Answer to a direct hit

With pricing pressure hitting direct lending funds, investors may become more likely to consider multi-strategy debt funds. But can direct lending fit into such offerings?

Like a fine whisky, it is not unusual for direct lending strategies to include a subtle blend of ingredients. Even funds marketed as senior debt often participate in deals further down the capital structure as managers find opportunities to increase returns.

As direct lending funds become larger, and pricing competition continues to put downward pressure on returns, there is talk that some managers may start to increasingly champion multi-strategy debt products that include a direct lending element. Such funds would offer investors non-correlation and senior-debt type returns with the added benefit of giving fund managers more flexibility over their holdings.

This flexibility doesn’t necessarily come easily. One fund manager recently told PDI such an offering has to be careful in its asset allocation since tactical changes to a multi-strategy portfolio are less than straightforward if too many investments are tied up in illiquid assets.

It means multi-strategy debt offerings may have to deprioritise direct lending investments in favour of high-yield bonds or loans. There may be some room for a sleeve of illiquid assets, but these can only be made with a manager’s overall strategy carefully taken into account.

So, how does such a multi-strategy fund product compare with a direct lending offering? One manager recently told PDI his multi-strategy fund, which doesn’t contain an allocation to direct lending, is targeting LIBOR plus 450 basis points.

This figure comes in slightly below where many direct lending funds market themselves, with many offering IRRs 5-12 percent depending on where in the capital structure they’re investing. Distress-focused products are sometimes able to offer returns in excess of 20 percent.

It’s tough to compare direct lending funds with multi-strategy credit offerings. The latter often have provisions allowing investors to access capital following a redemption request and lock-up period. Direct lending funds seldom employ this mechanism.

What can be said, however, is that while multi-strategy credit funds are achieving only mild popularity currently, direct lending is booming.

Credit-oriented hedge funds – which commonly deploy a multi-strategy approach – have pulled in just over $4 billion globally during the first half of 2017, according to figures from eVestment. By comparison, direct lending funds are set for a near record year in terms of fundraising – $36 billion was raised by direct lending funds holding a final close during the first half of 2017, according to PDI data.

Market sources say direct lending may find its way into multi-strategy funds despite the liquidity issues. If so, it could offer a continuing direct lending exposure to investors fearful of what effect a highly competitive mainstream direct lending market may have on returns.