How do you select the best private debt funds?
In this second issue of Horizon Private Equity, Stéphane Molère interviews Pierre-Olivier Desplanches, Co-Founder and Managing Director of Archinvest, to discuss a little-known topic in the private asset world: private debt. Why is this asset class attracting more and more investors? What are its advantages, risks and positioning in the current context?
Can you briefly take us back over your career and tell us about Archinvest?
Pierre-Olivier Desplanches: Yes, of course. Archinvest is a digital investment platform that enables individual investors to invest via their asset manager in leading private equity and private debt funds. The idea is to select for our investors the most difficult-to-access funds, which have performed over a very long period and have been established for many generations. We first select the strategies we consider relevant to the market environment. Today, we have selected three: primary LBOs, secondary LBOs and private debt, which we are going to discuss today. The Private Asset universe includes equity, debt, infrastructure and possibly even real estate.
What role does private debt play in the private asset ecosystem?
P-O.D: We need to go back to the origins of these private debt funds. If we go back to before 2009-2010, when we financed an LBO deal, we turned to traditional banks. These were specialized companies within banks, such as Société Générale, BNP and Crédit Lyonnais, with teams dedicated to LBO financing. Then, in 2009-2010, the global crisis hit. In addition to very poor visibility and banks becoming relatively skittish, there was also Basel III, which imposed very strict constraints on private equity financing in terms of cash consumption on their balance sheets. As nature abhors a vacuum, while private equity funds remained active even in 2009-2010, and were still agile enough to set up LBO deals, some people saw an opportunity and decided to create private debt funds based on the same model as a private equity fund, except that instead of financing the equity part of the LBO, they would finance the debt part.
So private debt funds only finance LBOs in the private asset universe?
P-O.D: The private debt funds we work with are funds that finance only LBO transactions based on a single tranche of debt that we call unitranche. The funds we have selected, which we'll talk about in a moment, are mainly focused on senior debt.
Can you explain the different types of debt and why you're focusing on senior debt?
P-O.D: Indeed, the least risky is senior debt. Why is that? Because you're the first to be repaid when the company is sold. Then you have what we call junior or mezzanine debt. So, you go behind the senior debt. So, obviously, if things haven't gone very well, we'll pay off the senior debt first. And if there's any left over, we'll repay the subordinated debt. And then, if there's any left over, we'll repay the capital. So, if we look at the financing structure of an LBO, the senior debt is the least risky part of the package, because we are the first to be repaid.
In today's world, if I'm a company and I do an LBO, can I still go to the banks? And if so, why? And for what type of debt? And if not, why do I need to go to the funds? And is there a difference in the cost of debt between banks and funds?
P-O.D: You've asked all the questions that are effectively points of distinction. So, as we said, before 2009-2010, 100% of the market was in the hands of traditional banks. Today, you have to bear in mind that over 70% of LBOs worldwide are carried out by private debt funds. Basel III regulations have had an impact on banks' appetite. And today, we're going to see banks mainly for fairly traditional assets, deals that we'll call "plain vanilla". As soon as things get a little more complicated, or involve a sector that the banks know a little less well, they're much more cautious. Today, what's interesting is that we're in an environment where visibility on the economy is relatively hard to read, so banks are very cautious. So, for example, a company they would have financed four years ago with 4 times operating income in debt, today it's more like 2 times. As a result, many LBO deals don't work with just 2 times debt. We are therefore obliged to go and see these famous private debt funds, which are, in quotation marks, more investors at heart. Rather, they come from subordinated debt, and had seats on the Board of Directors, and therefore often shares in the capital gains, even if they didn't vote. As a result, they analyze the company through a slightly different prism than the pure investment banker, who is much more conservative. This gives them access to higher quantums of debt, which are obviously more costly, though often necessary to set up an operation. And as these are unitranche debts, there is no amortizable part as in bank packages, where an A tranche is amortizable and a B tranche can be repaid in fine. Here, everything is repaid at maturity, so only interest is payable. This means you can invest much more in your business and create more value.
What rates can we expect, either for the funds when they lend money, or for the investor when he invests in this type of fund? Why have we selected this strategy today?
P-O.D: I wouldn't have suggested this four years ago, when we were in an environment of negative or zero interest rates. Today, the level of Euribor and Libor in absolute terms has been corrected somewhat over the past few months, but remains relatively high nonetheless. As a fund, you'll be charging margins of up to 8% in some cases. When you add the Euribor/Libor average, you can be looking at 11-12% interest coupons. And today, given the level of Euribor and Libor, we offer a product that can return between 8% and 10% net to the investor's pocket in terms of annual IRR.
These are funds that deploy over what period of time and return the funds over what period of time? Does this sound like the LBO funds themselves?
P-O.D: You'll be working with LBO funds that have identified a target and are looking for private debt funds to finance the operation, i.e. the debt part. So, in effect, these are successive drawdown funds, like LBO funds. You deploy the money over several periods. In general, you deploy the money over 4-5 years, like an LBO fund, because you're going to support LBO funds in these operations. The specificity is that often, when an LBO goes well, the investment fund will seek to refinance the debt along the way. They say to themselves: "Well, the operating profit was 20 million when I bought it, but now we're at 30. I'll be able to take on more debt. And with this new debt, we pay down the existing debt and, with the surplus, we can invest in the business. When you're invested in private debt funds, often by year 4, you're repaid part of the face value or the face value of the deals that have been made, because the funds have refinanced. This is why the life of a private debt fund is a little shorter. It's 8 years instead of 10 in a traditional LBO fund.
How do we protect ourselves against this risk, and what collateral do we take out when we're a private debt fund?
P-O.D: You select the managers you know, those who know how to choose the right assets and bring a lot of value to the table. Then, within the framework of our fund, we have diversification across roughly 4 funds. We have 3 managers, but 4 funds, and 200 underlying companies. Because we've chosen managers who hunt different prey, there's no risk of overlap. Already, when you have 200 geographically and sectorally diversified companies, you obviously take less risk than when you follow a single manager. But it's also linked to the very nature of these players who, as I was saying, are much more investors at heart. A private debt fund sets financial ratios. If ever the financial ratio is broken, because, for example, you're underperforming, a red light goes on, and we sit around the table and talk to the investment fund to find a solution to remedy the broken ratio. And if ever the fund realizes that the investment fund shareholder isn't doing the right thing, in certain cases, albeit rare, they will take the keys, i.e. they will, because the documentation authorizes them to do so, take control of the company. So, they sit in the driver's seat, ask the fund to leave, and they're the ones who run the company
Obviously, in these cases, their aim is to return the nominal amount, but often they return more and thus generate a capital gain.
What is the entry ticket for the Archinvest Dette Privée 1 fund? How far along are you in terms of fundraising, and how long does it remain open?
P-O.D: The minimum investment in the Archinvest Dette Privée fund is €100,000. If you are an investor who has already invested in professional funds, the minimum ticket is €50,000. Today, it is more than 50% deployed, so an investor arriving today already benefits from many companies that have been bought. He's obviously getting closer to the date when we'll start repaying him the first nominal amounts. And it's a fund that should close around September this year. Because we have a huge appetite for this asset class which, ultimately, generates a very attractive return with very moderate risk-taking, given that you're dealing with mainly senior debt with great diversification and managers with a track record over a long period.
Private debt offers between 8 and 10% yield, low volatility, fairly well-protected assets (we're not going to talk about guarantees), a minimum investment of €100,000, and you have until after the summer to decide to invest.
