper mid-market space. In the direct lending sector, question marks remain over the ability of lenders to connect with corporate Europe and thus transform the mountain of smouldering dry powder into a portfolio of performing loans.

Without a household brand or established relationships as a means to solicit opportunities, direct lenders typically rely on networks to identify attractive assets. Given the investment banking heritage of many fund managers, an obvious source of deals is thus banks themselves. The Legal and General-backed Pemberton team, led by Symon Drake-Brokeman, have been active in utilizing their banking networks to help bolster their pipeline. The end results are impressive, with the first time fund deploying over €300mn of their freshly raised capital – well ahead of their own 2-3 year investment schedule. Other, more formal, relationships are also a prevalent feature of the private debt landscape – most notably Bluebay’s agreement with universal bank Barclays and Hermes, M&G and AIG Asset

ACMV Top Theme

Can the new ‘direct lenders’ serve SMEs?


loan portfolio. Building and maintaining a physical presence in targeted geographies is also a key pillar in Beechbrook Capital’s origination strategy for their new SME sponsorless credit fund. The UK based lender is opening offices beyond its London headquarters, widening the net as it processes a large number of enquiries from corporate borrowers and their advisers around the country. A 30-year veteran of Lloyds Banking Group has been hired to run the platform.

However, the more direct lending funds look to bricks-and-mortar as an integral part of their deal sourcing infrastructure, the more the alternative lenders mirror the established banking system they are partly replacing.

Such a metamorphosis for private credit market participants is a long and difficult process. The Pemberton platform took 3 years to build and the major backing from one of Europe’s top 10 insurance companies. Beechbrook built up years of experience operating in the sponsored mezzanine space, building networks and expertise, before launching their own sponsorless lender. Bluebay, was able to rapidly deploy its first €800mn direct lending fund, aided by its partnership with universal banking behemoth Barclays in order to identify suitable investments. For new entrants wanting to move into this space, the challenge looks daunting and the barriers to entry high. With established regional offices, the debt teams spun out of the larger private equity groups appear well placed to surmount these obstacles. Building on their existing infrastructure, credit specialists can be brought in to negotiate and manage debt assets. However, in an industry where conservative borrowers are looking for a hands-off, long-term lender, the backing of a leveraged buyout house may be more hindrance than help.

Understanding these dynamics will go a long way to understanding the long run sustainability of the European direct lending market as a whole. Analysts have often benchmarked European corporate lending markets against the United States.

By this measure, Europe has a long way to go before private capital markets reach their potential - in America around 70% of American corporate lending is directly funded by capital markets, compared to only 30% in Europe. Although similar in market size, the unified regulatory regime, common language and universal accounting standards make the rapid replication of successful strategies an easier task for US operators. European funds have no such advantages and coupled with a conservative risk culture and smaller average firm size, the challenge for funds operating on the East side of the Atlantic is not insignificant. Moreover, key features of the private credit success story thus far may prove harder to scale to the levels needed to comprehensively connect with the full span of European industry. Bank-like branches provide presence but they also contribute cost, eroding one of the major advantages of private lenders. The pool of senior bankers, liberated by the post-crisis bloodletting at many of the establishment finance houses, will quickly diminish – reducing the quantity of credit experience applied to prospective opportunities. As is often the case in financial markets, the next wave of attendees may try to cut corners as they fight to gain a seat at the table, leading to a downward spiral of lower returns and laxer credit standards.

2015 was a stellar year for private credit markets. As 2016 rolls in, all eyes are on execution as funds look to fulfil promises made on the flurry of restless roadshows over the last 12 months.


Table 4: Negotiated Commercial Real Estate Debt

Real Estate Financing

Cash interest

3.5-5.5% 4.5-6.5%

6-8.5%

6-8.5%

UK

Return

4.5-6.5%

7-9.5%

9.5-12.5%

Deal fees

2.5-5%

3.5-5.5%

2.5-5% N/ NA /A

Deal fees

Deal fees

Deal fees

Deal fees,Capital

Deal fees,Capital

Deal fees, Capital

11-15%

Senior:0-60% LTV

Whole loan:0-75%

Stretched senior:60-75%

Mezzanine:75-85%

Cash interest

CORE EUROPE

Return Cash interest

Additionalreturn

Additionalreturn

Additionalreturn

SOUTHERN EUROPE

Return

2.5-4.5% 2.5-4.5%

6-10%

6-9%

5-8%

6-8%

7-10%

5-7%

N/A

Deal fees

Deal fees

12-16%

4-6% 4-6%

8-11% 7-10%

Market update

A s with many private credit markets, the pricing pressure on real estate transactions built throughout 2014 and into 2015.

Markets look most frothy at the top end, in sectors such as London prime office and luxury, where rapid capital growth has attracted a flood of foreign money. The end of the year was marked by a loss of momentum, as global economic uncertainty spilled over into a weaker investment climate. The continued deterioration in market conditions is likely to hit core strategies the hardest, while niche players look better positioned to maintain returns.

On the fund raising side, real estate debt is increasingly dominated by a small number of mega funds. Despite a rise in the total capital raised, Preqin data showed a sharp drop in the number of funds closed in the first 9 months of 2015. Amongst the big European players, AXA topped out its monster senior debt fund at €2.9bn, while AgFe was in the market with a £1.2bn floating rate senior fund.

In a nutshell


Real estate funds provide credit secured against an underlying real estate asset. Senior funds lend up to 75% loan-to-value (LTV), while mezzanine funds focus on supplying capital at the 75-85% LTV level.

Much as in other private credit sectors, bank retrenchment is being driven by capital considerations and regulatory burdens. This has meant a rise in real estate financing from debt funds and alternative lenders – which now make up around half of all European lenders. Liability driven investors are drawn to the benefits of the long duration loans that are on offer. While

the higher risk tolerance of institutional investors provides a strategic advantage to debt funds working at higher LTV.


Alternative Finance Participants

Sources of capitalAsset focus

Private debt: senior and mezzanine,Direct lending,Special situations

Pensions, insurance, SWFs

IPO,Trade sale

Pensions, insurance, SWFs,Parent co-investment,CLOs

Acquisitions,Organic scale-up

Pensions, insurance, SWFs,Parent capital

Pensions, insurance, SWFs

Further listings,Credit facilities

Listed equity,Bank facilities

Organic scale-up

Scale-up,Acquisitions

Further listings

Private debt: senior and mezzanine,Direct lending,Special situations

Private debt: senior and mezzanine

Acquisitions,Organic scale-up

Private debt: senior and mezzanine

Private debt: senior and mezzanine,Direct lending

Whole loans,Senior debt,Mezzanine

Private debt: senior,Syndicated loans

Primary LBO loans

Pensions, insurance, SWFs,Parent backing

Issuing more vehicles Organic scale-up,Acquisitions

Alcentra,CIFC,Lyxor

Balance sheet

Organic scale-up,IPO

Acquisitions

Private debt: senior

Independent lenders

Alternative investment groups

Fund of funds credit sections

Asset manager credit sections

Publicly listed financiers

Business development companies (BDCs)

Real estate lenders

CLOs

Balance sheet lenders

Beechbrook,Monroe,PembertonHarbert,CORDET

Blackstone/GSO,Partners Group,KKR,Bain/Sankaty,CVC

Pinebridge,Portfolio Advisors,Access,SVG

Oaktree,Babson,John Hancock,TCW,Tikehau

CIT,ICG,SVG,American Capital

Ares,Apollo,Golub,ACAS

Pension funds,Funds of funds,Family o�ices

Organic scale-up,Trade sale

Structured equity,Preferred shares,Convertible loans,Minority equity

Growth capital funds

Harbert,Summitt,IPF,PrefEquity

Venn,DRC,Green Oak,Longbow

Private debt: mezzanine,Minority equity,Private debt: senior

Pensions, insurance, SWFs,CLOs

IPO,Organic scale-up,Acquisitions

Mezzaninehouses

ICG,Mezzanine MgmtPark Square,Indigo

GE Capital

Ownerstrategy Examples

Table 5: Principal alternative capital providers, US and Europe



Alternative Capital A to Z

The additional yield paid to compensate investors for the illiquidity of an asset, irrespective of its credit quality

Illiquidity premium

An agreement between one or more creditors in a particular borrowerInter-creditor agreement

The financing of a buyer or a supplier of goods or services for the provision of those same goods or services. The lending is collateralised by the invoice exchanged and is normally non-recourse but may include insurance or credit guarantees

Invoice funding

An investor in a fund partnership who is not responsible for the management of the fund

Limited partner (LP)

The member of a fund partnership with fiduciary responsibility for the investment management of the fund on behalf of its limited partners (LPs)

General partner (GP)

The rate applied to one or more future payments so that these payments have a net present value of 100% of the invested amount. Thereby, a measure of the return expected from the investment

Internal rate of return (IRR)

Financing for relatively mature companies to expand operations or to enter new markets while they retain control ownership of the business

Growth capital

Mezzanine finance(European corporate)

Credit finance for companies that are not majority-owned by a private equity fund and where negotiation is with owner-management

Direct lending

An investment strategy that attempts to match future asset payments with future liability payments. It is commonly used in the portfolios of life insurance companies and defined benefit pension funds

Asset liability management (ALM)

The provision of finance to a supplier of goods for closing the cash flow gap between the issue of an invoicing and payment of that invoice. Factoring is the more traditional form of Invoice Funding

Factoring

The ratio of credit provided in proportion to the purchasing price of the assetLoan to value (LTV)

Shorter-term debt finance for small to medium-sized growing companies which is repaid relatively quickly as revenue grows

Growth debt

A measure of the difficulty in trading an asset, typically indicated by the difference between bid and offer prices

Illiquidity

A secured loan, typically floating rate, which contracts for additional equity-like exposure including PIK and warrants


An umbrella term for the universe of all non-public debt transactions not financed by banks

Private credit

An unsecured corporate credit investment typically with a high fixed-interest rate and often with an attached warrant to purchase equity

Mezzanine finance(US corporate)

The provision of credit by investors to private equity firms to finance buyoutsPrivate debt

A credit contract that does not involve transfer of cash flows from borrower to lender between drawdown date and maturity. PIK interest accrues until maturity or refinancing

Payment in kind (PIK)

A bond or loan that is issued at below its face valueOriginal issue discount(OID)

A lower-ranked loan backed by real estate up to typical loan value levels of 85%, with a correspondingly-high interest rate

Mezzanine finance(Real estate)

A derivative security that gives the holder the right to purchase interests (usually equity) from the issuer at a specific price within a certain time frame

Warrant

Mezzanine finance for companies that are not owned by private equity fundsSponsorless mezzanine finance

A debt facility that combines features of both senior corporate loans and mezzanine loans

Unitranche loan

Loans that retain the first claim on all interest and principal repayments from the company or property or project

Senior loan

A highest-ranking loan that lends up to a slightly higher loan-to-value ratio than a typical senior loan and charges a higher interest rate

Stretched senior loan

The provision of finance to a buyer of goods, commonly employed in accelerating payments to its suppliers in exchange for better trading terms. SCF is often called Reverse Factoring. To compound confusion, the term Supply Chain Finance or its acronym are often used to refer to the entire Invoice Funding space

Supply chain finance (SCF)



©Arbour Partners LLPAdvisor and Arranger in Global Private Capital Markets1 Cornhill, London, EC3V 3ND

Interested parties please email [email protected]

DisclosuresCertain information contained in this paper constitutes “forward-looking statements”, which can be identified by the use of forward-looking terminology such as “may”, “will”, “should”, “expect”, “anticipate”, “target”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors should pay close attention to the assumptions underlying the analyses and forecasts contained in this paper. The analyses and forecasts contained in this paper are based on assumptions believed to be reasonable in light of the information presently available. Such assumptions (and the resulting analyses and forecasts) may require modification as additional information becomes available and as economic and market developments warrant. Any such modification could be either favorable or adverse. Nothing contained in this paper may be relied upon as a guarantee, promise, assurance or a representation as to the future. Certain information contained herein has been obtained from published and non-published sources prepared by other parties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliable for the purpose used herein, Arbour Partners LLP and its affiliates assume no responsibility for the accuracy or completeness of such information. Historical information is not indicative of future results, and the historical information in this paper should not be viewed as an indicator of any future performance that may be achieved as a result of implementing an investment strategy substantially identical or similar to that described in this paper.

alternative capital - arbour partnersarbourpartners.com/acmv2016.pdf · we at acmv expect the lure...

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