The pace of fundraising for private debt strategies is showing signs of slowing, according to PitchBook data, a reversal from last year’s rapid clip.
Just $28.9 billion was raised for private credit funds in the first quarter of the year, a sharp drop from the record $72.8 billion raised in the fourth quarter of 2021, according to PitchBook’s latest report. . Global Private Fund Strategies Report. While the lag in fundraising data means the drop may be less severe than it appears, the decline signals that current economic conditions may begin to slow fundraising for such strategies.
A series of macroeconomic headwinds, including supply chain disruptions, persistently high inflation, a hawkish monetary policy environment and falling stock markets, are weighing on managers’ fundraising efforts. However, certain strategies – which could maintain resilient performance in volatile markets and rising rate environments – will remain popular among allocators looking for opportunities to earn higher returns in times of uncertainty.
We recently spoke with Jess Larsen, Founder and Managing Director of Briarcliffe Credit Partners, to take the pulse of today’s private credit fundraising market and what sponsors expect of managers.
Larsen established the firm in 2019. It is a dedicated placement agent for private credit managers and advises clients ranging from asset management giants seeking fundraising advice for their private credit offerings, to specialized credit managers with a few billion dollars in AUM.
PitchBook: Where are investors looking for yield in the private credit space amid the current market turmoil?
Larsen: Valuations in the public equity market have contracted, leading to what is known as the “denominator effect”. If you’re a pension plan manager, the sudden drop in public market valuations could leave your portfolio overweight private markets. Therefore, some sponsors are considering options to manage this situation.
We’ve seen more and more capital flow from fixed income into private debt strategies, which is an interesting development. And we are seeing demand for strategies that are uncorrelated to the equity market, including specialty finance, special situations and distressed debt. Examples could be equipment leasing, trade finance or financing pledged on non-financial assets such as athletes, barrels of whiskey and works of art. These are different from the typical direct lending strategy, which is about the health of the business. Since we expect a recession to come, we are likely to see a deterioration in corporate health. What LPs really want is a private credit portfolio that can weather the storm if we head into a recession.
We saw many investors raise distressed debt funds during the height of the pandemic in 2020. Why are we seeing renewed interest in this strategy now?
During the peak of COVID-19, we saw a fair amount of capital flowing into funds targeting distressed and special-situation investments, as investors believed the pandemic would trigger a recession. However, when we came out of it, we didn’t have a recession.
But the macro environment has changed dramatically over the past three months. We now face the prospect of a recession. If a recession is expected, this would be an opportune environment for managers who focus on stressed and distressed investing as companies will face challenges.
However, we are only beginning to see the macro environment change. So it will be some time before we actually see a recession and companies start going into default mode. We have started to see cracks, but we are still far from a real recession. Now is a good time to raise funds so that you have the capital available when the time comes.
Some GPs have raised trigger funds, which are set up so that when certain trigger events occur, they can withdraw the committed capital from the LPs. These triggers could be unemployment rates, slowing GDP growth, inflation rates, changes in credit spreads, and other financial and economic data.
Trigger funds, or contingent funds, have been around for years. They are mainly set up for struggling strategies. To be successful in distressed investing, you generally need a tough economic environment. The structure of trigger funds allows investors to make investments only when the market becomes ready for such strategies, as opposed to deploying capital during a bull market where distressed opportunities are hard to come by. We have seen significant growth in trigger funds over the past five years.
Infrastructure assets are generally considered a hedge against inflation. What about infrastructure credit? Is there currently an increase in demand for infrastructure credit funds?
One could argue that infrastructure credit is uncorrelated because the investments are tied to a physical asset. The challenge we sometimes have with infrastructure debt strategies is that their net returns tend to be 5% to 6% up to a maximum of 7%. And that doesn’t always match an investor’s 7% to 8% hurdle internal rate of return. While infrastructure debt is a great strategy, it doesn’t always meet this return requirement.
The market seems to have changed drastically over the past two months. Last year we had a trading frenzy, whereas now all of a sudden everyone is talking about prospects for stagflation or recession and trading activity has started to slow down in a variety of sectors. Have LPs adjusted their return expectations for private debt strategies?
About 18 months ago, the typical return target that US LPs were telling us about was 14% net return for these uncorrelated private debt strategies. Now, we hear 12% more often as a return goal. This is probably an argument that people set a less aggressive return expectation.
Is the current period more difficult for private credit fundraising in general?
In the short term, this will be a more challenging environment for private market fundraising in general as LPs adjust to the macro environment, the denominator effect and writedowns, particularly in venture capital .
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