Debt funds seeing pricing pressure on excess capital

A report from bFinance shows funds are beating capital-raising expectations, leading to pricing pressure and more dry powder.

Debt funds are beating expectations when it comes to raising capital. While this shows the popularity of the asset class, it also means managers have more dry powder to deploy and face greater price competition than in previous years.

A new report from bFinance notes the level of dry powder in debt funds in 2016 was greater than in previous years. As of June 2016, debt funds held $223 billion in undeployed capital, the report notes.

This is amid a backdrop of funds beating expectations when it comes to fundraising, Dharmy Rai, associate at bFinance, told PDI. In particular, she noted recent fundraising activity from Hayfin and Alcentra vastly beat original targets. “Obviously, there’s a lot more capital being raised than initially planned,” she said.

Dry powder shouldn’t remain unused for long, however. There is still a funding gap, Rai noted, with banks retrenching from lending to certain companies. Managers with strong sourcing capabilities should be able to find enough deals to deploy capital, she added.

When capital is deployed, however, debt funds can expect an increasingly competitive landscape. This may result in increasing pricing pressure and less covenants on loans made to businesses, Rai said. It also might result in more funds focusing on niche strategies as managers try to differentiate themselves.

One area the report notes is increasing competition is the senior loan fund space. With demand for senior debt high among investors, spreads have tightened and managers are taking steps to keep returns at targeted levels.

Specifically, the report notes leverage on senior loans has increased from 3.5 times in 2012 to 4.4 times in 2016. While the report notes higher leverage does not necessarily translate to greater risk, it also notes terms of loans have shifted to become more borrower friendly.

To maintain returns in senior debt strategies, Rai said some funds are stretching the definition of the strategy to include lower-rated and higher-yielding debt. Other offerings might deploy a pure subordinated-debt strategy to complement a senior debt portfolio, she added.