[Interview] Carlyle sees niche in opportunistic credit for mid-teen returns

Opportunistic credit is becoming a growing form of credit strategy, offering steady mid-teen returns with a low principal loss risk, compared with syndicated loans and direct lending for which increasing competition is cutting expected returns, said Carlyle Group’s global credit head.

With an estimated market size of $1 trillion, opportunistic credit is about providing funding to companies which need credit to finance acquisitions or recapitalization, or face special situations for a lower cost of capital than that of private equity funds.

“There exists interesting credit “alpha” strategy – opportunistic credit. ... This strategy seeks double-digit returns with equal or lower LTV than direct lending and powerful downside protection mechanisms, and it is a rapidly growing form of credit,” Mark Jenkins, head of global credit at the Carlyle Group, told the Korean Investors.

“Unlike other credit sub-strategies, not many large-scale alternative managers are actively focusing on the strategy yet, so the deal competition is more benign with very few transactions done in the form of competitive auctions.”

Further, neither direct lending funds nor financial institutions are capable of participating in the market yet, he added.

“At the end of the day, this strategy can be viewed as a strategy that aims for equity or mezzanine returns with direct lending-like risk,” he said in a recent written interview.

Last September, Carlyle’s co-CEO Kewsong Lee told the Korean Investors that Carlyle saw the private credit business as “a huge area of potential expansion of the firm,” noting that it placed a top priority on credit business.

In Asia, Carlyle is “cautiously exploring distress and special situations opportunities in China and India,” while seeking to offer attractive mid-return and mid-risk credit products to retail investors in the region.

Reflecting the growing presence of Korean investors in alternative investment markets, Seoul will be a new host city for Carlyle’s annual gathering of its senior investment managers from this year, after Washington DC, London and Hong Kong.

Zenkins joined Carlyle in 2016 after working for Canada Pension Plan Investment Board for about 10 years, in a rare move from the limited partner side to the general partner side.

The following are Q&As with Jenkins.

▶ Please introduce Carlyle Global Credit business group.

“Global Credit, with $45 billion of assets under management, is the fastest growing business group among the four businesses groups of Carlyle, enjoying the strong strategic supports from the top management and its founders.”

“As compared to many other credit managers who tend to focus on one or two principal strategies, Carlyle Global Credit has diverse platforms across the credit strategies, from low- risk low-return high-liquidity strategies to high-risk high-return distress strategies.”

“For the past 20 years, Global Credit has primarily focused on the US and European markets, but we plan to take a more serious look at the Asia market, which we believe will become one of the most important markets for credit strategy, as was the case with PE.”

▶ What are your thoughts on the sub-strategies of credit?

“Broadly Syndicated Loans and direct lending strategies continued to deliver attractive risk-adjusted returns, but the market competition continues to intensify as the money flows into this space.”

“Going forward, the competition should intensify more, not less. Direct lending strategies are attractive because they aim for higher returns than large-cap acquisition financing with a low-risk profile, allowing the investors to enjoy steady returns and deploy massive huge amounts of capital.”

“However, it is going to get increasingly difficult to create “alpha” from this strategy, and it will gradually become a more commoditized part of the business, with the advantage going to the larger managers with broad and diverse platforms that provide an edge in originating deal flow, better portfolio management capabilities and deeper resources and skills to manage troubled credits through a downturn. This will lead to a narrowing gap in the returns among different credit managers.”

“On the other hand, there exists interesting credit “alpha” strategy – opportunistic credit. Opportunistic credit is gaining a lot of attention from the investors as well as the investee companies. This strategy deploys designated bespoke capital to the situations that require quite sophisticated deal origination, due diligence and, deal structuring capabilities, in which direct lending funds or financial institutions cannot participate.”

“Typically, this strategy seeks double-digit returns with equal or lower LTV than direct lending and powerful downside protection mechanisms, and it is a rapidly growing form of credit.”

“Unlike other credit sub-strategies, not many large-scale alternative managers are actively focusing on the strategy yet, so the deal competition is more benign with very few transactions done in the form of competitive auctions.”

▶Why do performing companies get the financing from the opportunistic credit funds that aim for mid double-digit returns?

“The companies that get the investment from opportunistic credit funds are not the distressed companies. They are companies that seek the external financing for acquisitions, recapitalization, and many other non-recurring reasons.”

“One way to see this strategy is that opportunistic credit funds invest in the situations where the PE funds would invest in the form of minority PE. Here, the opportunistic credit funds invest in the form of debt.”

“For instance, PE funds invest in the minority stake in the company with the aim of securing 20+% PE-style return, asking for an equity stake, governance rights, exit mechanism, etc. On the other hand, opportunistic credit funds can invest the same amount by structuring the investment in the form of debt, asking for collateral, seniority, covenants, etc.”

“Opportunistic credit strengthens the mechanism for capital preservation, typically offering single-digit cash interest, some PIKs (payments in kind), and some equity upside, pursuing low- to- mid-teen returns.”

“Compared to PE funds, it can enjoy the more powerful downside protection or minimum return mechanism, while it would need to forgo the upside beyond mid-teens if the company performs phenomenally well.”

“From the investee companies’ perspective, they can get the same amount of investment from PE or an opportunistic credit fund, but the implied cost of capital is meaningfully lower in the case of opportunistic credit. They also do not have to negotiate equity valuation, governance rights, exit conditions, etc.”

“From the investors’ perspective, opportunistic credit strategy has a lower possibility for principal loss while delivering steady mid-teen returns in a steady fashion.”

“At the end of the day, this strategy can be viewed as a strategy that aims for equity or mezzanine returns with direct lending-like risk. Then it all boils down to the origination – whether the manager has the strong enough deal origination platforms. I expect the large-scale PE funds with powerful deal sourcing platforms to enter into this space continuously.”

▶ Any plan for Asia?

“Asia is a very important market for us, both on investment as well as on fundraising. We are watching closely the economic developments in China and India, cautiously exploring the distress and special situations opportunities.”

“We also explore the possibility of working with local partners of respective Asian countries to design the joint investment programs. We have seen quite interesting opportunities in Korea over the past 6-7 months as well.”

“From the fundraising perspective, the investors in Korea and Asia are continuing to get interested in credit investments. Rather than focusing on certain sub-strategy, many investors tend to invest in a broad set of credit strategies and structures.”

“Carlyle’s approach is not to push the single product that we want to sell to the investor, but to provide the “bespoke” solutions for the investors based upon the multiple credit investment platforms within Carlyle.”

“When we offer the single strategy, single product to the investor, our approach is to make sure that the entire Carlyle credit platforms should contribute to the execution of the investment strategy."

"We also explore the ways to offer the attractive mid-return and mid-risk credit products to the retail investors across Asia, including Korea, along with the local strategic partners.”

By Chang Jae Yoo

yoocool@hankyung.com

(Photo: Carlyle Group)