As the head of global investor relations for a number of prominent U.S.-based alternative investment management companies, and the former head of IR for both Fortress Investments and Angelo Gordon, Gareth Henry has a wealth of experience in the growing private credit sector. His education as an actuary has served him well in understanding the at-times complicated math behind these investments, while his extensive experience in the alternative asset industry and proactive work ethic has enabled him to help create awareness of and raise substantial funds for offerings in the industry.
The private credit sector has seen strong growth in recent years due to a confluence of factors. These include:
- Changes in regulatory guidance for banks in the wake of the financial crisis of 2008: Banks have cut back on lending to private companies, especially in the middle market area, in response to regulatory changes that force them to be more cautious when originating loans.
- Challenges associated with being a public company: Increasing regulation with regard to public company disclosure in the wake of accounting scandals and other malfeasance has served to increase the costs being a public company by increasing the amount of disclosures required of public companies.
- Additionally, the quarterly reporting requirement associated with being a public company means that investors are prone to react harshly in the short run when a firm’s results fall short of expectations. This can place added pressure on management to perform in the short run that may detract from the company’s ability to do well in the long run.
Gareth Henry has seen firsthand the movement into private credit and equity deals among institutional investors. In an interview with Ideamensch.com, he addressed the trend towards direct deal and single asset investments in both private credit and private equity: “You’re already seeing and will continue to see large institutions making major individual co investment decisions which will change the landscape in direct investing, this is really fascinating.”
What makes Gareth Henry so well equipped to navigate the complicated world of private credit deals?
His unique combination of mathematical training and industry experience has played a significant role in helping him build a successful career in the alternative assets industry. Henry’s extensive experience in the sector has seen him named Head of International Investor Relations for Fortress in the firm’s London office, where he created and executed a sales strategy to address institutional and fixed income product lines for the firm’s hedge fund, fixed income, credit, and private equity lines of business. Subsequently, Gareth Henry was named Global Head of Investor Relations at Fortress Liquid Markets. At this unit, he oversaw a team that targeted clients around the globe for all sales, marketing, and client services activities.
Prior to joining Fortress, Gareth Henry was employed by money management firm Schroders in London, where he worked as Director of Strategic Solutions. He also worked as an investment manager for SEI Investments in Philadelphia and London and as an analyst for Watson Wyatt LLP in London. He received a Bachelor of Science degree in actuarial mathematics from the University of Edinburgh in Scotland.
Gareth Henry has combined the precision thinking of a self-proclaimed “math geek” with hard work and a personal touch that facilitates relationship building to develop an extensive network of contacts at pensions funds, sovereign wealth funds, insurance companies, and other capital sources. In discussing the inspiration behind his firm, Henry stated: “I was always drawn to the way that finance and mathematics merged in so many ways, and once I developed an understanding of economics and risk management I was hooked. I think what made the difference for me was that I had a knack for talking to colleagues, clients and even strangers about their investments in a meaningful way, which not all students of mathematics can do. So, I naturally gravitated toward investor relations and raising capital.”
“I was always drawn to the way that finance and mathematics merged in so many ways, and once I developed an understanding of economics and risk management I was hooked.”
Types of Private Credit
When it comes to private credit, Gareth Henry’s wide experience in the sector is essential to staying on top of all the latest developments in the field. This is crucial in a sector with such a wide variety of product types and investor preferences. Given the customized nature of many of the product offerings in the sector, he finds that keeping in constant contact with his clients is essential. “I believe that I can’t truly serve you as my client unless I have a complete understanding of your needs, as well as the needs of the organization I’m working to help grow” he said. “With that in mind, I make a minimum of 8-10 calls to clients per day, plus at least two face-to-face client meetings.”
Private credit funds run the gamut from those focused on providing steady income streams while preserving capital to those that take on high degrees of risk in order to create the opportunity to generate a substantial IRR for investors.
The following focus areas can be used to categorize private credit funds:
- Mezzanine Loans: Funds specializing in mezzanine loans generally book junior capital investments, in many cases consisting of debt/equity hybrid instruments in both small and mid-sized companies. Historically, mezzanine loans were junior financing helping to fund mergers and acquisitions. Managers of mezzanine funds generally make loans that are subordinated to secured credit to finance buyouts of middle market firms, realizing the majority of their return as a result of interest payout rates often in the double digits. Extra return may be generated by paid-in-kind (PIK) interest and prepayment penalties. Mezzanine funds can in some cases gain equity participation via warrants.
Given the limited potential for extra upside, mezzanine lenders must be extremely sensitive to risk when evaluating potential deals. If credit losses are substantial, they can easily erode gains from any equity appreciation in other parts of the portfolio. Given the higher risk associated with subordinated lending, such funds typically aim for returns of from 10 – 15% or even more, depending on market factors. They often feature a lock-up period typically ranging between 6 to 10 years, during which investor liquidity is likely to be restricted.
- Senior Loans: Senior loan funds typically involve direct lending via first or second lien loans to mid-sized and smaller companies. These funds take an approach similar to mezzanine lenders in that they often work with private equity funders to help finance buyouts and corporate expansion efforts. Their returns are typically generated by current interest payments comprised of a floating rate made up of a stated credit spread based on the implied risk of the loan and an associated rate of reference such as Libor.
Senior debt funds engaging in direct lending focus on loans where they can acquire a senior position. It is important to understand the nuances of the type of deals that can be found in these funds. These loans should be carefully analyzed to properly gauge their riskiness as, in some cases, a direct lender may refer to a loan as senior because it has priority over all lenders other than those making first-lien loans. Senior debt funds focused on direct lending may be leveraged or unleveraged. Returns targeted typically vary from 6 – 10% for unleveraged funds, with leveraged funds at times realizing returns in the mid-teens as a result of their riskier approach.
- Capital Appreciation Strategies: Capital appreciation private credit funds look to generate returns more typically associated with private equity investments. These funds seek to invest in debt or instruments similar to equity investments that act as substitutes for private equity. The borrowers are often closely held firms that are looking to bring in capital but unwilling to give up control. Thus, such borrowers may use structured equity or subordinated lenders to raise the needed capital. Finding appropriate opportunities of this type typically requires a network of contacts who can identify promising opportunities. Because borrowers in these deals want to avoid giving up control, a fair amount of creativity may be required to design an investment instrument suitable for both lender and borrower.
Investments of this type are often made in instruments consisting of direct investments in middle market and lower middle market firms. The instruments often consist of preferred equity tranches or subordinated debt, thereby providing capital without stepping in front of senior creditors or resulting in dilution to equity stakeholders. They generally fall somewhere between senior debt and equity ownership in the capital stack and are most commonly used to provide capital for acquisitions or to fuel growth at higher-than-average rates in order to avoid diluting equity shareholders.
Often private credit funds aiming for capital appreciation will contain a mixture of debt and equity-like instruments. Instruments structured as debt will often have more substantial covenants and other forms of protection such as liens than equity-like instruments as a means of reducing risk. The typically high interest rates associated with these instruments also serve to offset the potential risk of such investments. The riskiest of these funds have liquidity, risk, and return characteristics similar to that of private equity, which can result in such funds being grouped with private equity allocations.
- Distressed Credit: Distressed or impaired credit usually refers to a strategy targeting debt sourced from middle or large capitalization firms that have experienced a negative credit event of some sort, such as a default or restructuring. These funds look to buy steeply discounted debt instruments trading either in public markets or directly from the owners. Once the debt is purchased, managers may pursue a variety of strategies to maximize their returns.
Some managers will negotiate with borrowers to enhance returns by using their position as a debtholder to win concessions from the borrower. Others may calculate that the investment price of the instrument will benefit from upcoming catalysts such as a refinancing or an improvement in the company’s business position.
Managers operating in this sector often possess extensive analytical resources which enable them to research the legal and economic issues associated with distressed credit. They will often work with other similar investors to maximize their negotiating leverage. By purchasing debt securities at what is often a deep discount, their returns are generated based on their ability to reduce this discount as a result of value-creating events they either actively or passively take part in. The average return targeted using such strategies is generally in the mid-teens or higher. A main risk of these strategies stems from the need to involve a variety of different entities in a restructuring, which can complicate attempts to achieve a mutually beneficial resolution.
- Business Development Companies: A business development company (BDC), provides “significant managerial assistance” to the companies to which the BDC extends loans. Most BDCs are considered to be RICs from the standpoint of taxation, making them subject to more regulatory scrutiny than most private credit funds.
- Specialty Finance: Private credit funds using specialty strategies are involved in a variety of niche approaches to debt investing. Managers of such funds typically choose one sector to focus on, hoping to benefit from their specialized knowledge in the area. A major subsector of specialty finance is the purchase of NPLs (non-performing loans). Some other segments include life settlement funds, catastrophe bond funds, and funds generating royalties from music and pharmaceutical sources.
Investors in these funds may find it challenging to perform adequate due diligence as a result of the specialized nature of the investments contained within the funds. Given the specialization needed, funds of this type can provide relatively high returns, depending on the level of risk involved, ranging from the mid-single digits up to the teens and higher. While these funds generally feature long-term lockups, in some cases they offer shorter-term lockups than are generally found in the private credit universe.
Private Credit Investment Management Process & Strategy
Private credit fund managers take a variety of approaches to fund management, depending on the type of fund. Managers of distressed or impaired credit funds typically take an active approach to creating value, while mezzanine and senior debt fund managers generally take a more passive approach to generating returns once a loan has been made. Managers in charge of NPL funds use either their own staff or hire others to contact debtors who have defaulted to try and negotiate a new payment plan that entices them to resume making payments on the loan.
When it comes to an exit plan, most private credit funds will either refinance themselves or liquidate their assets and distribute them to their investors. The vast majority of such funds typically invest in assets with a specified lifespan or with predictable cash flows. This serves as a point of differentiation between these funds and other alternative strategies such as private equity investments which offer less predictability in terms of both payout timing and return levels.
In working with firms offering private credit investments, Gareth Henry’s operating philosophy emphasizes collegiality as a means of enhancing synergy. Along these lines, he stated: “Always solicit feedback from your peers, your team and clients. Many people are afraid of feedback, but it’s key to understanding the internal and external dynamics you’re operating within.”
“Always solicit feedback from your peers, your team and clients. Many people are afraid of feedback, but it’s key to understanding…”
Private Credit and the Economic Cycle
During the full course of the economic cycle different private credit strategies may fare better or worse depending on their focus. Funds that specialize in distressed debt will tend to find the most opportunities during an economic downturn, while mezzanine and senior debt funds are less likely to find such periods to be to their liking, as any debt defaults due to a downturn can substantially reduce the performance of these types of funds. On the other hand, if they are able to initiate such investments during the start of a positive economic cycle, their holdings stand to benefit as the economy recovers.
Senior debt lenders are typically better equipped to weather a downturn than mezzanine lenders who are beneath them in the capital stack, especially if they have been thorough in their evaluation of the borrower’s collateral. Additionally, if they have made mostly floating rate loans, they are less likely to suffer if rates for comparable loans rise. The performance of specialty lenders over the course of an economic cycle will typically depend on their individual strategy.
Along with the potential for enhanced yield and higher returns, private credit funds feature various levels of risk. In addition to the risks previously enumerated and the standard risks found with any fixed-income or hybrid equity investment, private credit features other risks that should be taken into consideration, including:
- Leverage: Some private credit managers utilize leverage to boost their returns, but this can also increase risk. This is seen most often at the fund level in senior debt funds, as financing subordinated debt is generally considered a dicey proposition by most lenders. Leverage can significantly boost the returns a senior debt fund offers, so most of those in existence currently offer levered options. However, while leverage can juice returns during good times, during a recession or financial crisis lenders may cancel credit lines, adding to the risk of using leverage in a portfolio.
- Style drift: A private income fund that claims to focus on making loans to middle market businesses but expands into consumer NPLs is an example of style drift. When this happens, risks that investors have not accounted for can be introduced into a fund.
- Management capacity: Some private credit strategies lend themselves to rapid expansion, but unless a clear process is in place to manage this expansion, inefficiencies can creep into the operations of the fund’s manager. As a result, investors should pay close attention to a manager’s ability to scale up its operations if its business is expected to expand significantly over time.
- Legal Jurisdiction: Debt investors should take care to be familiar with the rules of the legal jurisdiction in which they operate. Different countries and territories within those countries may take different approaches to the rights of creditors in any dispute. Some jurisdictions are seen as more favorable to the rights of debtors than others. Thus, the risk of encountering a location-related legal setback should be considered when evaluating the geographic dispersion of a fund’s holdings.
The growth of private credit investment opportunities demonstrates the financial industry’s continuing ability to find innovative ways to enable investors to meet their goals. With a wide variety of offerings within the category, thorough due diligence is needed when considering an investment in the asset class. Gareth Henry’s extensive experience with alternative investments in general, and private credit in particular, has enabled him to position himself and his firm as a valuable resource to companies looking to spread the word about and raise funds for their offerings in the sector.
Gareth Henry has found that keeping his ear close to the ground helps him stay abreast of all the latest trends in the world of private credit investing. In this regard, he said: “Making sure you are constantly talking with clients is also very important, because it’s key to get a full picture, a full texture of what your clients’ needs and goals are.” As the sector continues to evolve, the services he and his firm provide look to become only more relevant as investors grow increasingly comfortable with private credit investments.
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