FEATURE ANALYSIS - goldingcapital.com

1 FEATURE . ANALYSIS . performance . The art of benchmarking The private debt industry's relative youth makes benchmarking difficult given the scarcity of historical data. This hasn't stopped investors committing to the asset class in search of yield, however. Anna Devine explores how they go about selecting managers. E. xperienced investors in both the AN ART, AND A SCIENCE. fixed-income and private equity Huber says returns are just one piece of markets are becoming increasingly the puzzle when selecting a fund, however. interested in private debt. With interest Like many LPs, Golding uses a third-party rates at record lows and private debt in database. It tracks around 270 mezzanine its many guises offering attractive risk / funds and around 170 distressed fund seg- return profiles, market sources suggest LPs mented by the US and Europe.

2 Are reallocating capital away from traditional What's also important and this is fixed income and even private equity into where it becomes more of an art than a credit funds. science is that you have to understand Yet selecting managers to back can be the fund manager on a deeper level how tricky, not least because it's a relatively young IT'S NOT ENOUGH TO the investment strategy is differentiated;. asset class. JUST LOOK AT NUMBERS the capability of its platform to source and Oliver Huber, head of private debt at fund PROVIDED IN THE TRACK select the right transactions as well as how of funds Golding Capital Partners, says: It's RECORD. YOU ALWAYS credits are managed in work-out situations. not always easy, particularly in Europe, where HAVE TO FORM YOUR You've got to meet as many managers the market is still developing with many first- OWN VIEW AND MAKE A as possible and try to see everyone who is time funds.

3 JUDGEMENT WHETHER in the market raising a fund, Huber says. If comparing the private debt industry to THIS MANAGER WILL Most crucial is how capable they are in private equity it is certainly more challenging CONTINUE TO BE work-outs when things go bad. Do they have due to the lack of available databases that track SUCCESSFUL IN THE the skills and also the passion to manage the asset class, he says. FUTURE and work hard with a company in a down- Jim Strang, managing director of the Euro- Oliver Huber, turn? There are managers in the private pean fund investment team at investment Golding Capital Partners debt space with a more passive approach advisor Hamilton Lane, says: private debt is their only option is to try and sell, which an enormously broad easiest way to are looking to buy into loans or obligations is very difficult in this illiquid asset class, think about it is in terms of risk and return, at less than their original face value and are particularly in a market crash.

4 We want to starting at the riskiest end of the spectrum, looking for an element of pull-to-par,' some see teams that can manage through a down- distress-for- control. Executing this strategy form of coupon on yield and potentially fur- turn and fight hard to get the money back in is challenging but returns are also the highest, ther upside through a restructuring. Returns restructuring situations, Huber says. at around 20 percent or higher. here are somewhere in the teens, he adds. At the other end you have direct lending, Strang adds that in Europe distressed A DEARTH OF DATA. which is a relatively new FEATURE of the private investing for control has been around about Industry data on returns is most compre- debt market, especially in Europe. Returns are twenty years, but that primary lending from hensive in the distressed and mezzanine typically in the single digits and the corre- debt funds emerged only in the last six to seven fund segment of the market.

5 Sponding risk should be relatively low. years since the crisis. In aggregate, the Euro- If you look at mezzanine, net returns In the middle of these strategies you have pean private debt market is a lot less mature are on average around 10 percent. For the active non-control space. Here investors than the equivalent US market, he says. distressed debt funds they are around 14. 18 private Debt Investor | June 2014. FEATURE . ANALYSIS . performance . percent over a period of around 20 years, out close to expectations. It is still early for Some LPs are agnostic regarding geog- Huber says. a number of these funds but returns are raphy [US versus Europe], strategy [spon- Huber thinks positive bias might also solid, if not as strong as in the first wave. sored versus non-sponsored] and capital skew reported returns by between 100 We have yet to see how the third wave of structure [senior versus subordinated].

6 And 200 basis points above what actual funds will fare. From my experience, these investors tend market returns are, as managers are more to favour funds targeting the highest returns likely to report if they can show strong TECHNIQUE rather than funds with the most attractive returns rather than if they underperform Golding also has its own in-house bench - risk / award profile, he says. the market, he explains. marking tools but it's thought many LPs rely Schryber highlights the perils of over- There are geographical differences in solely on third party databases. reliance on third-party data providers: returns as you might expect too. Not all [LPs] are set up with their own Comparing performing credit funds is In general the US market has performed dedicated private debt teams, Huber says. more difficult than comparing funds within better than Europe probably around 200 It is a broad LP investor base and it is my just about any other asset class, he says.

7 Bps better in returns throughout the last understanding that many just rely on [exter- Some third party data providers aggre- cycle. Part of that is that in the difficult 06/07 nal] databases when picking a manager or gate all performing private credit funds vintages, the US funds did significantly better pursue a more opportunistic approach to together for benchmarking purposes. It is as they had the tailwind of a relatively much investing with the few relationships they have dangerous to use these benchmarks to make stronger economy in recent years coming out in the market, Huber believes. investment decisions, as performing private of the dip in 2008. In consequence, they had Ben Schryber, director of private equity and debt encompasses a very wide range of sub- lower default rates as well as stronger repay- credit in the US at placement agent FirstAvenue, strategies, he says.

8 Ments / exits. Whether this outperformance shares that view and voices concerns about the When looking at variation in returns of the US market will continue through the private equity approach to benchmarking . between debt funds, Huber has a similar current cycle over the next five to seven years The private equity approach of bench - thought process. remains to be seen, he says. marking funds focuses on alpha generation Volatility [in private debt] is much lower In Europe, there have been three waves and upside, he says. than in private equity , yet it's still about 10 to of private debt fundraising since the crisis, With private debt, downside protection 15 percent for mezzanine between the top Strang says. The first wave came in 2008, is equally if not more important than upside, funds and the underperformers but it's hard the second around 2011 and 2014 is the he says, adding, benchmarking the default to quantify further when there is limited data third wave.

9 In the first wave, debt funds and recovery rates of private loan portfolios for individual vintages. For segments such as performed well and probably beat initial against each other and against similar quality distressed debt, mezzanine and senior loans, expectations around returns. Generally public debt is a good way to evaluate down- you need to look at each fund vs their relative returns from the second wave are playing side protection. peer group. Slicing and dicing just in terms of CAMBRIDGE ASSOCIATES: CAMBRIDGE ASSOCIATES: DISTRESSED SECURITIES INDEX GLOBAL MEZZANINE INDEX. The Index shows end-to-end pooled returns (net of fees, expenses and carried The Index shows end-to-end pooled returns (net of fees, expenses and carried interest) to LPs as of 31 December 2013, and is based on data compiled from interest) to LPs as of 31 December 2013, and is based on data compiled from 252 distressed securities funds, including fully liquidated partnerships, 142 global (123 US and 19 ex US) mezzanine funds, including fully liquidated formed between 1987 and 2013.

10 Partnerships, formed between 1986 and 2013. 25. 20 20. 15 %. %. 10 10 5 5 0 0. 1-Quarter 1-Year 3-Year 5-Year 10-Year 1-Quarter 1-Year 3-Year 5-Year 10-Year Source: Cambridge Associates Source: Cambridge Associates J un e 2014 | private Debt Investor 19. FEATURE . ANALYSIS . performance . quartile is not a good enough comparison, net income even after the first quarter of Huber says. COMPARING PERFORMING the fund don't have to go through a The new senior secured debt lending CREDIT FUNDS IS J-curve. A lot of investors like that.. market remains untested too, Schryber notes. MORE DIFFICULT THAN When asked whether some fund man- The dilemma is that with the market as young COMPARING FUNDS agers might be incentivised to pick credits as it is, It's really difficult to [benchmark per- WITHIN JUST ABOUT ANY which could be considered less than credit- formance] without seeing how these funds OTHER ASSET CLASS worthy just for the sake of increasing assets perform under financial stress.