risk; a lower EBITDA typically equates to lower creditworthiness. Several factors can affect a company’s EBITDA, including market share, customer concentration, and cash flow stability.
LTV: As with capital structure, the risk for the lender increases with the LTV ratio. Direct lenders seek greater compensation for loans that are less collateralized.
Leverage: The more leverage a company uses, the lower its ability to service that debt. Not surprisingly, highly leveraged transactions incur a premium. Conversely, our analysis shows that transactions using very little leverage also command a premium. In our experience, this situation tends to arise in lending to smaller companies with less solid credit metrics, as noted above, or to companies in cyclical sectors.
Covenants: Direct lenders can often put in place covenants to fit each borrower’s risk profile. This flexibility comes at a cost: Fewer covenants can equate to an additional risk premium.
Sponsor/non-sponsor: Lenders often require a risk premium for lending to non-sponsor companies. Sponsor-backed companies typically have better financial reporting and corporate governance, as well as stronger management teams. Sponsors’ rigorous due diligence process provides lenders with additional confidence in the company’s business plan and ability to service debt. Lending to non-sponsor companies typically requires more time and effort in due diligence. Consequently, lenders often seek an additional compensation premium for their work.
Strategy: Lenders specialising in complex situations also command a risk premium for their deeper sector expertise or the additional work needed to complete the transaction. They also have more freedom to charge a “scarcity premium” given the lower number of financing options available to borrowers in these situations.
3.3 Portfolio Positioning through the Credit Cycle
Determining the relative value of a particular market segment or capital structure through the credit cycle requires a closer look at its performance over time. This provides an investor with the necessary information to decide which portfolio rotations are sensible given a specific market outlook. To demonstrate the importance of a good positioning in the capital structure as the cycle evolves, we analysed distributions of IRRs and loss rates for pre- and post-GFC periods.
Using the resampling methodology, we randomly selected 100 loans from our proprietary private debt database to build a portfolio. We then calculated the IRR of each randomly selected portfolio and repeated this process 100,000 times to obtain the IRR distribution for each strategy.
Exhibits 9 and 10 illustrate the importance of a good positioning through the cycle. The pre-GFC period is characterised by a platykurtic IRR distribution for second-lien/mezzanine loans, demonstrating the sector’s higher risk profile, particularly in periods of market stress. Such a distribution also complicates portfolio construction, since expected returns are harder to derive and less robust.
Exhibt 9: IRR Distribution by Market Segments pre-GFC and GFC vintages (2005-2009)
Source: StepStone Private Debt Internal Database
Exhibit 10: IRR Distribution by Market Segments post-GFC vintages (2010-2017)
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