benefits, co-investments and secondaries enable the LP to more thoroughly vet the GP’s investment insight, and to gain a better understanding of a GP’s capabilities and style. For the GP, co-investments and secondaries provide an opportunity to showcase its skill set and, if all goes well, persuade the LP to commit to a future fund.
Given the many benefits of co-investments and secondaries, why do most LPs not participate? For co-investments, speed is the biggest obstacle. Most private debt deals are finalized within two to three weeks. Unless the LP has a dedicated co-investment team, it is not equipped to make investment decisions that quickly. Though many LPs may mention the desire for co-investments when discussing a commitment to one of the GP’s funds, they are rarely able to execute when the opportunity arises. For secondaries, LPs need to have the ability to analyse many loans in a short period of time, which may also require a dedicated team.
While the intangible benefits of co-investments to both LPs and GPs are clear, debate over the actual results continues. Academic research, including a study by Fang/Ivashina/Lerner (2015),[8] raises significant questions about the performance of co-investments, specifically a concern about adverse selection. In a white paper[9] published in 2014, StepStone demonstrated that co-investment deals generally performed in line with their parent funds on a gross basis, outperformed them on a net basis, and, on average, had lower risk profiles than their parent funds.
This analysis suggests that GPs actually had higher conviction in the co-investment deals and they were not simply “selling down risk”. Therefore, the performance comparison shows that the adverse selection concern in co-investing may be overstated. Thus, compelling returns are achievable in co-investing as long as the co-investment program incorporates processes and structures to mitigate the risks associated with co-investing.
LPs source co-investments and secondaries through their primary private debt manager relationships. The key to creating a diversified co-investment portfolio is to see many co-investment opportunities. This is important for three reasons:
Selectivity matters: GPs typically review 1,000 transactions per year, but close on only between 3% and 5%.[10] A strong co-investment “flow” helps LPs to be equally selective.
LPs gain knowledge of the current deal environment and are able to better distinguish between “good” and “bad” deals.
With good “flow” LPs will be able to create more diversified portfolios.
As a result, the key to creating a strong co-investment portfolio is to have significant scale and be a meaningful partner to many GPs. This can be challenging given that private debt has fewer managers than private equity. To make the most of this situation, investors might rely on an adviser with the reach and scale necessary to cover the global private debt market.
Although each secondary and co-investment opportunity has its own idiosyncrasies, which engender a certain level of customization, there are several analyses that should be part of any investment due diligence. In light of how time sensitive these transactions can be, drilling down into these five criteria may be helpful to LPs as they decide whether to proceed:
covenants (see also section 6),
control/lender of record (see also section 6),
EBITDA adjustments (see also section 2.2.4),
leverage levels & Loan-to-Value (LTV) ratios,
gross asset yield.
High equity cushions and low LTV ratios are tantamount to “skin in the game” for private debt managers. These metrics provide powerful insight into whether the lead sponsors will be properly aligned with their co-investors. If equity cushions are too low and leverage is too high, sponsors may not be as patient as they otherwise might be during a market correction. A high LTV ratio, on the other hand, may be evidence that the GPs’ underwriting standards are too lax, and they are willing to take unnecessary risks to boost returns.
The gross asset yield of an investment considers both the coupon and the closing fees paid by the borrower to the lenders. Though co-investors are typically entitled to receive the closing fee, they should be mindful of “skimming” – the practice of shaving one or two points off the Original Issue Discount (OID). This skim is similar to the origination fee banks charge for bearing the risk that syndication implies.
3 Return Drivers of Private Debt Investments
Investors considering the private debt asset class often raise the question “To what risk does an observed interest margin relate?” Their point of reference would typically be the gross interest margin that a local bank might offer to a corporate borrower. However, in countries with a competitive banking landscape and bank debt priced at around 250 bps to 300 bps interest margins for leveraged buyouts, a 600 bps margin for direct lending transactions appears to be risky. However, a more differentiated approach and analysis is needed to fully appreciate the attractive return and risk drivers of direct lending. The aim of this analysis is the attribution of the interest margin to specific risk factors.
An important requirement to do so is the availability of data for a notoriously opaque asset class. The analysis that follows is based on a comprehensive data collection and includes more than 5,100 loans originated from 2006 to 2018.
Exhibit 8 illustrates the findings of the interest margin decomposition. The analysis not only helps in understanding the risk/return drivers but also supports the efficient sourcing of loans and portfolio construction.
Exhibit 8: Risk premia decomposition of Corporate Direct Lending
Source: StepStone Private Debt Internal Database, based on more than 5,100 US loans originated between 2006 and 2018
3.1 Base Loan-related Factors
The base loan factors primarily relate to the variables present in a loan structured by a bank for a particular borrower. In exhibit 8, the base loan is defined as a core sponsored covenant-lite first-lien loan issued by a US utility company with an EBITDA between USD 30 million and USD 50 million, an LTV below 40% and leverage above 6x. The return of such a loan can be broken down as follows:
Risk-free base rate: This would be the floating base rate over which the margin is added; LIBOR is used as the base rate for a majority of loans.
Credit premium: A portion of the interest margin will be related to the borrower’s creditworthiness. If the bank deems the borrower to be of higher credit quality, a lower premium will be charged to reflect a lower risk profile.
Illiquidity premium: There is no active secondary market for loans made to middle-market companies. Hence, loan pricing includes an illiquidity premium to compensate lenders for the risk that holding these assets implies.
3.2 Direct Lending Specific Factors
Financing solutions provided by direct lending GPs tend to deviate from a bank-style base loan. As a result, they can tap into additional return drivers.
Capital structure: The more junior a loan is positioned in a company’s balance sheet, the greater the probability that its nominal amount is not covered entirely by the borrower’s enterprise value. Also, a lender taking on a second lien or junior position has less control over the recovery process. Therefore, a risk premium is attributed to the lender’s position in the capital structure.
EBITDA: Direct lenders consider a borrower’s