Interview with Mr Symon Drake-Brockmann, Pemberton Asset Management

Symon Drake-Brockmann

Q1: Why is private debt a good alternative to the classic private equity investment?

Although private debt and private equity are targeting the same universe of medium size companies, they are offering very different risk/return profiles by virtue of addressing different financing needs in the capital structure of those same companies. As such by providing complimentary risk/return attributes, institutional investors would typically have an allocation to both strategies albeit in different proportions.

However private debt offers a key advantage to private equity through a combination of a stable and known return (coupon, origination fees and ultimately repayment of principal) and a more senior position in the capital structure, meaning most of the time a first lien (priority) on the underlying cash flows and shares of the company in case of insolvency/bankruptcy. In addition, given the current (and projected) rising interest rate environment which tends to be detrimental to equity, private debt strategies are insulated through the variable rate component of the underlying loans. Finally, at this juncture where markets have been in an extended benign environment, we strongly believe that private debt offers investors a more resilient position than private equity to go through a reversal of the cycle while providing stable returns.

Q2: How can medium-sized enterprises profit from private debt as well?

The competitive nature of private debt financing is becoming increasingly well understood and appreciated. The owners and executives of mid-market companies understand that the investors in credit funds are often large, stable institutional investors such as insurers and pensions funds, which have long-term, patient capital. Credit funds can provide bullet loans with maturities of seven years, in comparison to banks, which prefer to do five year amortising loans. The ability of credit funds to provide long term and reliable financing is very valuable as they are making long-term investment decisions or evaluating options for expansion.

But the longevity of financing alone is often not enough, particularly in situations where companies want to grow inorganically, through new markets or acquisitions. The flexible nature of credit offered by private debt funds can be tailored to the specific needs of entrepreneurs, providing them with greater room to manoeuvre than they could receive from banks. This is particularly true in the case of committed and callable acquisition facilities. These require a more tailoredl approach to lending. The credit analysis of the initial borrower needs to be supplemented by a thorough understanding of its medium-term strategy and the rationale of the acquisitions it seeks to undertake, without concrete knowledge of what they are going to be. With their targeted business model and flexible decision-making processes, credit funds are in a better position to evaluate such complicated financing solutions. In a fast-paced and everchanging environment, this can be key.

Q3: How risky are private debt investments?

The levels of risk associated with private debt will vary across the credit spectrum and specific strategies. As its name suggests, private debt is privately negotiated and not readily tradeable. This gives rise to an illiquidity risk. But, we believe illiquidity should be viewed as a risk premium to be exploited and harvested. What’s important is to navigate the complexity of the credit markets by originating, selecting and managing investments adequately. We are therefore very focused on ensuring that we select the best opportunities for our funds, and we spend a lot of time working with the management teams of our borrowers to understand the key risks for each borrower, to make sure that we get comfortable with the risk profile for each loan that we make.

A lot of this risk management comes down to experience. The team here has been in the industry for more than 20 years each, through multiple credit cycles and therefore know what to look out for when assessing investment opportunities. Inevitably in a large portfolio of loans you will have a few companies that either underperform or will require resturucturing. Our team has excellent monitoring and restructuring experience: our chief credit officer, Nicole Gates, ran GE Capital’s international intensive care and restructuring business for 10 years. We do expect that over time, one or two deals will have challenges and you have to be able to work with the company and management team to get things back on track, potentially restructuring the cost base to get the money repaid, and having this skillset in-house is very important to us.

Q4: How are private equity and private debt returns going to be distributed in the future?

We believe that the future distribution of returns between private equity and private debt is a very pertinent question in the context of the compression of returns and possible (expected) increase in market volatility typical of the end of a cycle. Although private equity would typically generate a substantial pick up in return in normal conditions, this is achieved through taking the lion’s share of the risk and sitting behind the debt holder in the event something goes wrong; this means private equity holders takes more risk and has more volatility of returns in not a dissimilar way that listed equities are more volatile than public bonds. However, when markets start correcting, private equity would typically be more impacted as it is in a riskier position in the capital structure than private debt is, which should perform better due to its seniority. We would expect as such private debt to offer better relative value compared to private equity in the medium term.

Q5: What advantages can you see in private debt in principal?

This is a relatively new asset class: private debt in Europe is probably only six-to-eight years old but is one of the few asset classes where the ability for institutions to grow their exposure is matched by lending opportunities on the other side. If you look at the size of direct lending to mid-sized companies, we believe that it is a multi-trillion euro market across Europe and the capacity for institutions to allocate money to the asset class grows every year.

As banks continue to shrink going forward with continuing regulatory pressures from the likes of Basel III, we believe that the growth prospects are extremely positive over the next decade.

Q:6 In which markets is private debt already established, where is it going to become more important in the years to come?

The main regions to date that have seen the most activity are the UK, France and Germany. These markets were the three largest in terms of leveraged finance pre-crisis and they continue to support most of the direct lending activity in Europe. Increasingly, we are seeing more activity from the Italian and Spanish markets, as a combination of economic growth in the region and greater acceptance of these markets by institutional investors. As Spanish and Italian deals tend to be driven by corporates and less by private equity firms, it is crucial for direct lenders to have boots on the ground in both countries.

In terms of sectors, many direct lenders are sector-agnostic, with the intention being to build a fully-diversified portfolio. Not surprisingly, the sectors that have strong cashflow characteristics, low capital expenditure requirements and recurring revenue streams tend to be strongly favoured. This includes the Healthcare, Business Services and Manufacturing sectors.