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Selby Jennings Credit Market Update Q1 2019

Date: 25 February 2019

After an extremely turbulent end to 2018, credit market investors more than ever in recent memory seem to be taking a hard look at their strategic plans. Stocked with piles of fresh capital but struggling to generate deals with sufficient yield potential across familiar strategies, our clients have generally sought to broaden their mandates, and are seeking new talent to meet these pursuits. Below, we share some key themes that we saw in 2018 as well as our outlook for 2019, with a particular focus on hiring implications.

 2018 Trends

One thing is for certain: our private credit clients had no trouble whatsoever raising capital in 2018. Consistent with a trend of the last several years, investors continued to rotate assets away from public markets with excess volatility and subpar performance in favor of private markets that offer the prospect of higher yield derived from manager skill. According to Preqin, a total of 163 asset managers secured $110bn of investor commitments during 2018, and over $45bn of that capital (~40%) was allocated to direct lending fund strategies. Given the amount of fresh capital coming in the door, many firms were hiring across all seniorities and needing to compete aggressively for a finite talent pool.  

For investors, the dramatic pullback in markets during the latter portion of 2018, signaled impending stress in a more meaningful way than several other temporary shocks of the last several years. For our distressed/special situation clients we saw a number of active hiring mandates as firms anticipate a reversal of the credit cycle in the short to medium term. Our clients operating in this model made hires to ensure that that they have the appropriate company/sector coverage and ability to invest rapidly in response to compelling market events. Other clients have taken a slightly more wait-and-see approach, electing to sit on capital for the moment and to hold off on adding headcount until the direction of the market reveals itself further.

We see investor demand in nearly all sectors of private credit, but we think it most relevant to comment on the growth we’ve witnessed in structured products. We’ve seen our clients—some with a longstanding involvement, others with a newfound interest—migrate to this asset class given supply growth from many issuers representing many different underlying assets and a varied range of risk/return investment opportunities for different client mandates. Of note, CLOs were white hot in 2018—a record year of issuance—for a variety of reasons.

2019 Outlook

In our view the end of 2018 left most of our clients flocking into one of two camps for 2019: Defense or Offense.  This dynamic is captured best by our client’s reactions to the rapid market meltdown that began in October 2018. Many clients, as in years past, continue to believe that economic fundamentals remain strong, proclaiming that this pullback is just another example of the market crying wolf.  This cuts both ways though: clients who believe markets are healthy face an increasingly difficult investing environment in which they must find new niches, as demand exceeds the supply of traditional quality opportunities. For other investors however, this pullback left a more lasting impression that inspired change in their approach going forward, including actively supplying the coffers for a stressed opportunity set on the horizon. Regardless of which position you are playing, there seems to be one rule that is the same in everyone’s playbook: 2019 cannot look the same as 2018.

"The combination of the specific events witnessed at the end of last year and the sense that we are late in the credit cycle, has forced a number of firms to figure out how to best be defensively oriented going forward."

Many of our clients believe that it is undeniable that the economic cycle is deteriorating, and the current investment landscape is poised to perform poorly if/when economic conditions change. Therefore, they’ve chosen to focus on strategies, including building new ones, that will protect them for when the inevitable market turn happens.

As mentioned as a major growth area in 2018, CLOs – as well as structured products as whole - are continuing to be very appealing to investors in 2019. CLOs remain attractive not only because they present a hedge on rising interest rates, but also because the riskiest pieces of CLO capital structures have tended to perform well in periods of corporate stress. More generally, structured products as a whole, are appealing to a wide range of investors in potentially turbulent times. Structured products’ multiple tiers of securities allow investors to hone in on their desired appetite for risk, while providing liquidity and hedging opportunities – classic defensive attributes.  We’ve seen our clients invest heavily in hiring the right talent—either individuals or entire teams—to understand and invest properly in this space.

Another prominent approach many clients are taking to ensure they are ready for when the cycle turns is lifting out specialized distressed teams or proven individuals in the space to join their firm. Several firms have come to the realization that buying is easier than building, and they want to make sure they are prepared and ready to deploy capital nimbly when needed.

"In contrast, many firms are cognizant of a competitive market and are full steam ahead in terms of finding new niches to invest in, as traditional spaces become more crowded."

One of our almost universal observations is that clients are wanting/needing to expand their mandate box in 2019 in order to run their businesses.

Continuing a multi-year trend, 2018 was another banner year for private credit capital raising. From a demand standpoint, the asset class still presents investors with interesting risk-adjusted yield and more control of a lending relationship. And Borrowers continue to seek private debt shops to help fill the gap that continues to remain between what companies need and what Wall Street capital markets are best designed to handle. Overall, the market is characterized by competitiveness however, and certainly the prevailing investor sentiment is that traditional opportunities have gotten less interesting with more risk and less protection. All the while investors’ expectations of asset managers aren’t dramatically different than in years past. What this means is that firms have been forced to be find new pockets and new structures to achieve the same results.

Strategies vary, but most firms seem to be responding to this by broadening their capability set, even if marginally. Example of such pivots include (i) working down-market from a sizing standpoint, including with less instuitional management teams, (ii) expanding industry coverage, and (iii) seeking to blend private equity activism with a more traditional arms-length lending relationship (leading very often to what is referred to as ‘bespoke’ investment structures).This sounds easier than it is: in our view, firms are cognizant that venturing into new spaces and deploying capital in different ways is fraught with risk. We’ve seen firms respond to this by actively hiring subject matter experts versus taking the plunge on their own.

Beyond just sharpening their focus within corporate direct lending, clients have also begun applying traditional corporate fundamentals to the world of asset-based investing in a variety of spheres such as hard assets (real estate, aircraft, infrastructure) and non-traditional, non-bank consumer and commercial loans. While still small in the grand scheme of things, this last sector—specialty finance—is drawing interest from investors as a source of incremental yield, with supply being provided by a number of originators backed by venture capital or private equity sponsors. Asset managers are participating in this space both through direct deal structuring as well as through various structured product vehicles. We’ve seen firms—particularly those more accustomed to traditional corporate investing - consistently willing to compete for talent in these verticals.

Hiring Trends & Advice

Most industry participants know that asset managers are fiercely competing for deal flow.  What is less commented on, however, is how these same firms are vying for the talent to execute their business plan. We’ve seen this not only at the individual level, but also with respect to entire teams—where firms are clearly understanding that to buy is easier than to build.

Our most marked observation is that firms are needing to differentiate and specialize more and more—and at scale—given the amount of capital that has been raised in private credit. We’ve generally found that clients, rather than thinking that they can enter new spaces on their own, are placing a premium on being able to hire the correct talent in a turnkey fashion. We think this approach makes sense.

This dynamic has led to a candidate-driven market, particularly at the more experienced end of the spectrum. What’s more: the candidates know it. From a practical standpoint what does this mean? It means that clients should be aware that candidates are very often in multiple processes (typically 3-5). It means that clients need to move rapidly with attractive candidates with an emphasis on process efficiency. The days of candidates accepting being placed in a quasi-limbo are over.  Clients have been shortening their processes and cutting down the number of rounds or case studies, with an emphasis on getting to a yes/no decision more quickly.

Consistent with above, our view is that our clients should push extremely hard on candidates that they want.  Our historical experience is that clients who are first in line to offer candidates tend to get the result they want by virtue of creating a good attachment point. Furthermore, given that candidates are very often in multiple processes, we believe that putting forward a strong credible offer is the best strategy. We believe that candidates will do a benchmarking of all initial offers and choose one or two paths from there. Our experience has been that candidates do not want to negotiate 3+ offers.

We’ve also seen firms changing the general timing of their hiring needs. In years past it was quite commonplace to wait until after year-end bonus season to recruit. This dynamic is eroding today. We are seeing more and more firms willing to shoulder candidates’ forthcoming bonuses and other compensation in order to secure talent earlier rather than later. Of course, there is some inherent ambiguity and risk in this negotiation, but we’ve found that employers are choosing to focus on the bigger picture.

Another factor that we think our clients should understand is that candidates’ incumbent employers can and will counter prospective offers, including by offering promotion. It’s hard to quantify scientifically, but we’ve found that candidates express a tone of far more confidence in today’s environment. Furthermore, we’ve found that the compensation premium that candidates expect to justify the friction of a job switch is as high as it has ever been. Candidates are placing enormous value in their own capabilities—rightfully so—and expect prospective employers to acknowledge this in many ways.

5 Ways to Attract & Maintain Top Talent

While our clients are keenly focused on hiring to meet future needs, the firms that we work with are focused to an even greater degree on retaining top talent that has been institutionally trained within well-defined strategies over multiple years. While a full discussion of employment satisfaction is beyond the scope of this write-up, we’d like to draw clients to a few of our notable observations within asset management as it relates to candidates seeking alternative job prospects. These findings can be applied to both retaining existing talent as well as recruiting new talent.

Flexible Mandate: This is the number one topic that candidates mention when they describe the ideal firm they are looking to transition to.  Simply put: we believe that top-flight candidates want to use their brains! Candidates are looking for their career to feature diversity of industry, structure, etc. out of intellectual curiosity. Candidates want to be challenged. Furthermore, we believe that firms with flexible mandates appeal to candidates insofar as they present the prospect of there being deal flow agnostic of market conditions.  We’ve consistently found that candidates do not want to feel like their employment could be at risk. This finding generally syncs with other growing trends we are seeing in the industry: namely candidates being more-focused on partner track opportunities and more secure career paths.

Culture: Whether it is a junior candidate looking for an environment conducive to more mentorship or more opportunity to showcase their capabilities inwardly/externally or a senior candidate looking for a more pronounced voice at the investment table and/or the opportunity to develop their own team/strategy, culture is one of the main driving factors that motivates job transition.  What this boils down to is that candidates of all levels want to feel like they have an outlet to express their opinion and exhibit some degree of entrepreneurship versus simply falling into line. More often than not, firms do not realize that they aren’t implementing a good culture until it is too late.  For what it’s worth, developing a good culture is not easy. But, what we’ve found over and over again, is that candidates ascribe real value—often taking an offer with less overall cash compensation—to clients that are known to have and can articulate a good cultural experience.

Growth: This is a key influence for more mid to senior level candidates.  On the one hand, this applies at the firm level. Not to state the obvious, but candidates are more cognizant than ever of a firm’s recent fundraising and growth prospects. Immediate compensation is not the only factor that matters—candidates are increasingly looking at the slope of their compensation curve by considering the overall health of their employer. Furthermore, building off of earlier comments, highly-motivated and intelligent candidates value increased responsibility within a sphere of knowledge or a widening of their coverage in general. And this too is true regardless of compensation. We’ve consistently found candidates who are generally content with their compensation levels seek a chance to do more with their career. It is incumbent upon firms to clearly articulate this growth roadmap and to expect to be held accountable for it. We commonly hear a job switch refrain to the tune of a candidate being dissatisfied with their actual growth story compared to what was sold to them during the recruitment process.

Diversity: We believe that candidates and firms—as well as underlying fund investors--mutually value diversity across a number of dimensions. In our experience, highly-desirable candidates exhibit a great deal of creativity in the workplace and seek out environments that promote this energy. Consistent with the points made above, we believe that candidates associate diversity with culture and growth; we believe that these attributes promote the idea of unique career path, something that candidates strongly desire. And from the firm perspective, we believe that more than ever in a rapidly changing/expanding marketplace, firms are placing on emphasis on diversity as a means of reaching an ever-increasing sphere of knowledge, sourcing capability, and tangible investment opportunity.

Compensation: Last, but certainly not least, it should come as no surprise that in a market as competitive as ever, candidates expect to be compensated well and often choose between multiple offers on the basis of compensation above all else.  But beyond just strict dollars and cents, we’d specifically like to call attention to several prevalent things that resonate with candidates, namely around a theme of certainty. For one, we believe that candidates place a premium on guaranteed versus total potential compensation, at least in the early going. Second, we believe that in terms of short-term and long-term incentives, candidates are drawn to firms that are able to articulate a clear, somewhat formulaic methodology. We believe that candidates like to understand this both in terms of individual and firm-wide outcomes.

Conclusion

2019 has already been a more aggressive year in regards to hiring and expansion during Q1 than past years. Beyond the battle for deals and returns, the competition to find specialists and top talent is fiercer than ever.  If you feel strongly about a candidate and do not want to risk losing them, move forward quickly. While it is important to always be looking for top talent to join your firm, make sure you are retaining the talent you have – because once candidates find a reason to explore opportunities with your competitors, it is extremely difficult to eradicate the root cause and show that you value them. Overall, no matter what side you are playing, it is an exciting time to be an investor in the credit market, with lots of changes happening and a number of different paths to achieve success in 2019 and beyond.