Much has been written about the ongoing and expected increase in US dollar interest rates and its impact on fixed income markets.
Over recent years, bond yields have been pushed down relentlessly as central banks globally pursued an easy monetary policy.
Now, though, yields are beginning to go up as the Fed normalises its interest rate policy and investors demand commensurately higher returns on their investments. New investors are worried that the “lower for longer” interest rate environment may have finally run its course.
Against this backdrop, a relatively niche asset class has been quietly gaining ground. We are referring here to private debt.
Private companies that are too small to access the capital markets have historically used bank funding to grow their businesses.
Since the global financial crisis, banks have been forced to retrench and focus on their blue-chip clients. Smaller companies have found themselves increasingly bereft of their traditional funding source.
Private debt funds have stepped in to bridge the gap, typically by channelling investments from institutional investors such as insurance companies into loans for these companies.
As the market has evolved, the types of investment strategies have multiplied in order to cater for specific requirements. The bulk of the market is accounted for by senior loans (secured loans that generate returns from interest payments) and mezzanine loans (debt and equity, generating returns from a combination of interest payments and “equity kickers”).
Other strategies such as “distressed debt” and “special situations” focus on generating returns primarily from capital gains on recovery.
The asset class has grown rapidly in recent years. In 2017, total assets under management in private debt funds globally came to roughly $650bn, with $107bn raised in 2017 alone. New money continues to pour in, with some forecasts estimating AUMs to reach $2.5tr over the next 10 years.
While the US is still the largest and best-developed market for loans, there have been concerns raised in recent months about the credit cycle in the US.
We are, therefore, quite selective when looking at US private debt and believe that some other markets offer more interesting opportunities.
We find Western Europe quite interesting in this context. For a start, non-bank lending still accounts for a much smaller proportion of the total loans market in comparison to the US, so quite a lot of catching-up is possible.
For another, the ECB is still some time away from raising interest rates. Also, the credit cycle in some sectors, such as banking, is actually in the “Repair and Recovery” stage.
On the flip side, the legal environment is not the same in every country, but it is important to work with a manager who has local expertise and capabilities.
Since the global financial crisis... smaller companies have found themselves increasingly bereft of their traditional funding source”
Some parts of Asia also offer opportunities, in our opinion. As a GCC-based investor, we also look for opportunities in the local markets.
The SME sector in the GCC accounts for $360bn per year, or about 26 percent of GDP. Expectations are for it to grow rapidly, with some estimates putting the potential at $920bn over the next five years.
Most of this growth is expected to come from the UAE and Saudi Arabia. Surveys indicate, not surprisingly, that most SMEs in the region need to raise capital within the next two years.
From a credit perspective, SME access to formal credit from the banking system in the GCC is low.
Often, banks here are not best positioned to provide this capital due to the nature of the financing that is usually involved, such as long tenors, no amortisation and equity-like returns, among others.
Historically, this financing requirement has been filled mostly by equity, but this may involve a dilution of the promoter’s equity which is not something that meets his objectives fully.
As such, there is an opportunity for innovative credit solutions that make sense for both investors and borrowers.
Investors are now starting to take notice, and one can see definite “green shoots” emerging slowly but surely.
For instance, the implementation of the Bankruptcy Law in the UAE is an important step in the right direction, as is the setting up of the UAE Credit Bureau.
While the legal and regulatory environment is still catching up to more advanced markets, we do see progress as we move forward.
Private debt and the regional real estate sector
A new report by JLL in conjunction with Clifford Chance has underlined how private debt is growing in importance to the GCC’s development landscape. The report titled “Financing Bricks and Mortar: Opportunities for private real estate debt in UAE and KSA”, outlines how diversified debt sources and alternative financing structures will boost lending competition and in turn inject new capital into the real estate market.
The Middle East has historically seen less use of debt than the more mature overseas markets, primarily due to cultural beliefs and challenges related to lack of mortgage and bankruptcy laws, but steady improvements in transparency and regulations are providing a more supportive environment for private funding sources.
“It is not unreasonable to assume that up to 10 percent of the total real estate debt market could come from private debt providers within the next decade,” said Gaurav Shivpuri, head of investment transactions, MENA at JLL.
In 2017, a total of $81bn (AED300bn) of bank debt was lent to the real estate and construction sector in the UAE.
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