Just $28.9 billion was raised for private credit funds in the first quarter of the year, a sharp decline compared with the record $72.8 billion raised in Q4 2021, according to PitchBook’s latest Global Private Fund Strategies Report. While the lag in fundraising data means the drop may be less severe than it appears, the decline is signaling that the current economic conditions may be starting to drag on fundraising for such strategies.
A string of macro 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 who are hunting for opportunities to earn higher returns in a time of uncertainty.
We recently spoke with Jess Larsen, founder and chief executive of Briarcliffe Credit Partners, to take the pulse of the current fundraising market in the private credit space and what expectations limited partners have for managers.
Larsen started the firm in 2019. It is a placement agent dedicated to private credit managers and advises clients ranging from asset management giants seeking fundraising advice for their private credit offerings, to boutique, specialized credit managers with a couple of billion dollars in AUM.
PitchBook: Where are investors searching for yield within the private credit space amid the current market turbulence?
Larsen: Valuations in the public equity market have been contracting, leading to the so-called “denominator effect.” If you are a pension plan manager, the sudden decline in public-market valuations may leave your portfolio overweight on private markets. As a result, some limited partners are considering options to manage that situation.
We have seen capital increasingly coming from the fixed-income side into private debt strategies, which is an interesting development. And we see 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 the financing pledged on non-financial assets such as athletes, whiskey barrels and artworks. Those are different from the typical direct lending strategy, which is all about corporate health. Since we expect an upcoming recession, we will likely see an impairment on corporate health. What LPs really want is a private credit portfolio that can weather the storm if we are heading into a recession.
We saw many investors raising distressed debt funds during the 2020 peak of the pandemic. Why are we seeing renewed interest in this strategy now?
During the peak of COVID-19, we saw a good amount of capital flowing into funds targeting distressed and special situations investing, as investors thought the pandemic would trigger a recession. However, when we came out of it, we did not have a recession.
But the macro environment has changed dramatically over the last three months. We are now looking at the prospect of a recession. If a recession is expected, that’d be an opportune environment for managers focusing on stressed and distressed investing as companies are going to face challenges.
However, we have only started to see the macro environment changing. So it will take some time before we actually see a recession and companies starting to run into default mode. We have started to see some cracks, but we are some time away from a full blown recession. It’s a good time now to raise funds so that you have the capital available when the time comes.
Some GPs have raised trigger funds, which are set up in the way that when certain triggering events occur, they can draw down committed capital from LPs. Those triggers could be unemployment rates, slowing GDP growth, inflation rates, changes in yield spreads and other financial and economic data.
Trigger funds, or contingent funds, have been around for years. They are mainly set up for distressed strategies. In order to be successful in distressed investing you typically require a challenging economic environment. Trigger funds’ structure allows investors to only make investments 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 saw significant growth in trigger funds in the last five years.
Infrastructure assets are typically considered an inflation hedge. What about infrastructure credit? Are we seeing increased demand for infrastructure credit funds now?
You could argue infrastructure credit is uncorrelated because investments are attached to a physical asset. The challenge we sometimes have with infrastructure debt strategies is their net returns tend to be 5% to 6% to the maximum of 7%. And that does not always meet an investor’s internal hurdle rate of 7% to 8%. Whilst infrastructure debt is a great strategy, it does not always meet that requirement for returns.
The market seems to have shifted dramatically in the last couple of months. Last year, we had a dealmaking frenzy, while now, suddenly, everyone is talking about stagflation or recession prospects and deal activities have begun to slow down across a variety of sectors. Have LPs adjusted their return expectations for private debt strategies?
About 18 months ago, the typical return target we heard from US LPs was 14% in net return for these uncorrelated private debt strategies. Now, we are more often hearing 12% as the target return. That’s probably an argument that people are setting a less aggressive return expectation.
Is now a more challenging time for private credit fundraising in general?
In the short-term, it will be a more challenging environment for private market fundraising in general as LPs are getting to terms with the macro environment, the denominator effect and write downs—particularly in venture capital.
https://pitchbook.com/news/articles/private-debt-capital-fundraising-pe
